The Effect of Underwriting Diversification on Investment Risk of Insurance Companies

Document Type : Research Paper

Authors

1 Ph. D in finance-insurance, Department of financial management and insurance, Faculty of management, University of Tehran, Tehran, Iran and lecturer, Department of Business and financial management, Faculty of Economics and Management, University of Sistan and Baluchestan, Zahedan, Iran.

2 Professor in finance, Department of financial management and insurance, Faculty of management, University of Tehran, Tehran, Iran.

3 Associate Professor in economics, Department of Economics, Faculty of Economics, University of Tehran, Tehran, Iran

Abstract

Abstract
This study investigates the effect of diversification in the underwriting activities and insurance portfolio on the level of risk-taking in the investment activities of insurance companies. According to the coordinated risk management hypothesis, it is expected that there is a negative relationship between investment risk and underwriting risk of insurance companies. To examine the effect of insurance portfolio diversification as independent variable on the level of asset risk-taking as dependent variable, ordinary least squares and two-stage least squares regression models were used. Also, alternative measures of diversification and asset risk-taking, and an event study were used to do a robustness check and support the results. The research sample includes 29 direct insurance companies and covers the period from 2006 to 2023. The findings showed that consistent with coordinated risk management hypothesis, insurance companies that have a more diversified insurance portfolio take more asset risk than those with a less diversified insurance portfolio. The results were robust to corrections for alternative diversification and asset risk measures and potential endogeneity bias of variables.
Introduction
Risk management is of increasing importance to companies. The traditional risk management theory focuses on the use of hedging to reduce total firm risk. By contrast, the coordinated risk management theory argues that risk management can be used to allocate risk among multiple risk sources, rather than to reduce total risk. Indeed, the coordinated risk management is the substitution of core-business risk for homogeneous risk. In the insurance industry, Underwriting activities are considered as the core-business risk and investment activities are considered as the homogeneous risk. According to the coordinated risk management theory, it is expected that diversification of insurance portfolio redistributes risk between underwriting and investing. This study investigates whether diversification of insurance portfolio affects risk-taking in investment activities of insurance companies.
Methods
According to the coordinated risk management hypothesis, the greater (less) diversification in the insurance portfolio, which reduces (increases) the underwriting risk, the greater (less) the investment risk. Thus, the research hypothesis can be stated as follows: diversification in insurance portfolio leads to greater risk-taking in assets (investments). The following regression equation illustrates the relationships between variables according to this hypothesis:
where  is the level of asset risk-taking,  represents both diversification extent () and diversification status () and others (: firm size, : Geographic Diversification, : financial leverage, : extent of reinsurance, : extent of centeral ownership, : extent of managerial ownership, : long-tail line, : combined ratio, : returne of assets, : insolvency risk, : year fixed effects) are control variables. To test the research hypothesis, the regression equation is estimated with different risk-taking measures and diversification measures using ordinary least squares and two-stage least squares (2SLS) regression models.
Discussion and Results
The results of estimation of multivariate regressions of risk-taking in assets on diversification status and extent show the coefficient estimates on diversification measures are consistently positive and significant across all regression models. The positive sign of coefficient of  implies that diversified insurance companies take more risk in their investments than non-diversified insurance companies. Similarly, in the  (diversification extent) regressions it is found that as an insurance company becomes more diversified, it correspondingly takes more risk. Several results for control variables are noteworthy. The sign of the coefficient on  is positive and significant in all regressions, providing some evidence that large insurers are able to take more risk. The negative coefficients on  support the hypotheses that highly levered insurers take less risk in their portfolios to assuage the agency problems. According to expectation it was found that coefficients on  are positive, suggesting that reinsurance is a substitute of business line diversification.
Conclusion
The results of the model estimation showed that insurance companies that have a diverse insurance portfolio, and were identified as diversified insurance companies in this study, invest more in risky assets and allocate a greater proportion of their assets holding to risky assets than insurance companies that have a non-diversified or less diversified insurance portfolio. Thus, by reducing the risk of underwriting activities as core-business risk, they increase the risk of investment activities as their homogeneous risk.

Keywords

References

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