2009-38
THE DETERMINANTS OF THE USE OF DERIVATIVESIN JAPANESE INSURANCE COMPANIESAtsushi Takao
I Wayan Nuka Lantara

THE DETERMINANTS OF THE USE OF DERIVATIVES IN
JAPANESE INSURANCE COMPANIESAtsushi Takao1 and I Wayan Nuka Lantara2

ABSTRACTThe purpose of this study are to investigate the patterns of the use ofderivatives by Japanese insurance companies, and to examine which firmsspecific factors determine the decision of Japanese insurance companies to use
derivatives. Using a sample of Japanese life insurance and non life insurancecompanies during the period of 2001-2008, we find that the participation rate
for the use of derivatives by insurance companies in Japan is 72.4%, muchhigher than those found in the US, the UK or Australia. Using probit
regression models, we examine the determinants of the use of derivatives, andwe find that the decision to use derivatives by insurance companies ispositively associated with firm size, leverage, and proportion of asset invested
in stock, but negatively related with asset liability mismatch. We also find thatthe decision of Japanese insurance companies to extend their markets tooperate globally increase the need to use derivatives.

1

Professor of Insurance, Graduate School of Business Administration, Kobe University, Japan

2

Doctoral student, Graduate School of Business Administration, Kobe University, Japan, and faculty staff
of Faculty of Economics and Business, Universitas Gadjah Mada, Indonesia.

1

I. Introduction
Insurance is a form of risk management which spreads risk of many people or businesses
in exchange for a small payment from policyholders. Insurance companies arecharacterized by some uniqueness in term of its financing and investment decision.
Generally, the main sources of fund are obtained by issuing more contracts with
policyholders, rather than raising fund from capital market. Hence, insurance companies
tend to be relatively highly leveraged firms. In term of investment, insurance companies
generally invest the money into financial market and/or real market, which is also subject
to some types of risk.
Some types of risk can be diversified away using certain risk management tools or
risk pooling. Insurance companies usually employ reinsurance, coinsurance, geographic
distribution, and product distribution in order to minimize its business risks (Cummins etal. 1997). However, there are some other risks such as market risk, exchange rate risk orinterest rate risk that can be appropriately minimized by using other tools, such asderivatives. Hodgson (1999) and Shiu (2007) suggest that the main advantage of using
derivatives is that it provides a relatively inexpensive and effective method to reduce risk.
The use of derivatives also provides other benefits such as to manage income, to lower
taxes, and sometimes as a means of income generation.
The previous empirical evidences on the use of derivatives by non-financial firms
has been conducted in various countries around the world, such as Bodnar et al. (1995;
1998) in the US, Bodnar and Gebhardt (1998) in Germany, Grant and Marshall (1997)
and Mallin et al. (2001) in the UK, Alkeback and Hagelin (1999) in Sweden, De Ceuster
et al. (2000) in Belgium, Berkman and Bradbury (1996) in New Zealand, Heaney et al.

2(1999) in Japan, and Nguyen and Paff (2002) in Australia. However, only few studies
examining the topic on financial firms, especially on insurance companies, has been
documented, such as: Colquitt and Hoyt (1997) and Cummins et al. (1997, 2001) in the
US, Hardwick and Adam (1999), and Shiu (2007) in the UK, and De Ceuster et al. (2003)
in Australia.
More empirical researches from other countries, including Japan, are still needed
to obtain more empirical evidence on the use of derivatives by insurance companies. This
study is expected to be one of the first studies that provide Japanese empirical evidence
on two main ideas. First, to explore the pattern of the derivatives usage by Japanese
insurance companies, with respect to: the percentage of users Vs non-users of derivatives,
life insurance Vs non-life insurance, big-size Vs small-size insurance companies, andmutual Vs stockholding insurance companies. Second, to investigate which firms-specificfactors determine the decision for Japanese insurance companies to use derivatives.
This study extends the existing empirical evidences by examining two issues thathave rarely been tested in the previous researches. First, as one of the largest industries in
the world, Japanese insurance companies not only serve its domestic market, but also
operate internationally, that could increase the types and magnitude of risk faced byinsurance companies. Therefore, this study also examines the relationship between
international business operations of Japanese insurance companies and the decision to use
derivatives. Second, this study also investigates the relationships between the ability of
insurance company to meet all payments3 and the decision to use derivatives by Japanese3

We use ‘solvency margin ratio’ as a proxy for the ability of insurance company to meet all payments inthe event risks exceed the normal anticipated level of risk. The ratio is computed by dividing the solvency
margin total to the aggregate risk amount. The data can be obtained from NEEDS-Financial Quest 2.0
Database.

3

insurance companies. While some previous studies only use certain measurement for
specific risk, such as liability risk or catastrophic risk, this study employ morecomprehensive measurement of insurance company’s ability to meet all the payments.
The discussion proceeds as follows: In section 2, we provide review of literatureand previous studies, and the development of hypotheses. Section 3 describes the data as
well as the research design and proxies used in this study. Section 4 discuss the empiricalresults. Section 5 concludes.

2. Literature Review and Hypotheses
Cummins et al. (1997) state that insurance companies serve two primary functions in theeconomy; (a) as a risk-bearing and risk-pooling function, and (b) financial intermediation
function. In the first function, insurance companies provide a mechanism to transfer therisk of individual or businesses in exchange for some amount of premium payment. In theintermediation function, insurance companies raise fund by issuing written debt contractand invest the funds in financial markets, which also contain some types of market risks.
Furthermore, Cummins, et al. (1997) extend that both functions will also trigger
the problem of difference in asset and liability cash flow, because the cash flows of theliabilities issued by insurance companies have different patterns and characteristics thanthe cash flows of the assets they invest in. Smith (1982) depicts that insurance contracts
can also be viewed as a package of options contract, which need to be well managed inorder to minimize the negative consequences for the companies in future.
Insurance companies generally manage risk by implementing insurance pooling,reinsurance, coinsurance, geographic distribution, and product distribution to minimizerisks (Cummins et al. 1997). However, some types of financial market risks cannot be4

diversified away using standard procedures. Hodgson (1999) and Shiu (2007) suggestthat the use of derivatives will provide a cost effective vehicle to hedge against financial
market risks. It will also offer other benefits such as to smooth accounting earnings, tolower taxes, and to reduce expected costs of financial distress. Sometimes, insurancecompanies might also use derivatives to speculate in order to yield more return.
Colquitt and Hoyt (1997) note that in order to minimize financial risk, managers
of insurance companies generally diversify the risk by holding balanced portfolios ofinvestment. However, Berkman and Bradbury (1996) argue that it is also possible thatmanagers of insurance companies could be less efficient in diversifying financial risk,
which then could potentially increase the prospect of insolvency and generate cost offinancial distress.
There are two possible alternatives to overcome the problem. First, from theperspective of agency theory, the owner of insurance companies will have to compensate
their managers by giving more attractive compensation packages so that manager will
manage company’s portfolio more efficiently (Kleffner and Doherty, 1996). Secondly, by
shifting the risk of insolvency to the financial derivatives markets by using derivatives
instrument (Berkman and Bradbury, 1996). Hardwick and Adams (1999) also point out
that modern finance theory suggests that the use of derivatives will provide benefit for
manager to alleviate market imperfections and reduce firm-specific exposure to financial
risk, which could then minimize the volatility of company’s cash flow and create value toshareholders.
Some prior empirical studies have tried to investigate the extent of derivatives
usage and which factors determine the decision of insurance companies to use derivatives.

5Cummins et al. (1997) investigated the extent to which US insurance companies utilizefinancial derivatives, and they found that US life insurance companies are most active ininterest rate and foreign exchange derivatives, while property-casualty insurers tend to be
active in trading equity option and foreign exchange contracts.
Using the data of 571 life insurers in the US, Colquitt and Hoyt (1997) examinedthe determinants of derivatives usage and concluded that the size of the insurer, leverage,
and the degree of asset-liability duration mismatch are positively influenced thelikelihood of insurer to use derivatives. They also found that stock insurance companies
are likely to use more derivatives than mutual insurance companies. Cummins et al.
(2001) analyzed the derivatives holdings of US insurers and indicated that the measure ofrisk and liquidity positively associated with the decision to use derivatives. However, thesame measure of risk negatively related to the volume of using derivatives to hedge
against risk.
Hardwick and Adams (1999) found that, for the case of UK life insurance, thepropensity to use derivative instruments is positively related to firm’s size, leverage, andinternational links, and negatively related to the extent of reinsurance. They also find that
there is a tendency that mutual life insurance firms more likely to have higher propensity
to use derivatives than stock life insurance companies. Shiu (2007), also investigated theuse of derivatives by UK general insurance companies and indicate that general insurer’s
size, liquidity, interest rate risk exposure, line of business concentration andorganizational form are important determinant associated with the decision to use
derivatives.

6De Ceuster et.al. (2003) provide an empirical evidence of Australian insurancecompanies during the period of 1997-1999. The findings of their study indicate that forlife insurers, the important determinants of derivatives usage are size, leverage and levelof reinsurance. While for the general insurers, the determinants are size, the extent oflong tail lines of business, and the reporting year. Based on review of literature and priorresearches, we now consider the hypotheses of the determinants of the use of derivatives
in Japanese insurance companies.

Firm Size
As companies become bigger and their operations become more complex,
information asymmetries between various contracting groups will be worsen (Jensen andMeckling, 1976). Hence, agency costs will increase in order to prevent opportunistic
behavior by managers. In order to minimize the problem, shareholders could improve thecompensation package for managers, so that managers will be better on manage
company’s portfolio diversification (Kleffner and Doherty, 1996). However, Nance et al.
(1993) and Cummins et al. (1997) argue that hedging could also be an effective
mechanism by which agency incentive conflicts inside larger firms can be alleviated.
Colquitt and Hoyt (1997), Cummins et al. (1997, 2001), De Ceuster et al. (2003)
and Shiu (2007) find that larger insurance companies are more likely to use derivatives
and the usage by large insurance companies is much more pervasive. The finding is
associated with the advantage of larger insurance companies which has more substantial
economics of scale to running derivative operation. Large insurance companies tend tohave technical knowledge and potential trading volume to warrant an investment in a
portfolio of derivatives. In other words, large insurance companies or those with higher-

7than average risk exposure would find it meaningful to bear the fixed cost of using
derivatives. Hence, it can be hypothesized that the larger the insurance companies themore likely they employ derivatives, since they tends to have the necessary resources.
The first hypothesis of this study is:
H1: There is a positive relationship between the size of insurance company and the useof derivatives.

Proportion of Asset Invested in Stock
Cummins et al. (1997) suggest that one of the main functions of insurancecompanies is financial intermediation. In this function, insurance companies raise fundfrom many policyholders by issuing written debt contract and invest the funds infinancial markets, which also subject to some types of market risks. In order to minimize
the volatility of cash flow from their investment in stock, insurance companies could
employ derivatives.
Cummins et al. (1997) and Shiu (2007) argue that insurance companies may wantto account for the degree of market risk exposure they faces, via their holding of equity.
They also suggest that the more the proportion of asset invested in stock, the more theneed of insurance companies to hedge their investment in stock by employing derivatives.
Hence, we could expect the proportion of asset invested in stock will be positively
associated with derivatives usage by insurance companies, as stated in the following
hypothesis:
H2: There is a positive relationship between the proportion of assets invested in stockand the use of derivatives.

8Leverage
Colquitt and Hoyt (1997), Hardwick and Adams (1999), and De Ceuster (2003)
state that the increasing of leverage will increase the expected costs of financial distressand insolvency risk. Froot et al. (1993) argue that for a given level of debt, hedging canreduce the probability of financial distress, and it also can be used as a means to increasedebt capacity.
Nance at al. (1993) state that by hedging with derivatives, insurance companies
can decrease the variance of firm value and also alleviating the underinvestment problem
caused by the increase of leverage of the firm. Cummins et al. (2001) also notes that one
important theory of corporate risk management is that the reason why firm hedging with
derivatives is because they want to avoid the direct and indirect cost of financial distress.
Colquitt and Hoyt (1997) argue that the higher the leverage of insurancecompanies, the more likely they will use derivatives in order to decrease the volatility offirm value. They also suggest that firms with higher leverage are expected to gain moredegree of benefit from hedging than firms with lower leverage. Hence, following the
hypothesis of Colquitt and Hoyt (1997), the third hypothesis of this study is:

H3: There is a positive relationship between leverage and the use of derivatives.

Reinsurance
Berger et al. (1992) describe reinsurance as an arrangement whereby an insurancecompany transfer all or part of its liabilities arising from the customer market to anotherinsurance company (reinsurer). As an exchange for the risk transferring services, there9will be a reinsurance premium paid to the reinsurer. Therefore, reinsurance will give
benefit for insurance companies to hedge against liquidity risk and insolvency risk.
Colquitt and Hoyt (1997) suggest that even though the risk transferred through theuse of reinsurance and the use of derivatives is different, both instruments have the same
purposes, which is to reduce the variance of firm’s value and taxable income. Therefore,
when the variances can be reduced adequately by using reinsurance, the need to hedge
risk using derivatives would be reduced. Therefore, we use the following hypothesis totest the relationship between the degree of reinsurance and the use of derivatives:

H4: There is a negative relationship between the degree of reinsurance and the use ofderivatives.

Asset-liability Mismatch
Hodgson (1999) states that asset-liability mismatch will increase the net value
impact from the movement in interest rates, which then put the firm into the higher levelof interest rate risk. The more long-term asset outweighed long-term liabilities, the more
likely an insurance company will use derivatives to hedge against interest rate risk. De
Ceuster (2003) concludes that asset-liability mismatch will increase the amount ofinterest rate risk, and hence will trigger insurance companies to employ more derivatives.
Colquitt and Hoyt (1997) argue that in the case where the duration of asset andliabilities of insurance companies are matching, they will have less need for hedging with
derivatives to reduce economic risk. In other words, the higher the asset-liability
mismatch, the more likely insurance companies will use derivatives to hedge against risk.
Hence, the fifth hypothesis of this study is:10

H5: There is a positive relationship between asset-liability mismatch and the use ofderivatives.
Organizational FormMayer and Smith (1988) argue that stock held insurance companies tends to havemore closely relationship between stockholders and managers, and therefore, they will be
more efficient in writing agency contracts and more closely control the behavior ofmanagement. In contrast, since mutual held insurance companies are only held by its
policyholders, who usually do not have voting rights, there will be insufficient power tocontrol manager. Furthermore, Hodgson (1999) extends that stock held insurancecompanies have more reasons to use derivatives than mutual held insurance companies
because they have a higher probability of being involved in more complex and riskybusiness. Therefore, it can be expected that stock held insurance companies will havemore advantage to engage with derivatives than mutual held insurance companies, as thefollowing hypothesis:
H6: There is a positive relationship between stock form ownership and the use ofderivatives.
Solvency Margin
Yamori and Kobayashi (2004) explain that Japanese Insurance Business Law has
been revised several times in order to: (a) promote competition and enhance businessefficiency through deregulation, (b) preserve the soundness of business, and (c) ensure
fairness and equity in business operations. One of the main points on the regulation
requires Japanese insurance companies to report their total risk and solvency margin ratio,11

so that related parties such as policyholders, government or investors could obtain
information about the riskiness and solvency of insurance company.
The solvency margin ratio is one of the main indicators used by the supervisingadministrative agency to ascertain the ability of insurance company to cover the total
amount of payment arising from total risks by using total of capital and other internal
reserve as well as unrealized gains from securities and other assets (total solvency
margin). The solvency margin ratio is the total value of the solvency margin divided by
the quantified value of all risks exceeding those that can normally be forecast, such as
those arising from major earthquakes or collapses in the stock market
Hentschel and Smith (1997) suggest that the ability of insurance companies tomanage its total risk will reduce the probability of financial distress, so that it will
improve their reputations for prudent management and also increase the average level ofpremium willing to be paid by policyholders. Hardwick and Adams (1999) also note that
insurance companies need to transfer its risk to the financial derivatives markets, in orderto reduce the amount of risk and the probability of bankruptcy. Therefore, we can expectthat the higher the ability of insurance companies to cover all of its payments, the lower
the need to engage with derivatives, as stated in the following hypothesis:

H7: There is a negative relationship between solvency margin and the use of derivatives.

Foreign Business Operation
Japan is acknowledged as one of the world’s highest market penetrations for
insurance, especially life insurance, with 90% of households owning a life insurance
policy (Inoue, 2009). However, as a result of the declining in Japanese economic growth12rate and graying of the population, Japanese insurance companies have to revise theirbusiness strategy. One of the main possible strategies is to extent the market by serving
not only domestic market, but also international market, such as by opening foreign
branches or subsidiaries or conducting joint venture with foreign insurance companies.
Berkman and Bradbury (1996) and Joseph and Hewins (1997) argue that thenature of operations of firms can also influence the level of derivatives used. The more
the companies engage in international operation, the more likely they use derivatives tomanage foreign currency exposures. Therefore our last hypothesis of this study is:

H8: There is a positive relationship between the level of foreign business activity andthe use of derivatives.
3. Research Design and Data
We use the data of all Japanese life insurance and non-life insurance companies that areavailable in NEEDS-Financial Quest 2.0 Database, covering 8 years of study period(2001-2008). Although the data from NEEDS-Financial Quest 2.0 Database also include
data of Japanese insurance companies before 2001, however it does not contain data ofderivatives before the year 2001. The numbers of insurance companies are 38 with firmyear observations of 199 respectively.
In order to examine the hypotheses, we employ a Probit regression model, since
the dependent variable of this study is a dummy variables which consists of the value
equal to 1 when the sample use derivatives, and otherwise 0 when not use derivatives. An
insurance company is classified as a derivatives user if they report any use of derivatives
in their financial statement. The probit regression model to be estimated in this study,
with n observations and m variables is as follows:13Y j = β 0 + ∑ β i X ij + ε jj = 1,...., n , i = 1,...., m

i

where
Yj is the decision of insurance companies to use or not to use derivatives,
β0 is the constant term,
β1,…. βm is the coefficient of the independent variables,
Xij is a vector of independent variables, andεj a disturbance term associated with observation j.
The dependent variable and independent variables, its definition, and the expected
sign to be examined in this study can be described as the following table.
Table 1. Variables description, expected sign and proxies
Variables

Proxies

Dependent Variable
Derivative usage (DER)

Dummy variable, where:
Derivatives user = 1, Derivatives non-users = 0

Independent Variables (expected sign)
Firm’s size (SIZE)(+) Natural logarithm of total assets

Proportion of asset
invested in stock (PAS)(+)

Leverage (LEV)(+) The ratio of the total long-term liabilities to total assets

Reinsurance (REIN)(-) The ratio of total reinsurance premiums to total premiums

Asset Mismatch (ASSM)(+) Asset Mismatch = [(Non current asset – Non current liabilities)] /Total asset(only if a positive value is found, otherwise LIABM)(+) Liabilities Mismatch = [(Non current liabilities – Non current asset)]/ Total asset(only if a positive value is found, otherwise ASSM)

Liability Mismatch(LIABM)

The ratio of investment in stock to total asset

Organizational form (OF) (+) Dummy variables, where:
Stock held insurer = 1, Mutual held insurer = 0
Solvency Margin (SOLV) (-) Natural Logarithm of solvency margin ratio.
Foreign Business
Operation (FOREIGN)(+) Dummy variable, where:
Have foreign branches and or subsidiaries = 1, otherwise,
No foreign branches and or subsidiaries = 0

14The summary of descriptive statistics for users and non users of derivatives can befound in Table 2, which contains the means, standard deviations, and minimum andmaximum values of the independent variables included in this study. We also employ the
Mann-Whitney U test to examine the mean difference of each variable between user andnon user of derivatives. The results indicate that the mean values of the sample ofderivatives user tends to be larger than non user, in terms of firm’s size, proportion ofasset invested in stocks, leverage and solvency margin. They also tend to be moreaggressive to engage in international business than non user of derivatives. The result ofmean difference test indicates that most of the independent variables are statisticallysignificant, which imply that the mean values of those variables are statistically different
between user and non user of derivatives.
Table 2. Descriptive statistic and mean differences

A. TOTAL SAMPLES
Firm size (SIZE)
Proportion of asset invested in stock(PAS)
Leverage (LEV)
Reinsurance (REINDEP)
Asset mismatch (ASSMIS)
Liability mismatch (LIABMIS)
Organizational form (OF)Solvency margin (SOLV)
Foreign business operation (FOREIGN)
B. USER OF DERIVATIVES
Firm size (SIZE)
Proportion of asset invested in stock(PAS)
Leverage (LEV)
Reinsurance (REINDEP)
Asset mismatch (ASSMIS)
Liability mismatch (LIABMIS)
Organizational form (OF)Solvency margin (SOLV)
Foreign business operation (FOREIGN)

Mean

SD

Minimum

Maximum

14.38

1.64

10.16

17.77

0.18

0.13

0.00

0.44

0.04
0.09
0.06
0.02
0.86
9.23
0.74

0.04
0.09
0.08
0.06
0.35
6.94
0.44

0.00
0.00
0.00
0.00
0
3.13
0

0.20
0.30
0.34
0.48
1
98.16
1

14.88

1.48

12.12

17.77

0.23

0.12

0.00

0.44

0.05
0.10
0.07
0.03
0.81
9.94
0.93

0.04
0.09
0.08
0.07
0.39
7.84
0.26

0.004
0.00
0.00
0.00
0
3.15
0

0.20
0.25
0.34
0.48
1
98.16
1

Mean
difference-6.83**-7.46**-7.39**-1.33-2.05*-0.15-3.06**-5.01**-9.94**

15

C. NON-USER OF DERIVATIVES
Firm size (SIZE)
13.07
Proportion of asset invested in stock
0.07
(PAS)
Leverage (LEV)
0.02
Reinsurance (REINDEP)
0.08
Asset mismatch (ASSMIS)
0.03
Liability mismatch (LIABMIS)
0.02
Organizational form (OF)0.98
Solvency margin (SOLV)
7.36
Foreign business operation (FOREIGN)
0.24** Statistically significant at 0.01 level (2-tailed).
* Statistically significant at 0.05 level (2-tailed).

1.27

10.16

15.43

0.09

0.00

0.29

0.016
0.09
0.05
0.03
0.14
2.98
0.43

0.00
0.00
0.00
0.00
0
3.14
0

0.06
0.30
0.19
0.13
1
21.24
1

4. Empirical Results
The trend and pattern of derivatives usage by Japanese insurance companies in this study
is conducted based on: trend of participation rate during the study period, the percentage
of users Vs non-users of derivatives, life insurance Vs non-life insurance, big-size Vs
small-size insurance companies, and mutual holding Vs stock holding insurancecompanies.
The trend of participation rate can be seen in Figure 1. During the study period,
the participation rate of derivatives by Japanese insurance companies is 72.4%, whichrange from 66.67% to 82.61%. Surprisingly, this finding is much higher than the findingof participation rate in the US insurance industry, which around 11.93% (Cummins et al.
1997) and 13.3% (Colquitt and Hoyt, 1997), and in the UK of 57% (Hardwick and Adam,
1999), or in Australia by De Ceuster (1999) which found the participation rate of 58%.
As also shown in Figure 1, the trend of participation rate tends to slightly decline
after 2001. One of the possible reasons is because Japanese insurance companies mightput more emphasize on underwriting results than on investment results, and on the other
hand the need to use derivatives is slightly declining. Inoue (2009) argues that because of16

the contraction of domestic insurance potential market in Japan as a result of thedeclining in the Japanese economy’s potential growth and the shrinking of population. As
a consequence, Japanese insurance companies have to revise their business model, by
putting more attention to be more focus on increasing underwriting results, such as byextending product and or market.

Figure 1. Participation rate of derivatives usage by Japanese Insurance Companies
90.00%
80.00%
70.00%
60.00%
50.00%
40.00%
30.00%
20.00%
10.00%
0.00%
2001

2002

2003

2004

2005

2006

2007

2008

Table 3 shows the pattern of derivatives use with respect to: users Vs non-users ofderivatives, life insurance Vs non-life insurance, big-size Vs small-size insurancecompanies, and mutual Vs stockholding insurance companies. The results indicate that
72.4% of total samples use derivatives. With respect to firm’s size, the participation rateof big insurance companies is relatively higher than small insurance companies. In termof the type of insurance, the use of derivatives by life insurance companies is relatively
higher than those in non life insurance companies.

17

Table 3. Proportion of user and non-user of derivatives
User of derivatives

Non-user of derivatives

Total sample

144 (72.4%)

55 (27.6%)

FIRM’S SIZE
Big size
Small size

88 (61.1%)
56 (56.0%)

11 (11.1%)
44 (44.0%)

TYPE OF INSURANCELife insurance
Non life insurance

54 (84.4%)
90 (66.7%)

10 (15.6%)
45 (33.3%)

ORGANIZATIONAL FORM
Mutual held
Stock held

27 (96.4%)
117 (68.4%)

1 (3.6%)54 (31.6%)

Surprisingly, in term of organizational form, the participation rate of derivatives
on mutual held insurance companies tend to be higher than those on stock held insurancecompanies. One of the possible reasons is because all of the samples of life insurancecompanies included in this study are also mutual holding companies. Hence, the findingthat mutual held insurance companies use more derivatives is in line with the result thatlife insurance companies tends to have higher participation rate to use derivatives thannon life insurance companies.
This finding is not consistent to the so called managerial-discretion hypothesis(Mayers and Smith, 1981; Cummins et al., 1997) which argue that stock held insurancecompanies are expected to use more derivatives than mutual held insurance companies,
because stocks held insurance companies are more likely to be engaged in more complex
and risky business that could increase the need to use derivatives. On the other side, thisfinding is in line with the argument of Colquitt and Hoyt (1997) and Hardwick andAdams (1999), which suggest that as non listed companies, mutual insurance companies
are not subject to the discipline of the market for corporate control, which then put them18

in a situation to have more freedom to use imprudent investment including the use ofderivatives.
The result of Tobit regression can be seen in Table 4. The findings indicate thatthe coefficients for firm size, proportion of asset invested in stock, and foreign businessactivity are in the expected direction and are significant at the 1% level. Correspondingly,
the coefficient for leverage is significant at the 5% level. However, we do not find any
significant relationship between the use of derivatives with reinsurance dependence,organizational form, and solvency margin ratio.

Table 4. Probit regression result
Dependent variables

Expected sign

CoefficientZ-statistic

Firm size (SIZE)
Proportion of asset invested in stock (PAS)
Leverage (LEV)
Reinsurance (REINDEP)
Asset mismatch (ASSMIS)
Liability mismatch (LIABMIS)
Organizational form (OF)Solvency margin (SOLV)
Foreign business operation (FOREIGN)

+
+
+
+
+
+
+

0.30
7.76
11.84
-5.57
-3.61
0.20
0.14
-0.00
1.66

2.70**
2.76**
2.13*-1.52-2.84**
0.11
0.23
-0.02
4.81**

Number of observations
Chi square
Pseudo-R2** Statistically significant at 0.01 level (2-tailed).
* Statistically significant at 0.05 level (2-tailed).

199
65.50**
0.61

We also find that asset mismatch is statistically significant to influence thedecision to use derivatives. However, the result is not consistent with the hypothesis,
where we expect to find positive relationship as found by Colquitt and Hoyt (1997). The
finding of this study instead supports the results of Cummins et al. (2001) and De Ceuster(2003), who also find a negatively significant association between the use of derivatives
and asset liability mismatch.
19

One of the possible reasons suggested by De Ceuster (2001), who argues that thenegative relationship between the use of derivatives and asset liability mismatch could be
explained for a situation when an insurance company uses derivatives to hedge against
risk as well as to generate higher income. Since speculation motives is riskier thanhedging motives, we could expect that insurance companies will be eager to use morederivatives when they feel that other sources of risk such as asset liability mismatch isdecreasing. In other words, the use of derivatives will decrease when insurancecompanies feel that other risk including asset liability mismatch increase.
Overall, the result in Table 4 provides strong support that the decision of
insurance companies to use derivatives is positively related with firm size, leverage, andproportion of asset invested in stock, and negatively related with asset liability mismatch.
Furthermore, this study also find that the decision of insurance companies to operateinternationally increase the need to use derivatives. We find no relation between the useof derivatives by insurance companies to reinsurance dependence, organizational form,and solvency margin.

5. Conclusion
This study investigates the patterns of the derivatives usage in Japanese insurancecompanies and also examines which firms-specific factors determine the decision ofJapanese insurance companies to use derivatives. Using a sample of life insurance andnon life insurance companies in Japan from 2001 to 2008, we find that on average, thepercentage of the use of derivatives by samples of Japanese insurance companies is
72.4%, much higher as compared to those found in other countries such as in the US, theUK and Australia.

20We have examined some independent variables that might be expected toinfluence the decision to use derivatives by insurance companies. The finding of thisstudy provide empirical evidence that the decision to use derivatives by insurancecompanies is positively related with firm size, leverage, and proportion of asset invested
in stock, but negatively associated with asset liability mismatch. We also find that thedecision of Japanese insurance companies to extend their market to operate globally
increase the need to use derivatives.
The issue to operate globally will be interesting to be investigated further in future
research. Due to data limitations, we only used dummy variable as a measure for whether
insurance companies operate globally or not. Finding and including of more appropriate
proxy for this variable would be an interesting idea to be conducted in future research.
Results of some researches on the relationship between asset-liability mismatch
are remain controversial. Hence, there is a need to use a better proxy for asset andliability mismatch, which could measure not only the amount mismatch of asset andliability, but also the mismatch of its duration.
[2009.10.20 942]

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