Enterprise risk management, adverse selection, and the insurance industry

Current risk-management literature reflects a divergence regarding the benefits of hedging. Risk reduction models address hedging as a means to reduce total risk of firms, while risk allocation models represent hedging as a tool to coordinate risks in which firms possess different informational advantages. The insurance industry provides a perfect arena to test the implication of these competitive risk management models. Using a unique data set documenting hedging activities, we provide empirical tests of whether the enterprise-level risk management reduces total risk or allocate two primary risks: investment and underwriting risks. We specifically examine the effects of derivatives and reinsurance on the total risk of insurers, and analyze the potentially simultaneous interrelation of these two primary hedging activities. Our evidence is more supportive of risk allocation theory than risk reduction theory.; While many insurance economists have explored the impact of adverse selection between insured and insurers on the price and quantity of insurance products, little research examines adverse selection in the market valuation of insurance stocks. In this study we explain better adverse selection of insurance company common stock by focusing on the opacity of both investment portfolios and underwriting practices. Our results strongly indicate that greater coverage by analysts, larger number of holding institutions, larger proportions of institutional holdings, non-reinsurance identity, and more transparent underwriting lines produce less informational asymmetries and therefore lower adverse selection costs for insurers with stock traded on listed exchanges. We also find limited evidence of a negative relation between transparent assets and adverse selection costs for insurance stocks.