An Underwriting Approach to Estimating the Cost of Property and Casualty Equity

Abstract

Accurately estimating the cost of equity is a critical corporate finance capability, which has been the subject of significant research, the results of which have uncovered a number of practical insights, such as the analytical value of multiple factors. This insight is often leveraged in practice; for example, consider the property and casualty (P&C) insurance industry where the Fama and French three-factor model is often employed. However, managerial use of this model has been hampered in certain cases by the fact that its size and book-to-market factors are disconnected from P&C considerations, and therefore the model’s output can be of limited use to some P&C executives, especially executive-level underwriters. Several researchers have taken a different approach, one that is based on a traditional market risk premium as well as a premium for illiquid risks that must be retained within a firm due to financing frictions. This approach has been applied to the banking industry, which we have built on to develop a practically-oriented cost of equity model for P&C insurance companies based on both equity market and P&C market systematic risk factors. We have applied our approach at a number of insurance companies and therefore include real life-based examples that demonstrate its practical utility.