The cost of capital for insurance companies
The cost of capital of Insurance companies
By J.J Launie
Summary
The idea of this research paper is centered on the concept that the accounting data used in an insurance company balance sheet can be interpreted in a traditional cost of capital framework. In order to do this, first the capital framework of industrial firms has been defined and then compared with that of insurance companies. In an industrial company the debt component of the capital structure is divided into short term and long term categories. These are funds provided by creditors of the firm, mainly bond holders. External funds generated through the regular operations such as trade credit, are not considered in the traditional analysis. While in a property liability insurance company, there is no debt in the traditional sense. The funds other than those provided by the equity holders, are generated through the business operations of the firm. The main liabilities in an insurance company are the loss reserve and the unearned premium reserve. These liability accounts enjoy in the overall capital structure of the firm. Since these funds are provided by sources other than ownership and represent a debtor creditor relationship, they are defined as quasi-debt. The quasi debt portion of insurance company’s capital structure is defined as the sum of the loss reserve and the unearned premium reserve. The quasi debt percentage in the capital structure can be calculated by:
Conceptually there is no difference between the equity component of an industrial company and an insurance company so the required rate of return to the stockholders can be estimated by capitalization of dividends and the expected growth in earnings.
Once the cost of the individual components of the capital structure has been estimated on an annual basis the overall cost of capital can be calculated by means of a simple weighted average of the debt and equity components.
By J.J Launie
Summary
The idea of this research paper is centered on the concept that the accounting data used in an insurance company balance sheet can be interpreted in a traditional cost of capital framework. In order to do this, first the capital framework of industrial firms has been defined and then compared with that of insurance companies. In an industrial company the debt component of the capital structure is divided into short term and long term categories. These are funds provided by creditors of the firm, mainly bond holders. External funds generated through the regular operations such as trade credit, are not considered in the traditional analysis. While in a property liability insurance company, there is no debt in the traditional sense. The funds other than those provided by the equity holders, are generated through the business operations of the firm. The main liabilities in an insurance company are the loss reserve and the unearned premium reserve. These liability accounts enjoy in the overall capital structure of the firm. Since these funds are provided by sources other than ownership and represent a debtor creditor relationship, they are defined as quasi-debt. The quasi debt portion of insurance company’s capital structure is defined as the sum of the loss reserve and the unearned premium reserve. The quasi debt percentage in the capital structure can be calculated by:
Conceptually there is no difference between the equity component of an industrial company and an insurance company so the required rate of return to the stockholders can be estimated by capitalization of dividends and the expected growth in earnings.
Once the cost of the individual components of the capital structure has been estimated on an annual basis the overall cost of capital can be calculated by means of a simple weighted average of the debt and equity components.