• Risk Management Research Florida State University

Working Paper Series

Kathleen A. McCulloughKaren Epermanis, Patricia Born 
An Analysis of Property-Casualty Insurance Company Defense Expenditures
Evidence from the property-casualty insurance industry suggests that some insurers tend to settle quickly and out of court, while others vigorously defend all claims. A 1999 change in the National Association of Insurance Commissioners reporting standards now requires that U.S. insurers submit detailed data related to defense cost expenditures. This study incorporates the new defense cost data in a quantile regression framework to assess the relation of insurer characteristics to expenditures on defense costs. Our results support the hypotheses that factors related to the type of business and business environment shape the insurer's defense expenditures.

W. Kip Viscusi, Patricia Born 
The Catastrophic Effects of Natural Disasters on Insurance Markets
Natural catastrophes often have catastrophic risks on insurance companies as well as on the insured. Using a very large dataset on homeowners' insurance coverage by state, by firm, and by year for the 1984 to 2004 period, this paper documents the positive effect on losses and loss ratios of both unexpected catastrophes as well as large events that the authors term "blockbuster catastrophes." Insurers adapt to these catastrophic risks by raising insurance rates, leading to lower loss ratios after the catastrophic event. There is a widespread event of unexpected catastrophes and blockbuster catastrophes that reduces total premiums earned in the state, reduces the total number writing insurance coverage in the state, and leads to the exit of firms from the state. Firms with low levels of homeowners' premiums are most adversely affected by the catastrophes.

Patricia Born, M. Martin Boyer
Claims-Made and Reported Policies and Insurer Profitability in Medical Malpractice
The liability crisis of the 1970s led to the introduction of a new type of insurance policy designed, according to Doherty (1991), to reduce the un-diversifiable uncertainty associated with writing long-tail liability lines. These new claims-made and reported policies gained favor in place of the traditional occurrence coverage in the early eighties not only in medical malpractice, but also in the general liability arena. Under occurrence coverage, a loss incurred in a given year is covered by the contract for that year, regardless of when the claim is reported. In contrast, a claims-made policy pays only the claims reported in the policy year. Our paper presents a structure, conduct, and performance analysis a la Joskow (1973) of the medical malpractice insurance industry by focusing on the differences between the two contracts. The main question we want to address is why there are two types of contracts that cover the same risk exposure in the medical malpractice insurance industry whereas in other lines of insurance, only one exists primarily.

Dr. Cassandra Cole, Enya He, Kathleen A. McCullough 
A Comprehensive Examination of Insurer Financial Strength Ratings
While unsolicited financial strength ratings have been studied in the banking literature, these sometimes controversial ratings have not been studied in insurance. Utilizing data from multiple sources including a proprietary dataset, we provide the most comprehensive examination of insurer financial strength ratings to date and the first analysis of unsolicited ratings for US property-liability insurers. Similar to bank ratings, we find that insurers’ unsolicited ratings tend to be lower than solicited ratings. We also find some consistency in the importance of organizational and key financial characteristics when comparing the results for unsolicited and solicited ratings across the agencies.

Dr. Cassandra Cole, Enya He, J. Brad Karl
Market Structure and the Performance of the U.S. Health Insurance Marketplace: A State-Level Analysis
Health insurance premiums have more than doubled over the last ten years, with some suggesting that this may be the result of the high market concentration in the health insurance industry.  In this paper, we conduct a state-level analysis in which we examine the health insurance marketplace, the degree of market concentration, and health insurance costs across states.  We generally find that the barrier to entry into health insurance market is relatively low, as witnessed by the increase in the number of insurers operating in most states over the sample period; accordingly, the extent of market concentration has declined in recent years.  We also find evidence of a positive relation between market concentration and insurer profits. 

Patricia Born, Karen Epermanis, Kathleen A. McCullough 
Does a Persistent Defense Strategy Pay Off? An Analysis of Insurance Company Defense Expenditures
Evidence from the property-casualty insurance industry suggests that some insurers tend to settle claims quickly and out of court, while others vigorously defend all claims. While we expect this tendency to vary across lines due to the differential exposures to liability claims, we propose that insurer defense behaviors are not random, but reflect strategies that vary according to market conditions and insured preferences. We consider the extent to which financial and operating characteristics play a differential role for those insurers who select more aggressive or passive defense strategies, and propose that an alignment of insurer and consumer preference is a primary determinant of insurers’ defense strategies. Using insurer defense cost data from 1998-2008, we perform a multi-step analysis to assess the relationships between insurer and market characteristics to defense strategies and assess whether persistence in a particular defense strategy proves to be profitable.

Dr. Cassandra Cole, J. Brad Karl
The Effect of Multidimensional Product Operational Strategies on the Performance of Health Insurance Conglomerates
The conglomerate organizational structure of health insurers suggests two distinct dimensions of product line operations - the first is the product line strategy of the individual affiliates and the second is the product line strategy of the aggregate firm conglomerate. We hypothesize that multidimensional diversification strategies may magnify the costs or benefits of diversification on the financial performance of the conglomerate. Our results confirm this hypothesis and suggest a positive relation between health insurer financial performance and multidimensional product-line diversification. Our results not only contribute to the body of literature related to corporate diversification, but are also important to policymakers and all health insurance market participants as portions of the Affordable Care Act continue to be implemented.

M. Martin Boyer, Charles Nyce 
An Industrial Organization Theory of Risk Sharing
Examining the global reinsurance market for catastrophic losses, we propose a new theory of optimal risk sharing that finds its inspiration in the economic theory of the firm. Our model offers a theoretical foundation for the vertical and horizontal tranching of insurance contracts (also known respectively as proportional and excess of loss reinsurance contracts). Using a two-factor production model popular in industrial economics, we show how reinsurance should be optimally layered (with attachment and detachment points) for a given book of business. This allows us to find the minimum insurance premium necessary to cover the cost of catastrophic events. We conclude with public policy implications by showing the conditions under which government intervention in the catastrophic loss insurance industry can reduce the cost to society of bearing risk and increase its welfare.

Stephen G. Fier, Kathleen A. McCullough, James M. Carson
Internal Capital Markets and the Partial Adjustment of Leverage
Prior literature provides support both for the existence of target capital structures and internal capital markets (ICM). The issue of whether firms use internal capital to reduce deviations from target capital structures, however, has yet to be examined. We provide the first empirical evidence of a link between deviations from target leverage and ICM activity. Based on data that allow us to trace intra-group capital market transactions for property-casualty insurer groups, our findings provide the first joint evidence that affiliated insurance companies have target leverage ratios and that ICM activity is related to deviations from target leverage.

James M. Carson, Kathleen A. McCullough, David Pooser
On the Decision to Mitigate
Prior research provides theoretical insight on factors likely to impact the decision to mitigate such as the degree of risk aversion, the cost of market insurance, and the cost of self-insurance. While empirical evidence in this area has been limited due primarily to data constraints, we provide empirical evidence supporting several hypotheses from the self-insurance literature related to the decision to mitigate.

Patricia Born, William M. Gentry, W. Kip Viscusi, Richard J. Zeckhauser
Organizational Form and Insurance Company Performance: Stocks Versus Mutuals
One unusual feature of the U.S. property-casualty insurance industry is the coexistence of stock and mutual companies. This paper explores the performance of these forms in the industry through a dynamic assessment of how mutual and stock insurance companies respond to differences in their underwriting environment. Agency theories suggest that the stock company may be more 'opportunistic' and less obligated to their insureds than mutuals. This article assesses the responses by stock and mutual firms to changes in the underwriting environment from 1984 to 1991, using measures of individual firms' performance, by state and by line, in eight different lines of insurance. Stock companies are more likely than mutuals to reduce their business in unprofitable situations, and have higher losses than mutuals for a given amount of premiums.

Stephen G. Fier, Kathleen A. McCullough, Joan T. A. Gabel, Nancy Mansfield
Probability Updating and the Market for Directors’ and Officers’ Insurance
Over the past decade, much attention has been given to the topics of corporate governance and corporate risk management. One increasingly important insurance product associated with each of these issues is directors’ and officers’ (D&O) liability insurance. Given the interconnectedness that exists between D&O insurance, corporate risk management, and corporate governance, we exploit industry-specific D&O data to explain how industries most associated with the corporate scandals of the early 2000’s adjusted demand patterns during periods of certainty and uncertainty. The rich dataset coupled with dramatic changes in the marketplace allows for the testing of insurance demand patterns and enables us to offer insight into the market’s response to a unique type of loss shock. The results of this study suggest evidence in favor of demand-side probability updating, whereby those industries most associated with the corporate scandals of the early 2000s adjusted the demand for D&O insurance during periods of greater uncertainty.

Patricia Born, M. Martin Boyer
Risk Retention Groups in Medical Malpractice Insurance: A Test of the Federal Chartering Option
The liability crisis of the eighties led to the enactment of the federal Liability Risk Retention Act of 1986, which encouraged the formation of risk retention groups, a new organizational form that is incorporated under a federal charter. We use risk retention groups as a proxy for insurers opting for a federal charter and assess empirically the economic viability of an optional federal charter. Using annual data from the National Association of Insurance Commissioners, we assess whether risk retention groups increase insurance availability and competition in the medical malpractice insurance industry. We consider the insurers' use of two different types of insurance contracts, namely occurrence contracts and claims - made and reported contracts, and evaluate the benefits to policyholders and society of insurers having access to an optional federal charter, while remaining under state regulatory and solvency controls.

Jeffrey O'Connell, Patricia Born
The Similar Cost and Other Advantages of an Early Offers Reform for Product Liability Claims for Personal Injury Compared to General Liability Claims Therefor
An “early offers” program in which product liability lawsuits could be quickly settled would improve a tort system that is often slow, expensive and unfair. Under the authors’ early offer reform, a defendant facing a personal injury claim is given the option within 180 days after a claim is filed of offering to guarantee periodic payments for a claimant’s medical expenses and wage loss beyond any other applicable coverage, plus 10 percent for attorneys’ fees. There would be no compensation for pain and suffering. The claimant in return agrees to foreclose further pursuit of a normal tort claim for both economic and non-economic losses. Offers could be turned down by claimants, but only in cases where the defendant’s injurious acts were the result of gross misconduct provable beyond a reasonable doubt. The early offers plan would reduce the time it takes to pay losses by at least two years, and also greatly reduce the costs of such claims. Claims for product liability, would be cut by an average of approximately $129,105 per claim and by $563,000 per claim for severe injuries. The early offers plan is projected to save an average of approximately $33,000 in legal expenses in all such cases and about $207,000 in cases of severe injury. The savings come mainly from eliminating pain and suffering damages and reducing legal fees.

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