SYNERGY, ASYMMETRIC INFORMATION, OR WEALTH REDISTRIBUTION: AN EMPIRICAL INQUIRY TO THE FORMATION OF CAPTIVE INSURANCE COMPANIES

A captive insurance company is a subsidiary created for the sole purpose of insuring the accidental losses of its parent corporation. Since the 1960's captive insurers have proliferated. The explanation provided most often in the insurance literature for this phenomenon is synergy: captives are formed because they provide financial gains to their parents. A second explanation inferred from literature on asymmetric information is that captives enable their parents to signal the true distribution of their losses to insurers, allowing parent firms to reduce retained losses and get more insurance for their money. More insurance would result in lower variability of parent corporations' value. A third explanation is that captives endow their parents with greater flexibility in choosing the level of retained loss. By ceding a lower amount of losses to the reinsurance market, parent companies would increase the variability of their value, thus turning captives into a method for redistributing wealth from their bondholders to their stockholders.; This empirical study attempts to find which of these explanations is consistent with market data on the securities of parent firms. The cumulative abnormal return (C.A.R.) and the multivariate regression model (M.V.R.M.) techniques are used.; The C.A.R. method finds significant negative cumulative abnormal returns to stockholders over a 17-day and a 20-day periods preceding the formation of off-shore and domestic captives. The M.V.R.M. shows negative but not statistically significant aggregate excess return over the same time spans. Individually, some firms exhibit a significant negative excess return to stockholders while a few others post a positive one, but the M.V.R.M. could not detect any significant impact on stockholders return for the majority of corporations in the samples. Also, the C.A.R. method was used to test for abnormal return to bondholders. No significant effects were found, but missing observations complicates the study of returns to this class of securityholders.; Overall, the tests cannot reject the null hypothesis that formation of captive insurers has no effect on the value of parent firms' securities. An expansion of sample size coupled with more powerful tests may provide a more definite answer.