Estimating the Cost of Equity Capital for Property-Liability Insurers

The Wharton Financial Institutions Center provides a multidisciplinary research approach to the problems and opportunities facing the financial services industry in its search for competitive excellence. The Center's research focuses on the issues related to managing risk at the firm level as well as ways to improve productivity and performance. The Center fosters the development of a community of faculty, visiting scholars and Ph.D. candidates whose research interests complement and support the mission of the Center. The Center works closely with industry executives and practitioners to ensure that its research is informed by the operating realities and competitive demands facing industry participants as they pursue competitive excellence. Copies of the working papers summarized here are available from the Center. If you would like to learn more about the Center or become a member of our research community, please let us know of your interest. 1 Most of the important early financial pricing papers are collected in Cummins and Harrington (1987). More recent developments are reviewed in Cummins and Phillips (2001). Insurance pricing models that rely on estimates of the cost of capital are presented in Cummins (1990) and Taylor (1994). Abstract This paper presents new evidence on estimates of the cost of equity capital by line of insurance for the property-liability insurance industry. To do so we obtain firm beta estimates and then use the recently developed full-information industry beta methodology to decompose the cost of capital by line. We obtain beta estimates using both the standard one-factor CAPM model as well as the Fama-French three-factor cost of capital model. The analysis suggests the cost of capital for insurers using the Fama-French model are significantly higher than estimates based upon the CAPM. In addition, we find evidence of significant differences in the cost of equity capital across lines, indicating that the use of a single company-wide cost of capital is generally not appropriate.