EFFECTS OF RISK MANAGEMENT ON COST EFFICIENCY AND COST FUNCTION OF THE U.S.

PROPERTY AND LIABILITY INSURERS

Hong-Jen Lin,* Min-Ming Wen, and Charles C. Yang

ABSTRACT
This paper adopts the one-step stochastic frontier approach to investigate the impact of risk management tools of derivatives and reinsurance on cost efciency of U.S. property-liability insurance companies. The stochastic frontier approach considers both the mean and variance of cost efciency. The sample includes both stock and mutual insurers. Among the ndings, the cost function of the entire sample carries the concavity feature, and insurers tend to use nancial derivatives for rm value creation. The results also show that for the entire sample the use of derivatives enhances the mean of cost efciency but accompanied with larger efciency volatility. Nevertheless, the utilization of nancial derivatives mitigates efciency volatility for mutual insurers. This research provides important insights for the practice of risk management in the property-liability insurance industry.

1. INTRODUCTION
Insurance companies face both underwriting and investment risks. They tend to utilize appropriate mechanisms to manage the risks. The underwriting risks are attributed to the issuance of insurance policies, and insurers commonly apply reinsurance to transfer the risk to reinsurers. On the other hand, before insurance companies fulll their obligations to policyholders, premiums collected from policyholders provide insurers with one source of investment funds. Investment risks are incurred with insurers engagement in investment activities, and the use of nancial derivatives provides insurers a venue to manage their investment risks. This paper investigates how these two specic risk management tools, nancial derivatives and reinsurance, affect the cost function and cost efciency of the U.S. property-liability (P/L) insurance industry. The estimation of cost function has been an important topic in the study of industrial organization and nancial institutions. The functional form of cost function enables us to analyze the degree of insurers incentives to manage risks. In addition, cost efciency is an important factor to assess whether the application of risk management mechanisms can enhance insurers performance. The enhancement of cost efciency has become more and more imperative with increasing operational costs. It is very interesting and important to examine the effect of risk management on insurers cost efciency while insurance companies simultaneously apply nancial derivatives and reinsurance to manage risks. Corporate risk management helps reduce costs of a company by either reducing the level of cost function or enhancing cost efciency. As summarized in Smith and Stulz (1985), the application of
* Hong-Jen Lin is an Assistant Professor in Finance, Department of Finance and Business Management, Brooklyn College, CUNY, Brooklyn, NY, HJLin@brooklyn.cuny.edu. Min-Ming Wen is an Assistant Professor in Finance, Department of Finance and Law, California State University, Los Angeles, CA, mwen2@calstatela.edu. Charles C. Yang is an Associate Professor in Risk Management and Insurance, Department of Finance, Florida Atlantic University, Boca Raton, FL, cyang1@fau.edu.

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risk management can benet corporations in (1) the reduction of bankruptcy and distress costs, (2) the reduction of nancing costs, and (3) the reduction of expected payments to stakeholders. However, some literature provides mixed evidence on whether risk management can increase rm value. MacKay and Moeller (2007) show that a concave cost function implicitly motivates oil companies to use more derivatives to hedge their nancial and operational risks. With such a concave cost function, risk management can increase rm value with simultaneous cost reduction and revenue enhancement. Following this line of study, we examine whether the cost function of insurance companies can be depicted by concavity or convexity. In addition, we further explore whether a concave/convex cost function of the insurance industry can increase/decrease insurers rm value while using the risk management tools of nancial derivatives and reinsurance. We use the degree of efciency to measure an insurers performance. The efciency analysis for the insurance industry has focused on the impact of market structures (Rai 1996; Choi and Weiss 2005), organizational forms, corporate governance and ownership issues (Cummins et al. 2004), regulatory bodies and rules in different nations (Cummins and Rubio-Misas 2006), and mergers and acquisitions (Cummins et al. 1999). In addition, Cummins et al. (2006) investigate the effect of risk management on insurance efciency based on stochastic frontier analysis. They assume that the risk management decision is the outcome of the macroeconomic and environmental factors, given that a rms objective function is to minimize the total cost. Fenn et al. (2008) consider the volatility of cost efciency in the European insurance industry, but the impact of risk management variables is not investigated. This current paper differentiates itself from previous research by considering both reinsurance and nancial derivatives in the analysis of cost efciency. In addition, this study simultaneously investigates the effect on the mean and variance of cost efciency from the managerial decisions on the utilization of risk management tools. Furthermore, we make the rst attempt to identify the concavity or convexity of insurers cost functions in order to create a linkage of insurers risk management incentives to rm value creation. We intend to relate cost functions of different organizational forms of insurers (mutual vs. stock insurers) with different risk management strategies. The results of this study provide important insights for the practice of risk management in the P/L insurance industry. The next section of this paper describes the one-step stochastic frontier model and the hypotheses. Section 3 describes the data and variables used in our analysis. Section 4 presents empirical results, and the nal section concludes.

2. MODEL SPECIFICATIONS

AND

HYPOTHESES

This paper adopts the stochastic frontier approach developed in Wang and Schmidt (2002) to consider how risk management decisions and rm characteristics affect efciency and cost function within one step. The application of the stochastic frontier approach can further allow us to depict whether insurers cost functions carry the feature of concavity or convexity. McKay and Moeller (2007) conclude that a concave cost function can enhance rm value from hedging, while other literature provides mixed evidence. We make the rst attempt to examine the functional form of P/L insurers cost functions and to investigate whether the conclusions provided in McKay and Moeller (2007) is supported in the P/L insurance industry. Compared to the one-step stochastic frontier approach, the most commonly applied Data Envelopment Analysis (DEA) model (nonparametric) in the existing efciency literature (e.g., Noulas et al. 2001; Jeng and Lai 2005) cannot depict the shape of cost functions and thereby is unable to directly link cost function to risk management strategies. In addition, it has also been shown that the estimates of parameters in the one-step procedure are statistically more efcient than the traditional two-step approach (i.e., the simple stochastic frontier approach combined with Tobit regression). The general form of the one-step stochastic frontier model is illustrated by the following equations: ln CRit CR(Q, P, Z, T) R F uit Rit Fit it, 2 exp( Rit Fit), uit it uit, (1) (2) (3)

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where ln(CRi,t) is dened as the natural log of total costs from underwriting and investment on the incurred basis for rm i at time t, and CR(Q, P, Z, T) represents the cost frontier (function) of an insurer and renders the least cost given the level of insurance services Q, the input price P, control variables Z, and time T. Specically, Q and P represent respective output quantity and input prices that are related to underwriting and investing activities, Z depicts rm characteristics variables and represents the organization form (mutual vs. stock insurers), and T controls for time effects within the sample period. In equation (1), is the normal residual term of the cost function and uit is dened as the one-sided cost inefciency for rm i at time t.1 Equation (2) enables us to explicitly examine the factors contributing to the degree of cost inefciency uit. The factor Rit is dened as a vector of variables that are related to risk management. F is dened as nancial intermediate outputs and is specied by the ratio of surplus to risk-based capital and the growth of net premium written. The risk management variables R and nancial intermediate outputs F are both determined by the management of the insurance company, and their effects are depicted by the coefcients of R and F. Here is the residual term of cost inefciency function. Equation (3) indicates how the variance of cost inefciency ( 2) is affected by nancial intermediate outputs variable F and risk management variable R, which consists of underwriting risks and investment risks. The one-step stochastic frontier model considers not only the cost efciency level but also its variance. In the model equations (2) and (3) capture how the utilization of risk management mechanisms improves the mean and variance of cost inefciency, respectively. Equations (1) and (2) indicate the degree of the mean of cost efciency enhanced through the implementation of risk management, and equations (1) and (3) identify the degree of the variance of cost efciency that is improved via risk management. The inclusion of a vector of variables that are related to risk management in equations (2) and (3) enables us to consider the separate effect from managing underwriting risks or investment risks. The inclusion of equations (1), (2), and (3) in the model takes the mean and variance of cost efciency into account simultaneously, which contributes to the literature by expanding the insurance efciency study to consider different perspectives from both shareholders (emphasizing efciency enhancement) and policyholders (averse to variance). As indicated in the insurance efciency literature (e.g., Cummins and Weiss 1998; Cummins et al. 2006), the exact form of the cost function described in equation (1) is unknown, and without loss of generality, a natural log functional form of cost function is applied for empirical applications. Equations (4), (5), and (6) below carry out the empirical applications based on the one-step stochastic frontier model described in equations (1), (2), and (3).2 The variables in equations (4), (5), and (6) are the same as those dened in equations (1), (2), and (3). In addition, to examine whether the cost function of the P/L insurance industry carries the concavity/convexity feature, in equation (4) we include quadratic terms of input prices and its interacted terms with output quantity. McKay and Moeller (2007) discuss the case of nancial derivatives use. This current study examines whether the link between concavity/convexity and value creation can be observed in both reinsurance and nancial derivatives risk management mechanisms. The equations are as follows: ln CRit
i v v t Q,P v t R F Q v

ln Qvit

P s sit

{(ln Qvit)2
s s it

(ln Qvit ln Qvjt) uit it,

(ln Qvit Psit)

(Pvit)2

(Psit Psjt)} (4) (5) (6)

Dt

Ds

uit
2 uit

Rit

Fit

exp( Rit

Fit).

The cost inefciency is represented by e u. Its numerical interpretation is as follows: for example, with a value of 1.02, the total cost is 2% above the optimal level of the cost function. Thus, it is recognized as a measure for inefciency level. 2 For more details regarding total cost and cost efciency, see Fu and Heffernan (2008) and Baumol et al. (1980).

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In addition, the variables T and Z in equation (1) are realized by the dummy variables Dt and Ds in equation (4), which are designed to control the year effect and the ownership effect, respectively. Ds equals 1 for stock insurers. The specications of the models imply that the outputs of property/liability insurers are determined by the overall market or macroeconomic factors. Therefore, insurers should improve cost efciency to reduce total costs and hence increase prot. In other words, given the output level of an insurer, the best strategy of the insurer is to improve cost efciency or reduce total costs. Using reinsurance is to directly manage underwriting risks, and reinsurance premiums have to be paid up front. It is likely that insurers can adopt alternative methods to manage underwriting risks through underwriting insurance in different lines or in different geographic areas. We argue that in the long run, reinsurance is likely to reduce total costs, but, on the other hand, reinsurance costs can be higher in the short run. Consequently the net effect of reinsurance on total costs can be positive or negative. Nevertheless, insurers utilize reinsurance and expect to increase the mean of cost efciency from its net effect. As a result, we develop the following hypothesis: H1: The amount of reinsurance (R1) is positively associated with the mean of cost efciency. On the other hand, using nancial derivatives is to directly manage investment risks to reduce nancing costs as well as bankruptcy costs, as indicated in Smith and Stulz (1985). The evidence from the banking literature suggests that the use of derivatives is often referred to as off-balance sheet activities, and Clarks and Siems (2002) show that the cost and prot efciency can be improved via off-balance sheet activities. In addition, using sample banks from Taiwan and Latin America, Lieu et al. (2005) and Rivas et al. (2006) conclude that banks can enhance cost efciency if they apply more derivatives. With similar characteristics between the banking and insurance industry, we hypothesize that the use of derivatives can increase the mean of insurers cost efciency: H2: The notional amount of derivatives (R2) contributes positively to the cost efciency of insurers. The variance of cost efciency can be regarded as a risk factor. In other words, when the variance of cost efciency is large, the total cost of an insurer is more volatile. Intuitively, insurers tend to apply both R1 and R2 to reduce uncertainty, namely, the variance of cost efciency. Therefore, Hypothesis 3 suggests a negative relationship between risk management variables and the variance of cost efciency: H3: The risk management variables (R1 or R2) are negatively related to the variance of cost efciency.

3. DATA

AND

VARIABLES

To empirically examine how risk management affects the mean and variance of cost efciency based on the one-step stochastic frontier model, we collected insurance data from the National Association of Insurance Commissioners (NAIC) database. In addition, the data of derivatives use by insurers are separately retrieved from Schedule DB. Insurers are required to le regulatory annual statements and any derivatives transactions with the NAIC. The three-year sample period covers years 2002, 2003, and 2004,3 each of which includes 1,654, 1,662, and 1,654 sample insurers, respectively. The total number of observations over this three-year sample period is 4,970, of which 3,865 rms are stock insurers and 1,105 rms are mutual insurers.

Due to limited funding support for the data purchase of the NAIC annual statements and the NAIC Schedule DB data, this study is limited to include only a three-year sample period. This study will serve as a basis for future research that will expand to a longer sample period.

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This paper adopts the intermediary approach (Brockett et al. 2005) to specify the empirical cost function.4 In particular, the dependent variable of the cost frontier in equation (4) is the incurredbasis total cost that includes investment expenses and underwriting expenses derived from underwriting new policies, maintaining existing policies, and reserving. To empirically implement the methodology of the one-step stochastic frontier approach, we collect the variables that are related to output quantities (Q), input prices (P), risk management (R), and rm characteristics (Z). Since investment and underwriting risks are the two major categories of risks that insurance companies intend to manage, we collect the output variables and risk management variables that are specically related to investment and underwriting activities. In terms of output variables, Q consists of Q1 and Q2. Q1 is dened as the investment-related output quantity measured by the ratio of net investment income to total assets. Q2 represents the underwriting-related output quantity dened by the ratio of total loss incurred to net premium written. With respect to the variables related to risk management R, it includes R1 and R2, which represents reinsurance premium written (R1 ) and the notional transactions amount of derivatives (R2), respectively. The input price P is categorized based on the insurers ownership that can be classied by policyholders, stockholders, and debt holders. For the vector of input prices, P includes P1, P2, and P3. P1 stands for the ratio of total dividend specically paid to the stockholders and change in treasury stocks to the surplus; P2 is the surplus growth rate, dened as the ratio of current-year surplus to previous surplus; and P3 denotes the ratio of interest expenses to surplus. For stock insurers, there exist P1, P2, and P3, while for mutual insurers only P2 and P3 are used. P2 captures the proxy of an input price that stands for the contribution of surplus. Last, F factors, representing the exogenous rm characteristic variables, include the ratio of surplus to regulatory required risk-based capital (Sup RBC) and the growth rate of net premium written (NPW GW). The choice of Sup RBC and NPW GW is based on the empirical work by Born et al. (2009). Table 1 presents the summary statistics of the variables for the entire sample, stock insurers, and mutual insurers, which include 4,970, 3,865, and 1,105 observations, respectively. In addition, the comparison between stock and mutual insurers is also provided in Table 1. It is shown that, on average, the total cost CR for the entire P/L insurance industry in the period from 2002 to 2004 is about $189,421 million, and $220,225 million and $151,641 million for stock and mutual insurers, respectively. The difference in total costs between stock and mutual insurers is not signicant. As shown, each variable shows a greater degree of variability, evidenced by a larger standard deviation and larger coefcient of variation (CV). For example, the CV of the total cost for the entire sample is about 5.32. Mutual insurers tend to show larger variability of total costs than stock insurers. The CV is 4.92 for stock insurers, while it is 7.12 for mutual insurers. Results based on the univariate comparison suggest that the total cost of mutual insurers is more volatile than that of stock insurers in the sample despite insignicant mean difference. In terms of the output variables related to investing (Q1) and underwriting activities (Q2), stock insurers, on average, show a signicantly larger net investment income than mutual insurers, with mean values of $33,092 million and $3,397 million, respectively. However, no signicant difference is found in the underwriting outputs between stock and mutual insurers. The coefcients of variation of Q1 and Q2 for stock and mutual insurers suggest a different degree of variability in investing and underwriting activities. For stock insurers, the variability of underwriting outputs (with CV 42.28) is greater than that of investing outputs (with CV 29.71). On the other hand, for mutual insurers, the variability of investing outputs is greater with the value of CV at 9.92 compared to 2.67 for underwriting outputs.

4 Brockett et al. (2005) indicate that the intermediary approach is more relevant than the value-added (production) approach in the insurance industry.

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Table 1 Summary Statistics and Comparisons

Panel I Summary Statistics and Comparisons Two-Sample Z Test between Stock and Mutual Insurers C.V. H0:
s m

All Insurers Variable Mean S.D. C.V. Mean

Stock Insurers S.D. C.V. Mean

Mutual Insurers S.D.

CR 189,421 1,007,500 Q1 26,488 866,824 Q2 2,432 117,045 P1 (%) P2 (%) 1.55 28.24 P3 (%) 2.03 67.99 R1 163 800 R2 1,353 95,194 SUP RBC 0.96 0.23 NPW GW 5.77 183.05 TA 649,512 3,010,270

5.32 200,225 985,870 32.73 33,092 982,748 48.13 3,110 132,749 3.87 25.70 18.22 1.17 0.54 33.49 0.83 1.44 4.91 186 860 70.36 1,739 107,951 0.24 0.97 0.19 31.72 7.07 207.57 4.63 667,853 2,566,674

4.92 151,641 1,079,340 7.12 29.70 3,397 33,713 9.92 42.68 64 171 2.67 6.64 0.46 2.90 59.89 20.65 1.73 6.23 144.12 23.13 4.62 84 534 6.36 62.08 3 63 21.00 0.20 0.90 0.31 0.34 29.36 1.22 1.39 1.14 3.84 585,363 4,209,905 7.19

0.84 1.87* 1.43 0.56 0.72 3.30*** 1.00 4.15*** 1.75* 0.37

Panel II Number of Observations Year 2002 2003 2004 Total Number of Firms 1,654 1,662 1,654 4,970 Number of Firms 1,281 1,296 1,288 3,865 Number of Firms 373 366 366 1,105

Note: S.D. is the sample standard deviation. The two-sample Z test is to test the null hypothesis H0: stock mutual. *, **, and *** indicate the signicance at the 10%, 5%, and 1% levels, respectively. R1: premium written of reinsurance in million dollars R2: notional amount of derivatives in million dollars CR: total costs in millions of dollars Q1: investment related output quantity, i.e., net investment income in millions of dollars Q2: underwriting related output quantity, i.e., total loss incurred in millions of dollars P1: the ratio of the sum of dividend paid to the stockholders and change in treasury stocks to the surplus, i.e., (dividend paid change in treasury stocks)/surplus P2: the surplus growth rate, i.e., surplus in the current year/surplus in the previous year P3: the ratio of interest expenses to surplus SUP RBC: the ratio of surplus to RBC NPW GW (%): the growth rate of net premium written TA: total assets in million dollars

Regarding the input price variables, we observe that on average P2 and P3 for stock insurers are smaller than those for mutual insurers, but the difference is not signicant. For example, the values of P2 and P3 for stock insurers are 1.17% and 0.83%, whereas they are 2.90% and 6.23% for the mutuals. In terms of the utilization of risk management, as shown in Table 1, compared to mutual insurers, stock insurers tend to apply a larger degree of reinsurance and nancial derivatives for managing underwriting and investment risks. The difference in reinsurance is signicant between stock and mutual insurers, whereas no signicant difference is seen in the use of derivatives. Specically, the average values of R1 and R2 for stock insurers are $186 million and $1,739 million, respectively, and they are $84 million and $3 million for mutual insurers. This result suggests that stock insurers implement risk management tools for both underwriting and investment risks more intensively than mutual insurers. In addition, stock insurers show a smaller variability in reinsurance use than mutual insurers with the respective values of CV of 4.62 and 6.36. On the other hand, stock insurers use of nancial derivatives show a greater degree of variability, with a CV value of 62.28 compared to that of mutual insurers with a value of CV at 21. The comparison of rm characteristics shows that the ratio of surplus to RBC and the premium growth rate of stock insurers are signicantly greater than those of mutual insurers. On the other hand, no signicant difference in rm size is observed between stock and mutual insurers. Generally speaking, each input, output, or rm characteristic variable of stock insurers does not consistently show greater variability than that of mutual insurers. With a different degree of variability

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in the variables, it is likely that the cost functions of stock and mutual insurers can be different, suggesting their different applications of risk management mechanisms for underwriting and investing activities.

4. EMPIRICAL RESULTS

AND

ANALYSES

The empirical results of the applications of the one-step stochastic frontier model are presented in Tables 2, 3, and 4. In particular, the results of cost function analyses as indicated in equation (4) are summarized in Table 2. These analyses further associate the concavity or convexity of the cost frontier with the hedging strategy of an insurer. Tables 3 and 4 report the results of cost efciency analyses from the utilization of different risk management mechanisms for underwriting and investing risks as indicated in equations (5) and (6). As suggested in Wang and Schmidt (2002), the simultaneous consideration of the mean and variance of cost efciency enables us to detect how risk management utilization affects the mean and variance of cost efciency.

4.1 The Analysis of Cost Function

Table 2 presents the estimation of the cost functions for the entire sample and the subsamples of stock and mutual insurers. In order to identify the effect of rm size (measured by total assets), for each subsample, we further divide it into subgroups of big and small insurers. For the entire sample, its cost function incorporates all the observations of stock and mutual insurers. The results indicate that a majority of coefcients are statistically signicant (19 out of 24). For example, ln Q1 is negatively associated with CR, while ln Q2, P1, P2, and P3 show positive effects. In addition, the model parameters and are signicant at the 1% level. Lambda is dened as the ratio of the standard deviation of cost inefciency to that of the random error term, that is, u / . A signicant suggests a signicant difference of cost inefciency from the random error. Sigma is dened as the composite standard 2 2 deviation of both cost inefciency and random error: implies that the total u . A signicant composite error term signicantly departs from the cost function. Consequently the results of signicant of and indicate the existence of cost inefciency. The analysis of the cost function can be associated with the relation between the concavity of the cost frontier and the hedging strategy of a rm (McKay and Moeller 2007). For the entire sample (P1 )2, (P2)2, and (P3)2 are all negatively signicant at the 1% level, which suggests that the cost function for the P/L industry is concave along the dimensions of P1, P2, and P3, respectively. The year dummies (D2003, D2004) are included to control the year effect. The insignicant coefcients of year dummies suggest no difference over the sample period. The stock insurer dummy variable shows a positive and signicant effect on total costs at the 1% level, which suggests that stock insurers tend to have higher total costs compared to mutual insurers, which is consistent with the univariate analysis shown in Table 1. As for the subsamples of stock and mutual insurers, the results document that the estimates of stock insurers are principally consistent with those observed in the entire sample. In particular, the coefcients of the squared term of the surplus growth rate (P2)2 of both stock and mutual insurers are negatively signicant at the 10% and 5% levels, respectively. In addition, the coefcient of the interest expense ratio (P3)2 of mutual insurers is negatively signicant at the 10% level. The results suggest that the concavity relative to the surplus growth rate remains in both organizational forms, while the concavity relative to the interest expense ratio holds only in the mutual insurers group. On the other hand, compared to the results of stock insurers and the entire sample, the results of the mutual insurers group present different effects on their cost functions. For instance, the coefcient of ln Q1 in the mutual subsample is positive, whereas it has negative effects in the entire sample and stock insurers subsample. This suggests that while investment income of the entire P/L industry and the stock insurers can signicantly reduce total costs, the investment income of the mutual group increases its total costs. In addition, ln Q2 has positive effects on the cost function for the entire sample and stock insurers subsample, whereas we observe insignicant effects in the mutual subsample.

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Table 2 Empirical Results of Cost Function: Equation (4)

Stock Coefcient 12.336 0.683 0.358 0.022 2.098 0.345 0.026 0.036 0.000 0.123 0.005 0.018 0.000 0.001 0.008 0.001 0.358 0.025 0.014 0.165 0.002 0.132 0.617 4.211 6.224 14.61*** 13.48*** 3.715 7.311 2.27*** 2.27*** 1.191 138.095 6.89*** 16.2*** 2.814 5.157 6.55*** 6.08*** 1.620 3.570 0.69 1.29*** 50.17*** 26.01*** 3.75*** 2.15** 7.56*** 1.83* 18.91*** 4.44*** 1.26 1.94* 0.27 6.92*** 0.72 0.14 2.60*** 0.77 4.03*** 1.09 1.15 1.15 0.35 1.16 1.91* 22.896 0.961 0.432 1.451 0.205 0.018 0.117 0.002 0.000 0.047 0.064 0.010 0.865 0.041 0.027 0.050 26.77 5.19*** 5.07*** 0.40 0.37 0.46 1.86*** 1.41 1.90** 1.87* 3.55*** 1.19* 3.25 0.92 0.42 0.26 0.18 8.63*** 114.037 11.490 10.480 0.168 92.160 15.307 0.654 2.043 0.000 9.152 0.124 0.768 0.013 1.457 0.300 0.013 10.549 1.008 0.583 4.354 0.068 3.924 84.469 3.60*** 3.28*** 1.35 0.33 2.90*** 1.69* 3.08*** 4.32*** 0.42 1.23 0.34 2.78*** 0.25 0.74 0.73 0.15 1.44 0.85 1.50 0.70 2.06** 0.72 1.81* 21.441 0.402 0.725 0.029 0.186 0.103 0.013 0.117 0.000 0.005 0.048 0.006 0.001 0.004 0.005 0.001 0.014 0.035 0.017 0.044 0.003 0.107 22.394 10.18*** 1.80* 1.29 0.72 0.22 0.19 1.40 1.25 0.47 0.06 0.75 0.73 0.98 0.18 0.61 0.06 0.06 0.46 1.30 0.14 0.23 0.31 5.77*** 21.564 0.173 0.995 3.460 0.669 0.014 0.042 0.002 0.000 0.004 0.076 0.010 1.352 0.106 0.084 0.094 16.46 6.52** 0.33** 1.75* 6.04** 0.73 0.02 0.19 0.00 0.00 0.02 0.08 0.01 1.46 0.16 0.26 0.40 4.73*** t value Coefcient t value Coefcient t value Coefcient t value Mutual Small Stock Big Stock Small Mutual Big Mutual t value 8.671 0.619 4.825 10.422 0.131 0.018 0.340 0.844 0.036 0.025 0.033 0.004 2.208 0.098 0.088 0.172 23.32 2.90 5.07 11.63*** 0.29 3.77*** 9.02*** 1.33 0.01** 0.74 1.58 0.04 0.03 0.06 0.01 2.09** 0.24 0.52 0.44 4.54*** 2.72*** 4.47***

All Observations

Variable

Coefcient

t value

Coefcient t value Coefcient

Constant ln Q1 ln Q2 p1 p2 p3 ln Q1 ln Q1 ln Q2 ln Q2 p1*p1 p2*p2 p3*p3 ln Q1 ln Q2 ln Q1*p1 ln Q1*p2 ln Q1*p3 ln Q2*p1 ln Q2*p2 ln Q2*p3 p1*p2 p3*p2 p1*p3 D STOCK D 2003 D 2004

12.454 0.691 0.359 0.055 1.612 0.233 0.037 0.024 0.000 0.000 0.000 0.018 0.002 0.025 0.020 0.006 0.396 0.024 0.056 0.052 0.010 0.343 0.190 0.632

22.24*** 12.21*** 3.09*** 9.79*** 4.82*** 1.53 14.32*** 2.35** 15.25*** 2.16** 13.72*** 5.41*** 15.76*** 2.79*** 16.68*** 3.90*** 3.67*** 0.86 16.97*** 0.92 7.96*** 2.86*** 1.27 0.67

4.239 8.848

6.64*** 6.34***

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Note: *, **, and *** denote signicance at the 10%, 5%, and 1% levels, respectively. Big (small) stock insurers are dened as those insurers with rm size greater (less) than median size in the corresponding organizational group. ln Q1: natural log of net investment income ln Q2: natural log total loss incurred p1: the ratio of the sum of dividend paid to the stockholders and change in treasury stocks to the surplus p2: the surplus growth rate, i.e., surplus in the current year/surplus in the previous year.ate of increase in surplus p3: the ratio of interest expenses to surplus 2 2 u/ ; u D STOCK: the dummy variable for stock insurers, D STOCK 1 D 2003: the year dummy; for the observations in 2003, D 2003 1, otherwise 0 D 2004: the year dummy; for the observations in 2004, D 2004 1, otherwise 0

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Table 3 Effects of Risk Management Variables on the Mean of Cost Inefciency: Equation (5)
All Observations Variable Constant SUP RBC NPW GW R1 R2 Variable Constant SUP RBC NPW GW R1 R2 Coefcient 5.78439 0.02548 0.00381 0.00126 0.00003 t value 1.42 0.03 0.64 5.84*** 4.07*** Stock Coefcient 0.11509 0.10153 0.00121 0.00133 0.00000 Mutual Coefcient 6.24172 0.82205 0.03406 0.00195 0.08105 t value 0.60 0.31 0.04 1.95* 0.96 t value 0.07 0.08 0.89 17.31*** 0.08 Small Stock Coefcient 0.75740 0.25791 0.01880 2.06342 0.00011 t value 0.02 0.01 1.26 8.54*** 0.08 Big Stock Coefcient 0.00001 0.00001 0.00001 0.00076 0.00000 t value 0.00 0.00 0.00 6.32*** 0.07

Small Mutual Coefcient 3.61994 4.51933 0.13716 0.00119 0.00021 t value 9.07*** 4.05*** 0.19 0.00 0.01

Big Mutual Coefcient 1.36182 1.25728 1.59949 0.00050 0.00334 t value 12.85*** 5.64** 3.96** 0.00 0.00

Note: *, **, and *** denote signicance at the 10%, 5%, and 1% levels, respectively. Big (small) stock insurers are dened as those insurers with rm size greater (less) than median size in the corresponding organizational group. R1: premium written of reinsurance in millions of dollars R2: notional amount of derivatives in millions of dollars SUP RBC: the ratio of surplus to RBC NPW GW (%): the growth rate of net premium written

Table 4 Effects of Risk Management Variables on the Variance of Cost Inefciency: Equation (6)
All Observations Coefcient Constant SUP RBC NPW GW R1 R2 7.96474 0.00000 0.00000 0.00019 0.00192 t value 88.90*** 0.00 0.00 7.20*** 6,453.67*** Coefcient 7.98192 0.00000 0.00000 0.00020 0.00219 Stock t value 72.11*** 0.00 0.00 6.85*** 7,351.91*** Mutual Coefcient 7.49455 0.05964 0.00512 0.00111 0.00185 t value 38.83*** 0.45 0.07 7.13*** 2.51***

Note: *, **, and *** denote signicance at the 10%, 5%, and 1% levels, respectively. R1: premium written of reinsurance in millions of dollars R2: notional amount of derivatives in millions of dollars SUP RBC: the ratio of surplus to RBC NPW GW (%): the growth rate of net premium written

Table 2 also presents a comparison based on rm size for each organizational form. No signicant effects of the squared terms of input prices, (P1)2, (P2)2, and (P3)2, on cost function are observed for different rm sizes. In summary, the direction of the impact of the output variables and input prices on cost functions is generally the same as we expected for the entire P/L industry. In addition, the negative and significant coefcients of the squared input prices suggest concavity of the cost function, and thereby the P/L insurance industry tends to hedge risks for rm value creation purpose. The next step is to analyze whether both risk management mechanisms can effectively increase rm value measured by efciency.

4.2 The Analysis of Cost Efciency

The analysis of cost efciency here is to investigate the impact of risk management on the mean and variance of cost inefciency. In particular, equations (5) and (6) test the signicance of the contribution of the risk management utilization to the mean and variance of cost inefciency. Negative estimates of the coefcients of risk management variables in equation (5) suggest that the implementation of risk management tools can decrease the mean of cost inefciency, that is, increase the mean

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of cost efciency. In addition, negative coefcients of risk management variables in equation (6) suggest a decrease in the variance of cost inefciency. Table 3 demonstrates the empirical results of equation (5) for the entire sample as well as for both stock and mutual insurers. It displays the estimation of equation (5), indicating the impact of risk management factors R on the mean of cost inefciency u. As shown, for the entire sample, the coefcient of reinsurance use (R1) is positively associated with cost inefciency (u), whereas the coefcient of derivatives use (R2) presents a negative relation with cost inefciency. Both are signicant at the 1% level. This indicates that for the whole P/L insurance industry, only the use of nancial derivatives enhance cost efciency, but not the use of reinsurance. The results are consistent with Hypothesis 2, but not with Hypothesis 1, in which we expect cost efciency enhancement through reinsurance. Neither stock nor mutual insurers show efciency enhancement through reinsurance. Nevertheless, incorporating the concavity of the cost function into consideration of hedging implementation, we observe that for the entire sample, the concavity of input prices (i.e., cost) does contribute to the use of nancial derivatives, thereby leading to enhancement of cost efciency. The results on the use of nancial derivatives are consistent with the conclusions in McKay and Moeller (2007). Differently from McKay and Moeller, our research also examines the relationship between reinsurance and cost efciency and documents a negative effect of reinsurance on cost efciency. No signicant difference is observed between small and big insurers. Table 4 depicts how risk management variables are associated with the variance of cost (in)efciency as indicated in equation (6).5 For the entire sample, both R1 and R2 are positively and signicantly related to the variance of cost inefciency, which suggests that either the use of reinsurance or the use of derivatives increases the volatility of cost efciency. As for insurers different organizational forms, the sample of stock insurers group shows consistent results with those of the entire sample. Nevertheless, for mutual insurers, the implementation of nancial derivatives decreases the volatility of cost efciency as expected. For stock insurers, ownership is dominated by public shareholders, who may desire a larger degree of volatility to increase value. As a result, a positive effect of nancial derivatives implementation on volatility is observed.

5. CONCLUSIONS
More and more enterprises sense the importance of risk management. As for the insurance industry, there are two major types of risks: underwriting risks and investment risks. An insurance company can reduce its risks either by purchasing reinsurance policies or by using nancial derivatives. This paper adopts the one-step stochastic frontier approach to explore the impact of risk management tools such as derivatives and reinsurance on both cost function and cost efciency in the U.S. property-liability insurance industry. This study takes the rst attempt to examine the cost function of the insurance industry in order to link the cost function concavity (or convexity) to risk management and then to rm value enhancement According to the empirical results, the cost function for the entire P/L insurance industry carries the concavity feature not only toward the equity related input price, but also toward the debt-related input prices; and the P/L insurers tend to hedge by using equity-related derivatives, such as nancial derivatives. As to the effect of derivatives on cost efciency, the empirical result documents that the use of derivatives signicantly enhances cost efciency for the entire P/L insurance industry. On the other hand, the use of reinsurance does not enhance cost efciency for the P/L insurance industry. As we take one step further to examine the effects of risk management on the volatility of cost efciency,

There is no signicant difference observed between small and big insurers. Therefore, the comparison results between small and big insurers are not presented in Table 4.

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we observe that for the entire P/L industry and for the sample of stock insurers, the use of derivatives increases the volatility of cost efciency, resulting in a more volatile cost efciency. Theoretically insurers can adopt derivatives to hedge the investment risk. However, when insurers aggressively take on risks to seek higher investment reward, the volatility of cost efciency will increase to closely align with stockholders interests: That is, the use of derivatives is likely to increase the risk of the insurer and defeat the purpose of risk management. The implication of this nding is that insurers should keep a balance between the efciency gain and efciency volatility with the use of derivatives.

6. ACKNOWLEDGMENTS
The authors thank Professor Mary Hardy and the anonymous referee for their valuable and insightful comments. Hong-Jen Lin is grateful for the research award offered by the Research Foundation of the City University of New York (PSC-CUNY Award no. 63415-00 41). REFERENCES
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