The Pricing of Financially Intermediated Risks: Evidence from the Property-Liability Insurance Industry

Under perfect market conditions, standard capital budgeting theory predicts that the discount rates on projects should reflect only non-diversifiable risk and be constant across firms. However, theoretical research suggests that when firms invest in non-hedgeable assets under conditions where capital is costly, project pricing should reflect the covariability of the project with the firm’s existing portfolio, even if this covariability represents non-systematic risk. The theory is especially applicable to financial institutions pricing intermediated risks. Theoretical research also suggests that the prices of intermediated risks will reflect the capital strain that such risks place on the intermediary and hence reflect implicit allocations of capital to the intermediary’s business lines. We test these theoretical predictions by analyzing the prices of insurance risks for U.S. property-liability insurers over the period 1997-2004. Specifically, we regress insurance price variables on beta coefficients of insurance line of business losses with overall losses and firm assets, capital allocations by line, measures of insurer insolvency risk, and other risk and control variables. The results provide strong support for theoretical predictions that prices of intermediated risks vary across firms to reflect insolvency risk, non-systematic covariability, and marginal capital allocations.