Wednesday, October 27, 2010

FMA papers part III

In the continuing series of short reviews of papers (and presentations) from the recent FMA conference which was held in NYC.
Part 1
Part 2

Fung and Wen gave is a preliminary look at CDS usage in the insurance industry.  Insurance makes a particularly good study because of data availability due state regulatory filings.  The authors lay out a  breakdown of why firms would sell CDS (income generation, replication of bond cash flows, and speculation) as opposed to why a firm would buy (hedging or speculating).  Then showed that while not the largest (clearly banks) insurance companies made up about 18% of selling volume and 6% of buying volume so they were not insignificant players.  Based on cash flow profiles the authors hypothesized that life insurers would be more interested in replication than property insurers and then empirically show that this in fact is true life insurers sell more and when they do buy, hold longer, than property casualty insurance firms.  Moreover those organized as stock (as opposed to mutual) insurance firms tended to speculate more.  Finally that the insurance industry as a whole seemed to speculate more as the crisis approached.

Altuntas,  Berry-Stolze, and Hoyt used an intensive survey of German Insurance firms to look at the state of risk management.  They report (remember it was a survey and thus at least somewhat suspect due to behavioral biases) that firms are doing MUCH more risk mangement than in the past.  They show this in numerous ways firms do this (qualitatively as quantitatively), who does it (CEO 41%, 23% CFO, 10% CRO), what risks are managed (Investment risk 99%, major claims 91%, liquidity 55% for a few examples), and overall show a definite trend towards more risk management.  The authors then make the case that this increased risk management is being done more holistically across the whole firm, which is Enterprise Risk Management.  (FYI-I discussed this paper.)

 Borokhovich, Hegabm and Marciukaityte give a thought provoking, although not totally convincing, discussion of the merits of  excessive leverage as a proxy for managerial overconfidence.  Once this is established they build on previous findings that managers are overconfident (the majority believing their stock is undervalued) and that post financing price declines are tied to this excessive leverage measure as are errors in analyst forecasts.  This is interpreted as being consistent with overconfidence and not market timing.
Elkamhi, Pungaliya, and Vijh examine whether credit markets price target debt levels or just current levels.  The findings which are largely based on CDS markets suggest that these target ratios do get priced and play a more important role in longer term contracts.  This has implications for both capital structure (Target Ratios don't make much sense in a pecking order world) and market efficiency discussions.
Sanyal and Bulan give more evidence on the trade-off between incentives and risk aversion by examining the link between innovation and compensation of top level executives.  Innovation, as measured by patent quantity, quality, and type of innovation, is shown to not be monotonically increasing with pay sensitivity but to be a concave (think upside down U) relation that at first increases with pay sensitivity, but then decreases as risk aversion begins to dominate.  (And yes I confess, I was thinking of the family owned (yeah my family) Park and Shop when I was watching this presentation.)

 Rest of the series:
Part 1
Part 2

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