The Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2016-01, which requires firms to report unrealized gains and losses on available-for-sale (AFS) equity securities in net income. Previously, these gains and losses were reported in other comprehensive income and were not recognized in net income until the investments were sold. The rule change begs the question of whether insurers increased their earnings management discretion (largely via loss reserves) to offset the reduced discretion in terms of recognizing investment income. We examine how earnings reclassification impacts firms' investment strategy and earnings management behavior around earnings reports. Using data from U.S. insurers, we find that firms decrease their equity holdings while increasing holding periods on equity securities following the adoption of this new standard. These results suggest that ASU 2016-01 shifts firms' investment focus from short-term financial reporting to long-term investment income maximization goals. We also find evidence that this rule update changes firms' earnings management behavior in that the rule change removes firms' incentives to cherry-pick sales of equity. We document that public insurers are involved in less gains trading to avoid reporting losses following the rule adoption. Instead, we find evidence that public insurers are more likely to use discretion over reported loss reserves as opposed to gains trading to manage reported earnings after the rule change.

While the presence of deposit insurance from the FDIC is promoted in the banking sector, advertising the existence of similar protection provided via state guaranty funds in the insurance industry is prohibited. With respect to life insurance, such prohibition may stem from concerns over the potential for reduced market discipline in a market characterized by substantial price opacity and product complexity where market discipline already may be limited. We review the theoretical framework of market discipline in relation to insurance guaranty funds and empirically test for the existence of market discipline in the life insurance market. Based on two measures of firm risk, we find almost no evidence of a relationship between insurer risk and life insurance price (and limited evidence of market discipline based on life insurance quantity demanded). Our evidence suggests that market discipline is relatively weak in the life insurance industry, and further that guaranty funds lead to government-induced moral hazard, further weakening market discipline in life insurance. Our results help explain the existence of prohibitions against advertising the coverage provided by state insurance guaranty funds.

Life insurers face one-sided commitment risk that is partially mitigated by the introduction of various contract features, including front-loading and the option to backdate, that are intended, in part, to "lock in" the policyholder. While prior literature has discussed one-sided commitment and life insurance, research has not, to our knowledge, examined the intersection of risk tolerance, heterogeneity in commitment across policy type, and life insurance ownership. In this study, we employ a multi-step decision model to examine this intersection. Controlling for various financial and demographic characteristics among households that own life insurance, we provide the first evidence that as risk tolerance increases, the likelihood of owning only cash value life insurance decreases, consistent with these consumers having a greater willingness to bear the higher reclassification risks associated with term life insurance.

In 2023 total health care spending in the US totaled approximately $4.7 trillion and represented 18 percent of GDP. In an attempt to reduce these expenditures, the Affordable Care Act (ACA) drastically reformed the operation and structure of health care and health insurance. We explore the effect the ACA had on health insurer liquidity by exploiting state-by-state variation and providing evidence that the ACA led health insurers to significantly adjust cash holdings. We find that for the 2010 to 2018 time period, health insurer cash as a proportion of assets increased by 40 percent and growth in cash was significantly greater than that of other types of insurers, but that specific ACA provisions had differing effects-Medicaid expansion, loss ratio regulation, and exchange participation were associated with reduced cash. Far from changing cash reserves for no reason, our empirical evidence suggests that health insurers altered cash as a precautionary strategic response to uncertainty created by the ACA.

We provide the first evidence on the effects of executive compensation on corporate risk management for insurers. Our unique data set allows the construction of a new, more complete measure of corporate risk management behavior. Specifically, we include hedging-driven usage of not only derivatives but also insurance. To address potential endogeneity, we utilize a difference-in-differences approach, based on the implementation of FAS 123R that required firms to expense stock-based compensation at fair value. We find that the decline in the convexity of executive compensation following FAS 123R led firms to significantly increase corporate risk management, primarily through increased demand for insurance.

Caps on damages constitute one of the proposed reforms of the tort system, especially in the U.S. In this paper, we establish models to capture both the claimant's and the insurer's behaviors under a system whereby damages are capped. We also establish an objective function of maximizing the social benefit, expressed as the sum of claimant and insurer benefits. We examine the optimal upper limit that balances both claimant and insurer benefits. Our model implies that the optimal value of the upper limit should be the expected value of the random claim payment independent of the type of probability distribution the claim payment follows. Finally, we apply empirical data to our theory and arrive at an estimate of the optimal damage cap.

Internal capital markets enable conglomerates to allocate capital to segments throughout the enterprise. Prior literature provides evidence that internal capital markets efficiently allocate capital based predominantly on group member prior performance, consistent with the "winner picking" hypothesis. However, existing research has not examined the critical question of how these "winners" perform subsequent to receiving internal capital-that is, do winners keep winning? We extend the literature by providing empirical evidence on whether or not internal capital markets are ex post efficient. We find, in contrast to mean reversion, that winners continue their relatively high performance. Our study contributes to the literature examining the efficiency of internal capital markets and the conglomerate discount, as well as the literature specifically examining capital allocation in financial firms.

The Financial Accounting Standard Board (FASB) recently issued Accounting Standards Update No. 2016-01, which requires firms to report unrealized gains and losses on available-for-sale (AFS) equity securities in net income. This paper uses a difference-in-differences design and a sample of public insurers to examine the capital market consequences associated with this reporting change. We find a significant decrease in firms’ earnings response coefficient (ERC) after the application of this new standard, and this is driven by a decrease in earnings persistence. These results suggests that, after the reporting change, earnings less fully reflect the information investors use when revising their beliefs about firm value. However, our evidence indicates no significant changes in investor assessment of overall firm risk following the reporting change, suggesting that investors appear to understand that the reduction in earnings persistence is not reflective of a change in firm risk.

Managerial, or discretionary, earnings opacity is the intentional lack of transparency to hide the intrinsic value of a firm. Opacity arises through two channels. The first is ex ante, when managers manipulate current expectations about future performance; and the second is ex post, when managers hoard negative news that corrects their initial estimates. Using insurance industry data and the 2015 FASB accounting standards update in a difference-in-differences framework, we investigate the relationship between discretionary opacity and stock price informativeness. We find that the 2015 FASB update increased informativeness through a reduction in delayed news release that reduced opacity.

While the relation between foreign direct investment (FDI) and financial development is an important topic that has been examined in prior literature, we provide the first analysis of a direct relation for the insurance sector. We construct panel data on foreign direct investment and the level of life insurance in 29 emerging economies to test whether FDI coincides with increases in life insurance expenditure. For the sample period, our results suggest that countries with higher FDI tend to have higher life insurance penetration. While the result is mitigated by the role of financial development and country-specific variables, the relation persists across various robustness tests.

We develop a model of insurance pricing under heterogeneous lapse rates with asymmetric information about lapse likelihood within the context of an optional two‐part tariff as a screening device for future policyholder behavior. We then test for consumer self‐selection using policy‐level data on life insurance backdating. We exploit randomness in the initial tariff size to separately identify the selection and sunk cost effects of backdating on lapse proclivity. We find that consumers who are less likely to lapse self‐select into the two‐part tariff pricing structure and we also document consumer behavior consistent with sunk cost fallacy.

In this article, we discuss whether, and when, risk taking is beneficial to the insured and to the society at large. We establish models utilizing stochastic optimal control theory and obtain the optimal levels of risk taking from perspectives of both the insured and the society. As part of the analysis, we discuss the relation between insurance and excessive risk taking.

Empirical research has examined economic and demographic factors related to risk aversion primarily using cross‐sectional data. We add to this literature by investigating factors that are associated with changes in household relative risk aver‐sion (RRA). Additionally, we evaluate changes in RRA during a time period that includes an economic shock loss. We use data from the 1983–1989 Survey of Consumer Finances panel study to calculate changes in RRA. Our results shed light on behavioral and attitudinal changes in household risk taking across time. Specifically, we find that household RRA is positively related to increases in assets, age, and education, and negatively related to increases in human capital. [Key words: risk aversion, education, human capital]

Loss reserves are a discretionary tool for managing insurer earnings, with more accurate and/or less volatile reserve errors resulting in higher accruals quality. We investigate whether accruals quality is related to insurer financial strength ratings. Specifically, we use insurer loss reserve errors as a measure of the quality of accruals and examine whether overall accruals quality, as well as a decomposition into innate and discretionary accruals quality, is related to insurer financial strength ratings. We find that firms with lower-quality (noisier) accruals receive lower financial strength ratings from A.M. Best. This result holds for both innate and discretionary accruals. Overall, we provide the first evidence that the quality of accounting information is a significant factor in ratings of insurance firms.

Abstract We extend Kliger and Levikson’s approach for pricing insurance contracts by considering the influence of insurer capital on the price of insurance contracts. In the context of a multi-line insurer, we analyze how to arrive at the optimal price, number of policies, and capital level of the insurer. Our results differ from prior literature on capital allocation even in incomplete markets with friction in that we show that even with multiple lines of business, the insurer still only needs to hold a single amount of overall capital. Finally, our results show that the relation between the number of policies and price is important in the pricing and capital decision.

Classical welfare economics assumes that the demand function, or consumers’ utility, is known with certainty. Probabilistic microeconomics generalizes it by maximizing expected utility, or by optimizing under a specific constraint. Existing research has provided only limited insight into the welfare effects of demand uncertainty, and that limited insight suggests welfare reduction as a result of demand uncertainty. In contrast with previous works, our paper does not prescribe the form of demand uncertainty, but rather derive it from individual consumers’ choices. We then analyze monopolist optimization problem, first constrained by a “Safety-First” type condition imposed on the coefficient of variation, and then by considering risk-adjusted profit measure. Our results indicate that the Marshallian welfare measure, when compared with the deterministic model, increases with uncertainty of the demand function. We point out that uncertainty characterizes markets that lie between the pure monopoly model, and perfect competition model. We believe that our model of demand uncertainty is a realistic one, very much like observed behavior of markets. Most importantly, our work suggests that transition from monopolistic market structure to competitive one may be explained better by demand uncertainty than by mere presence of competitors, as opposed to the instant appearance of competitive pricing in common textbook models. Finally, we show how a demand can be efficiently estimated from simple consumer surveys (admitting its random structure).

There are large, upfront, fixed costs to writing a life insurance policy. Both agent commission and direct underwriting costs (e.g., fees for physicals and blood tests) are fully paid a few years into contracts that can last 10-30 years. Because of these upfront costs, insurers can actually lose money on policies when the consumer lapses early into the contract, even if no death benefit is ever paid out. Thus, to properly price contracts, insurers must estimate lapse risks. However, consumers will often have private knowledge of their lapse likelihood, leading to adverse selection. We develop a model of insurance pricing under heterogeneous lapse rates with asymmetric information about lapse likelihood within the context of an optional two-part tariff as a screening device for future policyholder behavior. We then test for consumer self-selection using detailed, policy-level data on life insurance backdating (a common practice that resembles a two-part tariff). We are able to identify, through a control function approach, the information about lapse risk a consumer reveals when they choose to backdate. Our contribution to the literature is twofold: we are the first to consider life insurance lapsing as a form of adverse selection; we also explore, both theoretically and empirically, the role of optional two-part tariffs as a screening mechanism using life insurance backdating as our primary example. We find that consumers who are less likely to lapse self-select into the two-part tariff pricing structure and also document consumer behavior consistent with sunk cost fallacy.

We extend previous research by considering the role of reinsurance in hedging underwriting risk, pricing risk, and investment risk. We consider a stochastic dynamic optimization model applied to the problem of insurance pricing under a competitive insurance market with a jump diffusion risk process. Our model seeks to maximize the expected utility of the insurer's terminal wealth, incorporating the interaction of a stochastic process for the insurance price evolution, reinsurance, investment strategy, and the possible hedging effect between insurance liabilities and investment risk. We solve this optimization problem by constructing a Hamilton- Jacobi-Bellman (HJB) equation.

In this article, we discuss whether and when the risk taking and moral hazard is beneficial to the insured and to the society as well. We establish model by stochastic optimal control theory. We obtain the optimal levels of risk taking and moral hazard from perspectives of the insured and the society. Finally we make some discussions on insurance and moral hazard.