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21
Apr
2014

ON THE DETERMINANTS OF DERIVATIVE HEDGING BY INSURANCE COMPANIES: CONTROL VARIABLES

Managerial ownership
Although shareholders can diversify business risk by holding well-diversified portfolios, they are unlikely to do so if they are shareholders in tightly-held companies. If the manager owns a large proportion of the company, one would expect the manager to engage more in hedging activities (Smith and Stultz, 1985), especially when the manager is rewarded with stock-related rather than option-related compensation (Tufano, 1996). In Taiwan, managers are generally compensated in the form of stocks in addition to salary. As a result, we can expect that managers with higher stock ownership would be more inclined to hedge with derivatives. In this study, managerial stock ownership (MH) is proxied by the proportion of stock held by the management.
Firm Size
Although a number of studies argue that large insurers have less need for derivative hedging from the perspective of financial distress costs and tax incentives (Warner, 1977; Altman, 1984; Nance et al., 1993), a majority of studies support the informational and scale economies hypothesis (e.g. Smith and Stulz, 1985; Colquitt and Hoyt, 1997; Cummins et al., 1997; Hardwick and Adams, 1999; Sinkey and Carter, 2000; De Ceuster et al. 2003). This hypothesis suggests that large firms are more likely to use derivatives because these firms have sufficient trading volume to make derivative hedging worthwhile, and sufficient resources to recruit and train professionals in the necessary skills. We expect a positive relation between insurer size and derivative use. Firm size (SIZE) is measured by the logarithm of the book value of total assets.
Sale of Investment-Linked Insurance
In life insurance, investment-linked policies provide not only insurance protection but also investment returns. If the investment-related risks arising from such policies are not completely assumed by policyholders according to the contractual terms, insurers offering these products are exposed to these risks. Interest rate risk and currency risk increase as the proportion of the investment portfolio invested in correspondingly higher risk investments increases. It is plausible to expect that the sale of investment-linked insurance products will have a significant effect on firms’ risk management policies. We use the proxy (INV), the notional value of assets of investment-linked insurance products deflated by gross written premiums, for the empirical analysis. this
Investment Returns
It might be argued that firms with high investment returns are generally more skilled at investment-related activities including derivative transactions. Such firms may rely on derivatives to enhance their income or hedge their risk exposure. It can also be argued that the higher returns are the result of riskier investments, and thus the firms are using derivatives to hedge against the higher risk investments. Both arguments suggest that derivative use increases with investment returns. In our analysis, investment return (IR) is measured by the investment yield, defined as net investment income divided by total assets. However, due to different product characteristics, life insurers generally pay more attention to investment returns, while for their non-life counterparts underwriting profits are of greater significance. Thus, we only consider the investment return variable in the life insurance analysis.
Local Resources
The Taiwan insurance market used to be dominated by only a very few domestic insurers before liberalization in the early 1990s. Our study investigates whether domestic insurance firms have a greater propensity to engage in derivative hedging since they have more resources and institutional knowledge of the local market than their foreign competitors. The domestic dummy (DOMESTIC) is set equal to one for domestic insurance firms and zero otherwise.

Managerial ownership Although shareholders can diversify business risk by holding well-diversified portfolios, they are unlikely to do so if they are shareholders in tightly-held companies. If the manager owns a large proportion of the company, one would expect the manager to engage more in hedging activities (Smith and Stultz, 1985), especially when the manager is rewarded with stock-related rather than option-related compensation (Tufano, 1996). In Taiwan, managers are generally compensated in the form of stocks in addition to salary. As a result, we can expect that managers with higher stock ownership would be more inclined to hedge with derivatives. In this study, managerial stock ownership (MH) is proxied by the proportion of stock held by the management. Firm Size Although

About The Author

Kevin J. Brandon

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