Risk/return Relationships for Life-Health, Property-Liability, and Diversified Insurers: Reply

Risk/Return Relationships for Life-Health, Property-Liability, and Diversified Insurers Abstract This study focuses on a risk-return comparisson for life-health, property-liability, and diversified insurers. Included is an analysis of risk-return relationships using both mean-variance and CAPM approaches. Both accounting and market data are used to measure profitability. The results suggest that for the time period of the study, 1973 through 1987, investment in individual life-health and property-liability insurers was better than investment in diversified insurers. Evidence also indicates that accounting measures of profitability may be poor proxies for market performance. This study undertakes to compare the mean returns for life-health, property-liability, and diversified insurers. Mean returns are compared both with and without adjustment for risk. Several measures of risk are used and both book and market returns are considered. The goal of the study is to assess whether identifiable risk-return advantages existed for investors in each of the three insurer segments during the period 1973 through 1987. A number of studies have been published on the topic of insurance company profitability. The Arthur D. Little (1967) report concluded that insurers were not earning excessive profits, especially on a risk-adjusted basis. Forbes (1971) and Trieschmann (1971) came to a similar conclusion. Fairley (1979) used the capital asset pricing model (CAPM) to determine the appropriate rate for automobile insurance. His findings suggested premium rates lower than those desired by insurers. He argued that only systematic risk, as measured in the CAPM, should be considered. However, Harrington (1983), in a study of life-health insurance stocks from 1961 through 1976, found evidence of a significant relationship between mean returns and both systematic and unsystematic risk. Cummins and Harrington (1988) analyzed the risk-return relationship of property-liability insurance stocks during the period 1970 through 1983. Their results were inconsistent with CAPM for the time period 1970 through 1980, but were consistent with it for the period 1980 through 1983. Cox and Griepentrog (1988) provided empirical results indicating that both systematic and unsystematic risk are important. Pritchett and Wilder (1986), in an extensive study of life-health insurers from 1950 through 1980, used mean-variance and CAPM, as well as accounting rate of return data. They concluded that life-health insurers had higher returns and greater volatility from 1950 through 1963 than during the period from 1963 through 1980. The Insurance Services Office (ISO) (1987) conducted a profitability study on the property-liability industry for the period 1970 through 1986. The study focused primarily on book rate of return and total risk. The ISO study concluded that for the time period studied, the property-liability insurance industry earned below average returns and had greater variability of returns than most of the other 89 industries examined. Research Issues This study, while considering risk-return issues similar to those investigated by previous studies, differs in several ways. First, the study focuses on a comparison of risk and return for life-health, property-liability, and diversified insurers. A key question is asked: Do investors gain by purchasing the stock of a diversified insurer versus separately buying the stock of a life-health insurer and of a property-liability insurer? Portfolio theory suggests that there would be no return advantage on a risk-adjusted basis. However, if efficiencies result from the combination of life-health and property-liability operations, then a risk-return advantage might be observed. None of the previous risk-return studies focused simultaneously on the three segments of insurers. …