Interest Rates and Profit Cycles: A Disaggregated Approach

Interest Rates and Profit Cycles: A Disaggregated Approach Abstract Changes in the performance of property-liability insurers have been dramatic, resulting in problems that affect the supply of insurance and the solvency ofinsurers. Numerous researchers have examined the behavior of returns in this industry and have concluded that they may be characterized as cyclical. This paper redefines the nature of returns that are studied and concludes that disaggregated models with interest rate terms perform better than simple autoregressive models in explaining the behavior of profits. Introduction Recent movements in prices and profits in the property-liability insurance industry have led to the assertion that the industry returns are cyclical, and all previous empirical work supports this conclusion. Cycles in the underwriting profits of the property-liability industry have been attributed to a number of causes. Doherty and Kang (1988) attributed cycles to fluctuations in interest rates, Smith (1981) attributed them to regulatory lags, Stewart (1981) attributed them to changes in capital flows into the industry, Jablonski (1985) attributed them to adaptation under imperfect information, and Venezian (1985) and Cummins and Outreville (1987) attributed them to procedural lags in the process of estimating marginal costs. Most prior work has examined the available data in the context of highly restrictive models. This paper seeks to expand on prior work in several ways. One is to introduce financial variables to reflect the effect of investment returns for individual lines of insurance. The second is to improve upon the by-line models of Venezian (1985) by allowing the error terms in various lines of insurance to be contemporaneously correlated. The third is to determine whether an aggregate model for the industry or separate models for individual lines are more consistent with the data. Financial Variables Models of insurance price determination [Biger and Kahane (1978), Kahane (1978), Fairley (1979), Hill (1979), Myers and Cohn (1981), Kraus and Ross (1982) and Venezian (1983)] lead to the conclusion that calculation of the required rate of return on equity from entering the insurance business should reflect both underwriting income and income derived from the investment of reserves and net worth. It is assumed that the measures of profit, both Joseph A. Fields is Assistant Professor of Finance at the University of Connecticut. Emilio C. Venezian is Chairman and Associate Professor of Business Administration at Rutgers University and President of Venezian Associates. underwriting and operating, are determined from a portfolio based model, where the level of return is based on the decision concerning the level of risk undertaken and exogenous economic variables. In view of the general agreement that overall operating profits and returns depend on both underwriting and investment income, it is surprising that cycles have usually been analyzed using data on the underwriting rather operating profit. (1) Foster (1977) showed that underwriting ratios do not contain as much information as operating ratios concerning the economic value of the insurance company. The use of operating margins would lead to an analysis of the cyclical nature of the "true price" of insurance representing both the economic profit to the insurer and the opportunity cost of funds to the insured. Interest Rate Effects Most of the models that address rate of return from insurance essentially focus on the price that would occur in long-run equilibrium. Krauss and Ross (1982) argue that, in the context of their model, the risk free interest rate should be considered as a "real" or inflation adjusted rate if expected claim costs are set at current prices. On the other hand, if costs are based on forecasts that include inflation the appropriate rate of interest should be the nominal rate. …