url
17
Apr
2014

ON THE DETERMINANTS OF DERIVATIVE HEDGING BY INSURANCE COMPANIES: DEVELOPMENT OF HYPOTHESES

Maximization of Shareholder Wealth Financial Distress
Smith and Stulz argue that risk management activities such as hedging enhances the expected firm value through reducing the likelihood of costly financial distress. Nance, Smith, and Smithson suggest further that small firms are more likely than large firms to hedge due to the greater potential impact of insolvency costs. Thus, firms with higher expected costs of financial distress are more likely to engage in hedging activities with derivative instruments.
One measure of potential financial distress is leverage, usually taken to be the debt to equity ratio. However, the liabilities of insurers consist mainly of insurance reserves. In Taiwan, the reserve management of insurers is closely monitored by the regulatory authorities and a high reserves to equity ratio does not necessarily imply a high probability of insolvency. Hence, the leverage ratio employed in prior studies might not be a suitable indicator to capture the likelihood of insurer insolvency. As an alternative to the leverage ratio we use the total amount of insurance claims and associated interests deflated by earnings before interest and tax. We expect that insurers with a higher ratio will face greater risk of financial distress and will therefore tend to hedge more with derivative instruments.
Growth Opportunities
Highly leveraged firms with good growth opportunities tend to suffer from underinvestment due to the conflicts of interest between debtholders and shareholders. Shareholders have an incentive to forego profitable investment projects if the gains arising from the project are primarily obtained by debtholders. Hedging can be used to address the underinvestment problem (Mayers and Smith, 1987). Firms with good investment opportunities need funds on a consistent basis. If risks are unhedged and losses occur, these firms will probably have to finance the losses using internal funds which were originally earmarked for investment projects. In this case, costly external funds must be raised or else these investment opportunities will be foregone. Therefore, insurers with better growth opportunities are expected to engage more in derivative hedging. Following Ross, Westerfield, and Jaffe, we define the level of growth opportunity (GROWTH) as the product of the cash reinvestment ratio and the return on equity. there
Tax
Hedging can benefit firms in that expected tax payments can be reduced when corporate tax rates are progressive. Moreover, firms with higher tax preference items (e.g., tax credits) are more likely to hedge using derivatives because these items indirectly create convexity in the tax liability (Geczy, Minton and Schrand, 1997). One can therefore hypothesize that hedging benefits will be higher for firms with more tax preference items. In the empirical analysis, the tax benefit (TLCF) is proxied by the amount of tax loss carried forward scaled by net income.

Maximization of Shareholder Wealth Financial Distress Smith and Stulz argue that risk management activities such as hedging enhances the expected firm value through reducing the likelihood of costly financial distress. Nance, Smith, and Smithson suggest further that small firms are more likely than large firms to hedge due to the greater potential impact of insolvency costs. Thus, firms with higher expected costs of financial distress are more likely to engage in hedging activities with derivative instruments. One measure of potential financial distress is leverage, usually taken to be the debt to equity ratio. However, the liabilities of insurers consist mainly of insurance reserves. In Taiwan, the reserve management of insurers is closely monitored by the regulatory authorities and a high

About The Author

Kevin J. Brandon

Home | Site Map | Contacts

Copyright © 2013 - 2019 Investment And Finance Online. All rights reserved