FIRMS WITH MULTIPERIOD ASSET PRICING MODELS

Previous research on insurer cost of equity (COE) focuses on single-period asset pricing models. In reality, however, investment and consumption decisions are made over multiple periods, exposing firms to time-varying risks related to economic cycles and market volatility. We extend the literature by examining two multiperiod models—the conditional capital asset pricing model (CCAPM) and the intertemporal CAPM (ICAPM). Using 29 years of data, we find that macroeconomic factors significantly influence and explain insurer stock returns. Insurers have countercyclical beta, implying that their market risk increases during recessions. Further, insurers are sensitive to volatility risk (the risk of losses when volatility goes up), but not to insurance-specific risks, financial industry risks, liquidity risk, or coskewness after controlling for other economy-wide factors. INTRODUCTION Prior studies on insurer cost of equity (COE) focus on single-period asset pricing models, such as the capital asset pricing model (CAPM) and the Fama and French (1993) three-factor model (FF3). Merton’s (1973) seminal article on multiperiod asset pricing demonstrates that when investment decisions are made at more than one date, additional factors are required to construct a multi-period model because of uncertain changes in future investment opportunities. Moreover, firms are exposed to business and economic cycles. Multi-period models account for the time-varying risks (factors) that reflect these cycles. © 2018 The Journal of Risk and Insurance DOI: 10.1111/jori.12267 Alexander Barinov is at the Department of Finance, School of Business, University of California Riverside, 900 University Ave., Riverside, CA 92521. Barinov can be contacted via e-mail: alexander.barinov@ucr.edu. Jianren Xu (corresponding author) is at the Department of Finance, Insurance, Real Estate and Law, G. Brint Ryan College of Business, University of North Texas, 1155 Union Circle #305339, Denton, TX 76203-5017. Xu can be contacted via email: jianren.xu@unt.edu. Steven W. Pottier is at the Department of Insurance, Legal Studies, and Real Estate, Terry College of Business, University of Georgia, 610 South Lumpkin Street, Athens, GA 30602. Pottier can be contacted via e-mail: spottier@uga.edu. Steven Pottier gratefully acknowledges the support of a Terry-Sanford Research Grant. 213 . Vol. 87, No. 1, 213–245 (2020). In this study, we extend the insurance literature by examining two multi-period models—the conditional CAPM (CCAPM) and the intertemporal CAPM (ICAPM). These two models are examined along with the single-period models studied in the prior literature—the CAPM and FF3, as well as newer single-period models like the Fama and French (2015) five-factor (FF5) model and the Adrian, Friedman, and Muir (2016) (AFM) model with financial industry risk factors. Our empirical analysis consists of three major parts. First, we evaluate the four asset pricing models mentioned earlier (CAPM, FF5, CCAPM, and ICAPM) and consider their applicability to insurance firms by examining the relation between realized (actual) returns on portfolios of insurer stocks and the risk factors associated with each model. We show that insurance firms are exposed to volatility risk and have countercyclical betas. More specifically, insurance portfolio values drop when current consumption has to be cut in response to surprise increases in expected market volatility, and its market beta increases in recessions when bearing risk is more costly. Therefore, insurers are riskier and thus should have higher cost of capital than what the CAPM/ FF5 estimates. FF3/FF5 are also often regarded as ICAPM-type models with SMB, HML, and recently RMW and CMA acting as “placeholders” for yet unidentified risk. While a number of articles have tried to identify the risks behind these factors (Liew and Vassalou, 2000; Petkova and Zhang, 2005; Petkova, 2006; Campbell, Polk, and Vuolteenaho, 2010), the consensus as to which business cycle variables are behind the factors still has not emerged. Even more, a number of articles have contested the claim that SMB and HML are driven by risk and argued that they represent mispricing and market sentiment swings (Daniel and Titman, 1997; Baker and Wurgler, 2006). Company stakeholders might want to know not only the COE of their firm or projects, but also the reasons behind a certain rate, namely, what risks result in a high or low COE. Without risk-based explanations, stakeholders might feel uncomfortable accepting a COE estimate. The additional alternative that the factors can be picking up market-wide mispricing makes the decision even more complicated. For example, the “Model Performance and Applicability and Insurer Risk Sensitivities” section reveals that insurers tend to be value (positive HML beta) firms. If we believe that HML picks up high returns of value firms as their underpricing is corrected, should we benchmark insurers’ COE against other value firms, thus asking them to deliver a higher return than their risk warrants and abandoning some positive NPV projects? In the “Asset Pricing Models and Literature” section, we review the related literature on insurer cost of equity capital and argue that since the models used are single-period models, they do not account for the time-varying risks that insurers face. As discussed in the “Asset Pricing Models and Literature” section, while reestimating beta(s) in CAPM/FF5 allows for the COE to vary over time, these approaches do not incorporate the covariance of factor beta(s) with economic conditions. In COE estimation, the CAPM and FF5 implicitly assume, by using long-term averages of the factor risk premiums, that the amount of risk in the economy is constant. Thus, in the CAPM and FF5, there is no possible covariance between the betas and the business cycle “by construction. ” For example, this is the view Fama and French took in their original article, Fama and French (1993), as well in subsequent articles like Fama and French (1995) and Fama and French (1996). 2 THE JOURNAL OF RISK AND INSURANCE