Capital Allocation and the Price of Insurance: Evidence from the Merger and Acquisition Activity in the US Property-Liability Insurance Industry

This paper examines empirically the impact of mergers and acquisitions on the capital allocation of newly formed insurers as well as on changes in the price of insurance across lines of business of those insurers in the U.S. property-liability insurance industry over the sample period 1995-2004. Our analysis is guided by the theoretical propositions set forth in Froot and Stein (1998) and in the capital allocation literature (Myers and Read, 2001) which predict the prices of illiquid risks depend upon the firm’s capital structure, the covariance of an individual line of insurance relative to the riskiness of firm’s entire portfolio, and marginal capital allocated to the line of business. This paper also investigates whether changes in the price of insurance across lines reflect the changes in firm insolvency risk and new marginal capital allocation due to M & A activity in the newly formed insurer. We find that M & A leads to reduction in capital requirement (capital-to-liability ratio), lowering the price of insurance in the newly formed insurer. We also provide support for the hypotheses that the changes in the price of insurance across lines are inversely related to the changes in firm insolvency put value and are positively related to the changes in marginal capital allocation.