Debt as a value creation tool in the short-term insurance industry

Abstract

The role of debt in the capital structure of companies as a value driver (Modigliani and Miller, 1963; Jensen and Meckling, 1976; Ross, 1977) as well as in increasing the strategic agility of companies as can be concluded from O'Brien (2003), Kochhart and Hitt (1998), Barton and Gordon (1987) and Sandberg, Lewellen, and Stanley (1987), in general, is contentious given the potential risk of financial distress introduced by it. This study aims to assess whether the introduction of debt, and increase in financial leverage would have any impact on the firm value of short-term insurance companies given the nature of the business. Tobin’s Q (Staking and Babel, 1995), the ratio of the market value of a company to the liquidation value of the company’s assets is developed and used as a key proxy for the franchise value of an insurance company (O'Brien, 2003; DaDalt, Donaldson, and Garner, 2003; Keeley, 1990). Multiple regression analyses is then performed on a sample of listed short-term insurers over an 11 year period to assess the relationship between their financial leverage, franchise value and other key ratios used to determine the value of insurance companies (ROE and underwriting return), with risk being implicit in the franchise value variable. The results show no causal relationship between financial leverage and franchise value or risk which would have been represented by a declining Q. Insurance leverage however is found to be a good predictor of Q. The implication is that short-term insurance companies could borrow money without destroying much value in the short run. The companies could use the borrowed money to fund strategic projects that could add value in the long run. Copyright