i

The University of Southampton

Academic Year 2013/2014

Faculty of Social and Human Sciences

Mathematical Sciences

MSc Dissertation:
How Does the Use of Credit Default Swaps Affect Firm Risk and Value?
Evidence from Europe Economic Area Life and Property/Casualty Insurance
Companies.

Leah Hannah Munjiru Njuguna.

A dissertation submitted in partial fulfilment of the MSc in Actuarial Science.

I am aware of the requirements of good academic practice and the potential

penalties for any breaches. I confirm that this dissertation is all my own work.
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Abstract

Early in the 21st Century there was a rapid increase in the amount of credit default
swaps (CDS). Even with this increase in CDS trading, there are mixed findings on
the effect of CDS on financial stability. In this line, this study sought to examine the
impacts of CDS utilization on the risk profile and the value of a firm. The study used
a unique set of data from the Life and Property &Casualty insurance companies in
Eurozone Economic Countries on their CDS transactions between the year 2001
and 2009. A two-stage Heckman model was used in adjusting any potential
endogeneity of CDS utilisation in connection with firm risk profile and firm value.
The analysis explored on how participating in the CDS market affects risks of an
insurance company in three dimensions that is total risk, market risk and
idiosyncratic risk. In addition, the researcher examined how CDS usage has an
impact on the market value of a firm and its performance. Logit regression model
was employed in data analysis. The researcher found that there is consistent
evidence that use of CDS for the purposes of income generation is related with
higher market risk, a descent in a firm’s financial performance, and a lower firm
value, both the Life and Property & Casualty insurance companies.
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Acknowledgement
I would like to thank God for seeing me through my course and the completion of my
M.Sc. Project. My appreciation goes to my supervisor, Dr. Madhu Acharrya, for his
ideas, help and encouragement throughout the project period. I would also like to
thank my second supervisor Prof. Jon Forster for the assistance he offered during
my data analysis. Thanks to Dr. Erengul Dodd for the helpful suggestions she gave
me towards the end of the project. I would like University of Southampton for
creating a conducive environment that made it easy for me to carry out my project.

Finally, I would like to appreciate Michael Whitton, without his help I would not have
been able to retrieve data from the University’s data stream, and thus enabling me to
complete my project.

Thanks to my brother, George Njuguna, for spending a lot of time answering my

questions and giving me feedback. Finally, I would like to express my sincere
gratitude to my mother, Pauline Njuguna, family and friends for their support and
endless encouragement which was of great assistance to see me through to the
completion of my project.
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Table of Contents
Chapter One........................................................................................................................................ 4
1.1 Introduction.............................................................................................................................. 4
1.2 Background.............................................................................................................................. 5
1.3 Problem Statement ................................................................................................................ 7
1.4 Objective.............................................................................................................................. 8
1.5 Dissertation Structure ........................................................................................................... 8
Chapter Two: Literature Review .................................................................................................. 10
2.1 Introduction............................................................................................................................ 10
2.2 Credit Default Swaps ........................................................................................................... 10
2.3 Credit Default Swaps and Firm Risk ............................................................................... 14
2.3.1 Market risk ...................................................................................................................... 16
2.3.2 Idiosyncratic Risk ......................................................................................................... 17
2.3.3 Total Risk ........................................................................................................................ 18
2.4 Value of a Firm ...................................................................................................................... 18
2.4.1 Capitalized Value Measure ......................................................................................... 19
2.5 Credit Default Swaps and Value of the Firm ................................................................. 23
2.6 Conclusion ............................................................................................................................. 24
Chapter 3: Research Methodology ............................................................................................. 25
3.1 Introduction............................................................................................................................ 25
3.2 Research Design .................................................................................................................. 25
3.3 Research Population ........................................................................................................... 26
3.3.1 Sampling technique ...................................................................................................... 26
3.4 Data collection ...................................................................................................................... 26
3.5 Variable Construction ......................................................................................................... 27
3.5 Limitations.............................................................................................................................. 29
3.6 Assumptions.......................................................................................................................... 29
3.6 Data Analysis ......................................................................................................................... 30
Chapter Four: Findings and Discussion ................................................................................... 32
4.1 Introduction............................................................................................................................ 32
4.2 Descriptive Statistics .......................................................................................................... 32
4.3 Empirical Findings ............................................................................................................... 38
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4.3.1 Risk Models .................................................................................................................... 38

4.3.2 Market Value and Performance Analysis .................................................................... 49
Chapter Five: Conclusions and Recommendations .............................................................. 54
5.1 Conclusion ............................................................................................................................. 54
5.2 Recommendations ............................................................................................................... 57
References ........................................................................................................................................ 59
Appendix ........................................................................................................................................... 70
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List of Tables

Table 1: CDS Users and Participation for Life and P&C Insurance Companies. ...... 32
Table 2: Brief Statistics for Life and P&C Insurance Companies. ............................. 34
Table 3: Attributes of Life Insurance Companies. ..................................................... 36
Table 4: Attributes P&C Insurance Companies. ....................................................... 37
Table 5: The Heckman first-stage logit regression results........................................ 40
Table 6: Statistics of Life and P&C Insurance Companies on Total Risk Model. ...... 43
Table 7: Statistics of Life and P&C Insurance Companies on Market Risk Model. ... 45
Table 8: Statistics of Life and P&C Insurance Companies on Idiosyncratic Risk
Model. ...................................................................................................................... 47
Table 9: Statistics of Life and P&C Insurance Companies on Tobin's Q Model. ...... 51
Table 10: Statistics of Life and P&C Insurance Companies on ROE Model. ............ 53
 4

Chapter One
1.1 Introduction
The credit default swap (CDS) market has grown substantially from $180 billion in
notional amount in 1997 to $34.5 trillion in 2006 and $62.2 trillion in 2007 (ISDA,
2010). The exceptional increase of the CDS market highlights the efficiency of the
CDS as a tool for both speculating on credit risk and hedging. Hull (2012) observes
that the use of credit derivatives opens novel potential to financial corporations to
actively deal with their credit risk by adding positions in the derivatives market to
protect themselves from credit actions in their loan collection. For that reason the
major participants in the market constitute banks which mainly take part in the buy-
or long side of the derivative contracts while the other main part of the market is
taken by insurance companies that enter short positions in the CDS market (Hull
2012). Similarly Rule (2001) noted that credit derivatives have been a noteworthy
advancement in the credit risk market. This has resulted to fast development of
credit risk market as the financial institutions embrace CDS to shed or take on credit
risk (Shconbucher 2003).

Early in the 21st Century, the world financial market experience a financial crisis that
in general had negative effect on most financial instruments. During and after the
financial crisis, the CDS market went through unstable times which led to significant
worldwide reductions in the amount of CDS traded. According to International Swaps
and Derivatives Association (ISDA) (2010) market surveys, the outstanding amount
of credit default swaps had increased from USD 0.9 trillion in 2001 to an impressive
USD 62.2 trillion at the end of 2007 immediately prior to the financial crisis.
Remarkably, after the financial crisis the amount of CDS traded reduced to USD
26.3 at the end of 2010. Holding all other factors constant, this shows that the
financial crisis had a huge effect on CDS market. Subrahmanyam, Tang and Wang
(2012) used (CDS) trading data evaluate the relationship between CDS and financial
health of a firm. The researchers found that the credit risk of reference firms was
significantly reflected in rating downgrades and that bankruptcy increased
considerably upon the commencement of CDS trading. In addition upon controlling
for the endogeneity of CDS trading, this finding was strong. This implies that
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distressed corporate are more liable to filing for bankruptcy if they take part in CDS
trading. Upon commencing CDS trading, the increase in credit risk is both
economically meaningful and statistically significant (Subrahmanyam,Tang& Wang
2012) .Particularly credit ratings reduce by roughly half a notch, on average, within
two years after the commencement of CDS trading while the possibility of
bankruptcy increases twofold once a corporate begins to be referenced by CDS
trading.

Asset managers can improve the return of portfolio by utilising CDS (Mackay&
Moeller, 2007).This is because CDS can be used in risk management and if it is
properly done there can be more returns. A firm that manages its risks will be of
more value than one that is affected. When dealing with CDS, a financial institution
can achieve higher returns without making additional investments by selling
protection to bond holders or otherwise, using more risky CDS to achieve leverage
to a portfolio. Risk has been one of the major concerns of financial institutions
(Batten & Hogan 2002), but now the development of credit derivatives has offered a
useful tool to manage credit exposures. For main users, such as banks, financial
institutions, insurance companies and larger companies the credit derivatives offer a
way to transfer risk from their balance to other market parties. There are various
types of credit derivatives and various objectives to exploit them, while for specific
purposes there are also naturally several suitable credit derivative types. Credit
derivatives were initially created as tools to hedge credit risk exposure, as
supplement Choudry (2003) presents also yield enhancement and arbitrage as
applications for these instruments. In addition, Meissner (2005) names cost
reduction and regulatory capital relief. Hedging against credit risk is obviously the
most common application for credit derivatives.

1.2 Background

Credit default swaps are delegation claims that have payoffs it linked to the
creditworthiness of a sovereign entity or a firm (Acharya et al., 2007). The rationale
of using CDS is to enable market participants to trade the risk linked to certain debt-
related events. Credit default swap contracts were first used by in 1994 by J.P.
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Morgan, where the instruments were used for the purpose of selling off Exxon Mobil
credit risk to the European Bank of Reconstruction and Development (Blanco et al.,
2005). Initially, CDS were principally used to hedge credit risk in relation with banks’
lending initiatives. Remarkably other players, such as hedge funds and asset
managers, insurance companies started taking part in the CDS market more actively
early in 21st Century leading to significant growth of a market that was aided by the
normalization of CDS contracts by the International Swaps and Derivatives
Association (ISDA) (Harrington, 2009). This lead to an increase in CDS traded
from a $300 billion in 1998, to $62.2 trillion as of 2007 which later and stabilized to of
$25.1 trillion as of 2012, after the financial crisis (ISDA, 2010).

If not used appropriately coupled by unfavourable economic times, CDS use can
result into losses in hedge funds, banks and insurance companies particularly during
the past financial crisis. For instance, one of the world’s largest insurance
companies, AIG was on the brink of collapsing because of its CDS trading.
Generally CDS can be utilised to hedge credit risk, take on credit risk, leverage by
offering credit protection to others, as in with of AIG, or to arbitrage fiscal markets.
Financial institutions are rewarded by trading CDS during ordinary times by earning
more profits that those from other investments such as stocks and bonds. This
implies that exploiting the CDS market enables market players to create value for
shareholders in normal times but exposes them to risks during turbulent economic
times. This is emphasized by the finding that some CDS became illiquid when the
financial crisis blew up, consequently leaving firms with significant losses.
Furthermore, CDS-referenced firms were most prone to default on the loans they
had taken during the credit boom, hence may have led to not a good performance by
their lenders.

The fast growth in CDS trading stirred up a deliberation about the effects of credit
risk transfers for financial stability even before the financial crisis. The Deutsche
Bundesbank (2004) was of the opinion that, on one hand, advanced and liquid credit
risk transfer markets facilitates broader expansion and more proficient price-setting,
which improves the distribution of credit risk, consequently promoting financial
stability. Conversely, on the other hand, there are risks linked to transfer of credit
risk, which can have a harmful effect on financial stability (Allen & Carletti, 2006;
Deutsche Bundesbank, 2004). As noted by Wagner and Marsh (2006) these risks
 7

could be a result of unsuccessful safeguards and imprecise ex-ante assessments of

risk to return ratios, a high application of conciliator services on only a little number
of market players, a possibility for regulatory arbitrage, the dealings between
financial markets and credit risk transfer markets and asymmetric information. The
deliberation on CDS can be shaped by empirical research in order to provide
informative conclusions. The researcher was motivated by the need to add more
empirical literature to the discourse on CDS. This study will contribute to practices in
the financial industry on use of effect of CDS on financial stability. By investigating
the relationship between the European insurance market uses of CDS and firm
value and risk the market stakeholders will have information that is empirically
arrived at. Such information is valuable in decision making process of investors and
management. The government and other policy makers will also benefit from these
findings in enacting the appropriate policies that will strengthen the financial markets.

1.3 Problem Statement

There is a concurrent by researchers that CDS is a significant financial instrument.

In the last financial crisis of 2008, there has been debate on factors that contributed
to the crisis. Schich (2011) observes that while there is an ongoing discourse about
the causal factors for the crisis, there is a general agreement that, not just single but
different factors have been at play. One of the factors as argued by Hull (2012) and
Rule (2001) is the participation of financial firms in CDS trading. This is
strengthened by the observation of Harrington (2009) who noted that AIG and
other market players became chief writers of CDS a scenario when tied with high
leverage, CDS protection sellers were very vulnerable to defaults. This lends claim
to the effect of CDS on risk management and by extension value of a firm. In this
regard the International Association of Insurance Supervisors (IAIS) (2011) notes
that insurance firms and conglomerates that take part in non-insurance or non-
traditional activities are more susceptible to financial market changes and
importantly more probable to magnify, or contribute to, universal risk. IAIS (2011)
adds that examples of non-insurance events include CDS transactions for non-
hedging reasons or leveraging assets to increase investment return.
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In this line there is need to evaluate the effect of CDS in the insurance market.
This study sought to evaluate the effect of CDS on firm value and risk in the
Europeans economic area by paying focus to Life and Property/Casualty
Insurance Companies.
1.4 Objective
The aim of the study was to explore the effects of CDS use on risk for Life and P&C
insurers. The risk evaluated was in three facets namely; market risk, total risk, and
idiosyncratic risk. Total risk includes both idiosyncratic risk and market risk. This was
achieved by evaluating the following objectives:
I. To explore the effect of CDS use on firm risk of European Life and
Property/Casualty Insurance Companies
II. To explore the effect of CDS use on firm value of European Life and
Property/Casualty Insurance Companies.
Research Questions
I. Does CDS use affect firm risk of European Life and Property/Casualty
Insurance Companies?
II. Does the use of CDS affect firm value of European Life and Property/Casualty
Insurance Companies?
1.5 Dissertation Structure

This dissertation is organised as follows:

Chapter Two: Literature Review. This chapter entails the review of the available
literature on effects of CDS usage on firm risk and the value of the firm in relation to
the Life and P&C insurance companies.

Chapter Three: Methodology. This chapter outlines the steps that were employed in
conducting the research study. The chapter highlights the research design that was
employed and the data collection and analysis process. Included in the chapter are
details on is the research population, and sampling technique.

Chapter Four: Findings and Discussion. This chapter presents the findings of the
study. The chapter begins by presenting the results of descriptive statistics followed
by inferential statistics. This chapter also presents an in depth discussion of the
study findings.
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Chapter Five: Conclusion and recommendation. This chapter presents a conclusion

of the study findings followed by recommendations for practice and future research.
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Chapter Two: Literature Review

2.1 Introduction
This chapter entails the review of the available literature on effects of CDS usage on
firm risk and the value of the firm in relation to the Life and P&C insurance
companies. It is logically organised as follows: Firstly, there is a discussion on CDS.
This includes the definition of CDS and the attributes, mechanism of the CDS and
the difference between CDS and insurance policies. Secondly, there is a brief
description on the Life and P&C insurance companies. Thirdly, a discussion on the
effects of CDS usage on risk of a firm follows. Fourth, a general discussion on the
value of the firm is done. This includes calculation of the firm value using different
methods and a discussion on CDS and value of the firm. Last but not least, a sub-
section on the role of CDS in the financial follows. Finally, the chapter is concluded.

2.2 Credit Default Swaps

According to Michail (2010), a credit default swap is an exchange between two
counter-parties of a fee in exchange for a payment of a credit default event occurs.
Similarly Stulz (2009) defines this financial instrument as an insurance contract
against the cost of default of a company. This implies that a CDS is a financial
instrument that involves the seller of the CDS compensating the buyer in the event
of a loan default or in case of a credit event. The buyer is obliged to make a series of
payments to the seller of the CDS, in exchange of a payoff if the loan defaults. For
instance, suppose an investor holds BMW bonds and is concerned about BMW’s
default risk. The investor could insure his bond holdings with a CDS. Just the same
as an insurance contract, the investor is obliged to make payments over time. If
BMW does not default, the investor loses the payments already made. On the
contrary, if BMW defaults, the CDS allows him to exchange the BMW bonds he held
which are now worth little, for the principal amount of the bonds, or alternatively,
depending on the agreement, for a payment equal to the principal amount of the
bonds you hold minus their current value at the time of default. By buying a CDS on
BMW, he protected his investment against a BMW default. In the event of the bond
losing its value without default by BMW, then in this case he would not receive
payment form the BMW CDS.
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These financial instruments were devised by a team of bankers at J.P Morgan in the
late 1990s to insure the bank and clients from potential default (Simkovic and
Michael, 2011). Originally, the derivatives were only used by investors for hedging
against potential default in large position therefore it was a very small market. In the
final decade, the market burst out as buyers and sellers engaged into it. As of 2008,
the CDS dollar value of securities was larger than the actual bond market that is it
exceeded $ 50 trillion. Investors were buying insurance against default risk in
securities that never were. This raised concerns that CDS are in some way
unethical.

Some articles erroneously label CDS as “default insurance” (Schmaltz and Thivaios,
2012). This section will discuss the similarities and differences of the CDS and
insurance policies. In insurance policies, the group of both the life and non-life is
sufficiently large to meet the insurance model which is centred on the law of large
numbers. This ensures a well-diversified portfolio is achieved. (Stulz, 2009) On the
contrary, the CDSs are normally written on a small subset of the economic entities
for instance large corporations, sovereigns and some public sector entities from
which relevant pricing information on CDS is available to the public. An individual
insurance is priced from data concerning past losses and portfolio characteristics,
whilst individual CDS is priced depending on the individual attributes of the
economic entity. Generally speaking, an insurance policy holder must have
satisfactory interest concerning the subject of insurance for instance the interest is
justifiable if the policy buyer is the owner of the insured object and would suffer a
drawback in the event of it being lost. Quite the opposite for the CDS, neither party
needs to hold any interest whatsoever in the underlying debt. Therefore, a CDS
without the exposure to the underlying instrument would result to credit motivated
market risk. An argument closely related to the insurable interest is that insurance
policies requires the owner of the insured object or the insured person to
acknowledge the policy beneficiary, by so doing the speculative element is
eliminated (Schmaltz and Thiavois, 2012). Unlike the insurance policies, for the CDS
reference entity, no permission is to setup a CDS. This means that a reference entity
does know the CDS-volume on its debt. With regard to underwriting in the insurance
market, it is greatly regulated from legal and prudential risk management perception.
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Only experts are expected to offer insurance services without violating the law. By
contrary, CDS trading is not restricted to experts only, any firm can perform CDS
underwriting. Insurance policies can be termed as contracts between a protection
seller and a protection buyer, there is only a very small fraction of insurance
contracts that are intra-sector that is reinsurance. Unlike the insurance contracts, the
CDS contracts a substantial of them are sold in the intra-sector within the bank
industry, thus leads to considerable interconnection, which in one way leads to an
increased systematic risk (Baranoff, 2011). A CDS and insurance policy also differ
on basis of trade-ability. The main objective of an insurance contract is not the aim
to re-sell it after a short while. As for the CDS contracts, one can hedge them by
entering into an opposite CDS contract. This means that transfer of risk to other
parties can be done as quick as possible and also at a low cost. Consequently this
makes it quite difficult in tracking the final protection seller who will assume the
default risk.

Insurance policies and CDS also bare similarities. In one way the two financial
instruments are similar in that there is a conditional payment by a protection seller in
case of a trigger event. There is also the payment of premium in both contracts. In
the CDS contract, just like the insurance policy, the swap buyer is obliged to pay the
swap seller a premium to protect against losses resulting from a defined credit event
(Juurikkala 2011).From the above discussion CDS contracts cannot be branded as
“default insurance policies”. The CDS and insurance policies are two different
contracts.

There are a number of reasons that persuade market players to take up CDS. One
reason is the wide functionality of CDS where they can be used as hedging
instruments to manage or reduce risks and for speculation to make profit by risk
taking. It is perfectly clear that credit default swaps hedges an investor risk in the
market (Skora, 1998). For a protection buyer, a credit derivative may serve a
function similar to more traditional risk management instruments; but the CDS buyer
can adopt take a short position, seeking to profit from the default of the reference
entity. This explains the growing participation of hedge funds as protection buyers.
On the other hand protection sellers, have access to a number of highly definite risks
 13

through credit derivatives. Generally, the protection seller is laying wager on the
creditworthiness of the reference entity, and in return gets premium payments,
essentially just like an insurance company. The growing participation of hedge
funds also as protection sellers is an indication that this is a lucrative market not
conventionally accessible to those other than insurance companies. However, hedge
funds may also be taking concurrently short and long positions in the markets,
seeking to profit from pricing inefficiencies (Federal Reserve Bank of Atlanta, 2008).

The researcher has limited the study of CDS contracts to the Life and P&C
insurance companies in relation to their risk and value. The Life insurance
companies are the insurance companies that offer protection against the cost of
income that would be incurred if the insured person passed away (Smith, 2005). The
proceeds are given to the beneficiary thereby is safeguarded from the financial
effects caused by the death of the insured. The P&C insurance companies can be
defined as the insurance companies that offer insurance on homes, cars, and
business at large (Kaplan Financial Education, 2010). Precisely, property insures a
person or a business with the concern in physical property against its loss or the loss
of its abilities of income-producing. While, casualty insurance protects mainly people
or businesses against legal liability for the losses that can be caused by injury to
second party persons or damaged property that belong to others.

Clerc, Gabrieli, Kern and Omari, (2014) recently did a study on the structure and the
topology of the European reference entities from 2018 to 2012, resorting to network
analysis, the study was based on a unique data set referencing exposures on single
CDS on European reference entities in the financial sector. In addition, Chiaramonte
and Casu(2010) carried out a study that examined the determinants of CDS spreads
and whether CDS spreads can be considered a good proxy of bank, it was based on
data from the European market. On the contrary this study focused on CDS data
from the insurance industry specifically the Life and P&C insurance companies, the
same as the study done by Fung, Wen and Zhang (2012).The different between the
two studies is that Fung, Wen and Zhang focussed on the US insurance industry
while this study focusses on the European Economic Area insurance industry.
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2.3 Credit Default Swaps and Firm Risk

CDS are financial instruments that can be used either for hedging or speculation.
Hedging can be explained as a process to minimise the risk of adverse price
volatility in an asset, this is achieved by making an investment (Baxter, 1998). This
process normally involves taking an offsetting position in an associated security.
Whereas, speculation is the art of conducting a financial transaction, that has a large
amount of risk of either losing most/all of the initial investment or reaping a
substantial gain. Depending on the purpose of the CDS involvement it can have
different repercussions on the insurance company’s risk profile. The risk impact of
hedging and speculation is different. Hedging and asset replication can reduce risk
to insurers, whereas speculation can lead to higher risk (Hung-Gay Fung, Min-Ming
Wen, and Gaiyan Zhang, 2012).There is mixed evidence provided by existing
literature concerning the impact of applications of CDS on the firm risk.

Previous theoretical literature shows that there are various reasons as to why firms,
including insurance companies, hedge. A value-maximising firm can hedge against
risks due to three reasons: 1.) Taxes.2.) Costs of financial distress. 3.) Managerial
risk-aversion (Smith and Stulz, 1985). Similarly, Guay and Kothari (2003) find that a
program on economically small derivatives is actually consistent with those firms
utilising derivatives to adjust a general risk-management program that possibly
includes other hedging means. One reason for hedging is that tax laws may profit
those investors that hedge risks. According to Amin (2006) under current tax law, as
FA 1996 s84A (3) will apply to exclude the foreign exchange differences on the
hedging liability from taxation. Most governments exempt taxes on the derivatives so
the cost of transaction is cheaper for the investors, which is a motivation to hedge.
Small businesses also hedge since protect themselves from catastrophic or extreme
risks. This would minimise the costs and likelihood of distress that would result from
these risks. Hedging would be a solution to under investment problem that is
prevalent in numerous firms caused by the limited capital markets and risk averse
managers. Another reason for hedging is the minimisation of exposure from some
 15

risks incurred by the firms may enable the firms to adjust their capital structure.
Hedging also attracts investors as they prefer firms that hedge against extraneous
risks than those that do not. The balance sheets of the firms that hedge are more
informative compared to those that do not. According to Stulz, (1984); Smith and
Stulz, (1985) point out that market imperfections such as taxes, financial distress
costs, and agency conflicts, motivate the companies to hedge.

In line with the above mentioned reasons, firms can end up participating in the
derivatives’ market. Some researchers have a different view on the relationship, that
is participation in the derivative market and the firm’s risk profile have no significant
relationship. Hentschel and Kothari (2001), after using a panel of 425 large US firms,
did not find a justifiable relationship between the firm risk attributes and the extent in
which the firms participate in the derivatives markets. Conversely, Adam and
Fernando (2006) examine 92 North American gold mining firms from 1989 to 1999
concluded that there was no significant relationships between derivative usage and
the firm’s risk profile. In the contrary, a part of researchers provide suggestions that
derivative usage does affect the risk of a firm. Tufano (1996) investigated the gold
mining industry and found evidence supporting the hypothesis of risk minimisation
from derivative usage.

There are a number of researchers who have ventured into studying the impact of
credit derivatives usage on the risk of a firm (Instefjord 2005; Shao 2009; Morrison
2005). The risk-allocation benefits from the credit derivatives market may encourage
the stakeholders in the bank industry to take more risks, thus causing more
instability in the industry (Instefjord, 2005). Morrison (2005) concluded that credit
derivatives can result to a reduction in the banks’ incentives to monitor their loan
portfolio. Centred on US bank holding companies’ sample, Shao (2009) found that
participation in the CDS market increases the risk profile of protection sellers,
motivates banks to move to riskier loans from safer ones.In addition, Pelizzon,
Subrahmanyam, Tomio and Uno (2013) find a strong, dynamic relationship between
changes in sovereign credit risk and market liquidity, conditional on the CDS spread
during the Euro-zone crisis.
 16

As seen from the literature there is a gap, therefore one of the objectives in this
study is to investigate the effects of participation in the CDS market to the risk firm in
the European Economic Area countries. Naturally, it is expected that buying CDS
protection for purposes of hedging should assist in the minimisation of credit risk.
However, a reduction in the credit risk via the CDS protection purchases may
increase the capacity of an insurer to take in other forms of risks, for instance
investment risk, as established by Fairley (1979). Plausible, selling of CDS
protection for income generation purposes will increase the insurer’s credit risk,
while CDS selling for replication purposes may possibly maximise the insurers’ credit
risk. The net effect is quite not clear, there is need to differentiate the CDS trading
motives. The researcher investigated the impacts of CDS usage on the risk for the
Life and P&C insurance companies in the aspects of market risk, idiosyncratic risk
and total risk.

2.3.1 Market risk

Market risk can be defined as the likelihood of an investor to incur losses due to
aspects that affect the financial markets’ general performance. Market risk is defined
as the risk of losses in the trading book in the bank because of the changes in
interest rates, commodity prices, credit spreads, equity prices, foreign-exchange
rates and more indicators whose values are set in public market (Mehta, Neukirchen,
Pfetsch and Pppensieker, 2012).It is also known as the systematic risk which cannot
be eradicated by portfolio diversification, although it can always be hedged against.
The cost of equity capital can be used to measure the market risk caused by the use
of CDS. Fung et al (2008) pointed out that the participation in the CDS market
largely affects the general stock market, as such, the market risk component. The
investigation of the impact of CDS usage on the systematic risk particularly takes
into account the response of the market to the participation of an insurer in CDS,
hence shedding light on the value of the firm. Existing literature shows that the
banks that participate in the CDS market have borrowers’ default risk private
information. For instance, Acharya and Johnson (2007) investigated banks that
hedge against lending defaulters by banks using CDS, these banks use the CDS
market because they are privileged to have access to the financial information of
 17

their clients. Similarly, investigation on the anticipation bond rating news effect
showed that that banks utilise underlying companies’ private information in their
CDS trading (Norden 2009). Insurance companies would probably be at an
information disadvantage compared to the banks, since the banks are the main
rivals of the insurance companies in the CDS market, we expect that insurers are
more likely to have an information disadvantage relative to banks. This will result to
the market investors viewing negatively the CDS participation by the insurance
companies (Fung et al, 2012).

2.3.2 Idiosyncratic Risk

This is the type of risk that is exclusive to a small number of assets or to an asset.
Idiosyncratic risk is independent of the market risk that is it has a slight or no
correlation to the systematic risk. Therefore it can be significantly be mitigated or
minimised from a portfolio by sufficient diversification. (Goyal and Santa-Clara, 2001)
show that the idiosyncratic risk is the cause of most of the variation of average stock
risk through time and it is idiosyncratic risk that drives the forecast ability of the stock
market.

This risk echoes firm-specific risk. Durnev et al. (2003) and Laux (2007) found out
that the higher the firm’s idiosyncratic risk, the less information the public knows
about the firm. There are details of the CDS usage by insurance companies that are
not available to the public domain before it is reported to the regulators. Therefore,
this may cause opaqueness to the public investors on CDS transactions concerning
the insurance companies. There are developed models by DeMarzo and Duffie
(1995) and Breeden and Viswanathan (1998) that investigate the relationship
between hedging and asymmetry in information. The models suggest that by
hedging, managers can minimise the “noise” in earnings interposed by the
macroeconomics aspects for instance interest rates, thus reducing the level of
information disproportionateness about a firm. In addition, reduction in asymmetry of
information can be of benefit to the value of a firm (Myers and Majluf, 1984). A study
by DaDalt, Gay, and Nam (2002) supported the idea that there is an indirect
relationship between the information asymmetry and the derivatives of a firm. It is an
 18

experimental issue to investigate the relationship between the insurer’s CDS usage
to idiosyncratic risk.

2.3.3 Total Risk

Total risk is the summation of the systematic risk and idiosyncratic risk (Fung et al,
2012). Each investment has systematic risk that is any risk carried by the whole
class of assets and/liabilities and unsystematic risk that is the risk that is specific to
the investment. During decision making concerning investments, investors must put
into account the total risk to the investment. To capture the overall risk profile of an
insurer, the investor has to use the total risk.
A rational reason as to categorising risk is to measure exposure to risk of a
firm .The risk effects have first to be decided on, then the measurement of risk
exposure is done. At the simplest level, the changes on the firm’s risk as an effect of
the risk can be used. At the broadest level, the changes in the value of a firm can be
used to capture a firm’s exposure to risk.

2.4 Value of a Firm

According Bayes (2010) the firm value is the firm’s current and future profits’ present
value. The main objective of an organization is to maximize value. The value of a
firm takes into consideration the long-term effect of managerial decisions on profits.
The value to be maximized depends on a number of factors like the size of a firm's
free cash flows, the timing of those cash flows and the risk attached to the cash
flows.
There are number of ways in to calculate value of a firm. In some cases the
approaches result to dissimilar values of a one firm. This is owed to the different
assumption made. The first approach is using the accounting net worth, of a firm or
it’s or book value. This approach is anchored on generally accepted principles of
financial accounting (Goosen, Jensen & Wells 1999). Observing such principles,
 19

such as historical cost and conservatism, can lead to values that are far from what is
rational. The second approach is using the market value of the firm’s outstanding
shares. This is a common approach though it requires a proficient real market value
for shares. The third approach is the capitalized value of a firm’s projected future
performance (Miller & Modigliani 1961). When the analysts are competent, rationality
is applied and future of the market can be predicted, the four discrete methods of
capitalization give rise to precisely the same valuation. The fourth measure is the
deductive application of human opinion. In this regard, the value of the firm is rated
along a psychometric scale. The results are then converted by a known formula to
fiscal values. The fifth measure is the firm’s accounting net worth standardized for
intangibles and the peculiarity of the accounting rules utilised in the simulation.

2.4.1 Capitalized Value Measure

In the capitalized value measure, the value of firm is realised through a series of
steps by Thavikulwat (2004) as outlined below in the following equations:

Following the argument of Miller and Modigliani (1961), the basic idea behind
the capitalized value measure is that the value of a firm to its owners at time 0
is equal to the discounted value of net cash inflow from the firm to its owners at
time 1, plus the discounted value of the remaining value of the firm. Thus, if V0
is the value of the firm at time 0, if F1 is the net cash inflow from the firm to its
owners at time 1, if V1 is the value of the firm at time 1, and if r is the cost of
capital between time 0 and time 1, then:

Equation 1.

Likewise, expressing V1 in terms of F2 and V2, V2 in terms of F3 and V3, and

so forth, and then successively substituting these latter expressions into
Equation 1, the value of a firm can be expressed as follows:
 20

Equation 2.

In as much as the last term of Equation 2 approaches zero as the number of future
periods, n, approaches infinity, Equation 2 can be written concisely as follows:

Equation 3.

Where summation of t is from one to infinity.

Net cash inflow to owners, Ft, is the difference between the dividend paid to owners,
Dt, and the additional capital supplied by owners, Kt, thus,

Equation 4.

Additionally, the supplementary capital from the owners is the variation between the
firm’s investment net of depreciation, It, and its undistributed earnings, which in turn
is the discrepancy between its profit, Xt, and its dividend. Thus,

Equation 5.
 21

Substituting Equation 5 into Equation 3, the value of a firm therefore is as follows:

Equation 6.

Where summation of t is from one to infinity.

A practical valuation method cannot depend upon an unbounded number of

forecasts into the future, so Equation 6 must be simplified. If net investment is set to
zero for all periods and if profit is likewise set to a constant, X*, then Equation 6
reduces to the following:

Equation 7.

Goosen, Foote, and Terry (1994) suggested computing the constant profit term, X*,
by multiplying the most recent profit figure, X0, by a growth factor, w, which is
derived from a forecast of the profit growth rate, g, projected to an arbitrary future
time, m, as follows:

Equation 8.
 22

The computed value of a firm would then be as follows:

Equation 9.

Goosen et al. (1994) did not present the growth factor, w, as given in Equation 8, but
it can be derived from their work.

Equation 10.

Equation 10 reduces to:

Equation 11.

Considering that MVPS corresponds with V0, NIPS with X0, GR with g, ECC with r,
and FP with m, it follows that the collection within the parentheses of Equation 11 is
w.

Goosen et al. (1994, p.66) proposed that profit growth rate, g, ought to be based on
profits of the final the time periods, although they did not suggest any means of
deriving m, “the number of the future periods that stockholders would be willing to
extend growth”. Examining the method, Gold (2003) made an observation that so
that the calculated value would be less receptive to the possible illusory profit of the
 23

last period the recent profit figures had to be rapidly smoothened. Nonetheless, this
model is still reliant on a random parameter.

2.5 Credit Default Swaps and Value of the Firm

The CDS is a special type of financial derivative used for risk management. Risk
management is the process of identifying, assessing, and prioritising of the risk
incurred, then a well-co-ordinated and economical application of means of
minimising, monitoring, and controlling the possibility and/or effects of unfortunate
events (Clusif, 2008).The present literature sends mixed views on the relationship
between the firm value and the derivatives use. One group of researchers are of the
opinion that risk management can result to value creation. For instance, Mackay and
Moeller (2007) find that there can be an increase in the firm value by risk
management if there is a non-linear relationship between costs and revenue
functions with the input and output prices. Similarly, Smithson and Simkins (2005)
focusing on particular financial instruments and hedging-specific risks find out that
there is an increase in firm value if the interest rate and foreign exchange risks are
regulated. While, Allayannis and Weston (2001) make a conclusion that non- users
of foreign currency derivatives have lower market values. In addition, similar
conclusions are provided by a research done on risk management of a particular
industry. For instance, Dionne and Triki (2006) find that hedging maximises asset
returns in the gold mining industry. Therefore risk management regulations are
relevant to the value of a firm.

There is scarce literature that shows there is creation of a firm from the use of credit
default swaps. For example, Jin and Jorion (2006) find out that there is no significant
effect of hedging on the value of the firm in the oil and gas producers, whilst the
study by Shao (2009) found no significant effects of the bank holding companies’
returns by the use of the credit derivatives. The researcher's views supplements the
literature by investigating the effects on the value of the firm from the use of CDS in
the insurance industry. By narrowing the study the researcher is able to alleviate any
probability of spurious results from other diverse aspects in various industries. The
research analyses the CDS usage in Life and P&C insurance companies separately
taking into account the underwriting operations differences. Particularly, the Tobin’s
 24

Q and return on equity (ROE) are used as the two measures of the financial
performance of a firm.

2.6 Conclusion

The discussion on the effects on the effects of CDS usage on the insurance
companies, the researcher will look into depth the profile risk in the insurance
companies in relation to the use of CDS. This risk profile will entail total risk, market
risk and idiosyncratic risk. Then there will be a detailed investigation of the CDS
usage on the value of the firm. The research will utilise the Tobin’s Q and ROE of
the firm as the proxies of the firm value. In addition these comparisons will be a
comparison of CDS users and non-users in the insurance industry. The Life and
P&C insurance companies will be used to represent the insurance sector. Finally,
the researcher will investigate the period between 2001 to 2009.This is the period in
which the financial crisis happened.
 25

Chapter 3: Research Methodology

3.1 Introduction

This chapter outlines the steps that were employed in conducting the research study.
The chapter highlights the research design that was employed and the data
collection and analysis process. Included in the chapter are details on is the
research population, and sampling technique.

3.2 Research Design

Research design is a framework that a researcher will follow in collecting, analysing

and making conclusions from the analysed data (Creswell et al., 2012). When
selecting a research design a researcher take into consideration the data to be
collected that will provide informative conclusion upon being analysed .
Additionally the practicability of the research design should also be a reason besides
other factors such as available monetary and human fiscal resources and time.
Taking into considerations all these aspects the researcher utilized a quantitative
research design.

Quantitative research is explaining a research problem by collecting numerical data

that is to be analysed by use of mathematical approaches (Sukamolson,
2007).Orodho (2010) noted that when a researcher plans to evaluate a research
phenomenon that can superlatively be elucidated by analysis of numerical facts,
then a quantitative design is apposite. This is for the reason that a quantitative
design permits use of statistical analysis that mines imperative information. The
researcher also selected quantitative design as it will allow data analysis at a given
level of significance hence the findings can be put side by side with those from
other analogous studies. Further, if the researcher thinks that there are relationships
between research variables then a quantitative design is applicable (Saunders,
Lewis, and Thornhill, 2007). The researcher hypothesized that the there is a
relationship between CDS, and firm value and risk. Such relationship was explored
by use of regression that is mathematical approach utilized under a quantitative
research design.
 26

3.3 Research Population

In research activities, the target population constitutes the number of subjects or

objects from which relevant information can be collected (Castillo 2009). When
sampling, Foy (2004) noted that irrespective of the sampling technique applied the
researcher should ensure that the participants are sampled from the right sampling
frame. In this line, the study’s populations are P&C Insurance and Life insurance
companies that operate in European Economic Area countries. There are 214 P&C
Insurance in total and 192 Life insurance companies as rated by the standard and
poor’s ratings services (2014)

3.3.1 Sampling technique

According to Foy (2004) not all members of the research population can provide
relevant information. As such a researcher should sample part of the population from
which pertinent data can be collected. In this line the researcher utilized criterion
sampling to sample the firms whose data was used in the study. Criterion is
sampling members of a research population that meet a set principle (Creswell et al.,
2012). In this study the P&C Insurance and Life insurance companies must be
publicly traded.

3.4 Data collection

To analyse the effects of CDS use on firm risk and market value the focus was on
publicly traded insurance companies whose data is provided by University of
Southampton data stream. There are 115 P&C and 101 Life insurance companies
that publicly trade. After concluding the insurance companies that with missing data
for 2001 – 2009 and also the companies that have non-positive total assets there
were 59 life insurers and 47 P&C insurers. The Life insurers have 32 CDS users and
27 non-users whilst the P&C insurers have 27 CDS users and 22 CDS non-users.
An insurer is deemed as a CDS user if its CDS transaction information is reported in
the data stream. The selection is done manually. To identify whether an insurer is a
CDS user is a buyer or a seller the list compiled by Bloomberg for this period 2001-
2009 was used. There were 9 buyers and 23 sellers in the Life insurers CDS users
and 19 buyers and 8 sellers in the P&C insurers.
 27

3.5 Variable Construction

The variables that the researcher used in the study will be derived from other
variables. The constructed variables will be in various categories namely CDS
variables, Risk variables, Performance variables and Control variables. First, there is
the measure of the extent of CDS involvement by the using the price of the CDS
depending on the position the CDS user that is whether the user is a buyer or a
seller. Price of the CDS was used in the variable construction as a proxy of the
notional amount of the CDS position. In particular, the researcher defined the net-
buy position of an insurance company, Net_ buy =CDS Price of buyer/ risky bonds,
as the CDS price of the buying insurance company divided by the non-governmental
bond investments by that specific insurance company(buyer). It is zero for the rest of
the insurance companies that are not CDS buyers. Also, the researcher defined the
extent of the net-sell position of an insurance company, Net_ sell= CDS price of
seller/ liabilities, as price for the CDS divided by the liabilities of that particular
insurance company (seller). In a similar manner, Net_ sell is equal to zero if the
insurance company is not a CDS seller.

In addition, CDS use may be provoked by the need to hedge or generate income. As
a consequence, construction of two empirical variables is necessary to capture the
incentive of the CDS in relation to hedging and income generation, later examine the
impacts of CDS incentives on the firm’s risk and the value of the insurance
companies. The objective of an insurance company is to reduce the equity’s risk and
depending on an insurer’s CDS participation the following should be demonstrated:
the CDS positions that arise from a hedging purpose is positively correlated with the
co-movements between the CDS returns and the return of the bond investment of
the insurance company. That is the covariance of the returns of the CDS market and
the returns of the bonds to the variance of the returns of the CDS market. It is
defined as H_ ratio for the CDS users and is zero otherwise. The researcher used
the CDS market returns to proxy for the CDS returns.

Furthermore, CDS arising from generation of income purposes are positively

correlated alongside negative co-movements between the market returns of the
CDS and the equity returns of the insurance company that is the ration of the
covariance of the returns of the CDS market and the returns of the equities to the
 28

variance of the returns of the CDS market. This is denoted as Ig_ ratio, income
generation ratio, for users of CDS and zero otherwise.

Secondly the researcher constructed risk variables namely market risk, idiosyncratic
risk and total risk. By regressing the daily returns of an insurance company on the
market portfolio’s daily return using the capital asset pricing model shown:

Represents the insurance company’s j’s daily return at a time t is the market
weighted return, and represents the risk-free rate. The study involved daily
equity returns within a year to approximate the proxies for risk. After regression,
market risk is represented by the co-efficient of regression, β, whilst the standard
deviation of residuals stands for the idiosyncratic risk. The standard deviation of the
everyday returns for specific insurance company represents the total risk which
compromised of the market risk and idiosyncratic risk.

Thirdly researcher constructed performance variables. There was the use of two
measures to investigate the relationship between the CDS activities of the insurance
companies and their financial performance. The Tobin’s Q defined as the summation
of the market equity value and the liabilities as recorded in their books divided by the
assets. In addition, there is the utilization of accounting information in the study. To
measure the financial performance based on accounting the researcher used ROE
which is the net income to the equity value.

Finally, for the control variables, the researcher used the R_ratio to represent the
ratio of the underwriting ratio was transferred to reinsurers. Reinsurance is termed
as the ratio of reinsurance relinquished to the amount of direct business written
premiums and the assumed reinsurance (Cole and McCullough, 2006). Therefore,
reinsurance can be specifically be used as a traditional management tool for risk
specifically for minimising underwriting risks. The higher the reinsurance ratio the
more underwriting risk the insurance company transfers to reinsurers for
minimisation of unexpected losses. The researcher examined the allocation of asset
 29

in bonds and stocks for the insurance company to capture their strategies in
investment. E_ratio represents the expenses used during underwriting activities in
the insurance company. The ratio of the bond investment to the total assets invested
is B_ ratio while S_ ratio represents the ratio of investments in stocks to the total
assets invested for each insurance company. Normally, of the two investments,
investing in bonds is considered to be a safer investment strategy. The researcher
also used O_ derivatives as a dummy variable for an insurer’s other derivatives
utilisation. It takes one if an insurer utilises other derivatives and zero if otherwise.
P_ ratio is the used as a proxy for insurer’s investment prospects and is used to
represent the percentage change in premiums with respect to the earlier year’s level
(Cummins, Phillips, and Smith, 2001).To capture the probable distress costs
concerning to the RBC, the researcher used Cummins et al. (2001) to define RBC_
ratio as the proportion of the actual RBC to the RBC of authorised regulatory.
According to Cummins et al RBC provides a platform to whether minimise or
maximise risks all depending on whether the RBC perfectly measures the risk of the
firm.

To conclude on the control variables, the study utilized the natural logarithm of the
assets in the books with the use of F_ size as the dummy variable. This is used to
control for the effect of size. L_ ratio was the proportion of liabilities to the assets.

3.5 Limitations

The study only used publicly available data of Life and P&C companies. Most of
the Life and P&C insurance companies in the European Economic zone are not
public listed so this narrowed the sample sized that was used. This data was
available at the Southampton University database. Given that CDS is an over
the counter traded financial instrument and the effect of sharing confidential data,
there were limitation in data access. In this line the researcher used the CDS
market returns data from Bloomberg as a proxy for CDS return for the insurance
companies. In addition there was missing data from 2001- 2004. The researcher
used moving average values for these companies.

3.6 Assumptions
 30

The researcher assumed that market returns are a good representation of CDS
return for insurance companies. By employing the Heckman’s sample selection
model the researcher assumed that both error terms have a normal distribution
with a mean of 0, and that the error terms are correlated. The error terms are
independent of the explanatory variables.

3.6 Data Analysis

The researcher used R studio v0.98.1028 for data analysis process. The researcher
used both descriptive and inferential statistics to extract meaningful information from
the data. In regard to descriptive statistics the researcher utilized median, mean and
standard deviation to extract meaningful summaries. The researcher hypothesized
that there exist a relationship between CDS and risk and firm value. This
relationship was explored by performing regressions. In applying the ordinary least
squares (OLS) model where risk is directly related to CDS, there was a high
likelihood of biasness. This is because insurance firms that exhibit particular
performance and risk traits might self-select themselves into CDS involvement. As
such the researcher sought or eradicate the biasness by use of Heckman two-
stage selection model (Bushway, Johnson., & Slocum 2007). In the first phase, the
researcher used logit regression model with firm fixed effects to evaluate how
market factors and firm attributes affect the odds of CDS use by insurers. The first-
stage decision model, after taking into account endogeneity, also offered the
researcher with a self-selection parameter which is the inverse of Mills ratio that
was consequently utilized as an input to the second-stage regression model. This
enabled the researcher to explore how firm value and firm risks are influenced by
the CDS activities.

Logistic regression seeks to establish the effect of multiple independent variables

that are presented concurrently to forecast membership of one or other of the two
dependent variable clusters (Peng & So 2002).Logistic regression utilizes a best
fitting function or equation that uses the maximum likelihood method. This method
optimizes the probability of categorizing data into the suitable classes given the
regression coefficients. In logistic regression the null hypothesis holds that all the
coefficients in the regression equation take the value zero while the alternative
hypothesis holds that the model with predictors being considered is correct and
 31

significantly differs from the null of zero (Guido, Winters, & Rains 2006). The null
hypothesis is retained when the probability corresponding to the log likelihood is
less than the level of significance (Marques, 2007).
 32

Chapter Four: Findings and Discussion

4.1 Introduction

This chapter presents the data analysis and findings of the study. In each section
there are the findings and a discussion that links the findings with the aim of
determining the factors that affect the firm’s risk profile and its value in relation to the
use of CDS, showing what the researcher found out in clear and in simple terms.
This chapter will entail a detailed sub-section on the descriptive statistics, which will
be followed by the inferential statistics. Finally, there will be a summary of the
models and statistical tests the researcher used in the study.

4.2 Descriptive Statistics

Table 1 below gives a summary of the CDS transactions for both Life and PC
insurance companies from 2001 to 2009. In addition it includes the number of the
entire sample firm-year observations, the number and participation of CDS users
and CDS buyers and sellers as reported. The percentage of CDS participation is
based on firm-year observations. Within 2001-2009 the CDS involvement for the Life
insurers is about 54.24%, of which 28.13 % are buyers while 71.88% are sellers of
CDS. For the PC insurance companies samples there is a 57.45% CDS involvement
of which 70.37% are buyers while 29.63% are sellers. Table 1 shows that Life
insurers are participate more in the CDS market as compared to PC insurers.
Furthermore, the life insurers are more likely to participate in the CDS market as
compared to the PC insurers. Also, the statistics depict that they involve themselves
as market sellers, as for the PC insurers are more of buyers in the CDS market.

Table 1: CDS Users and Participation for Life and P&C Insurance Companies.

Item Life PC
Number of Insurance 59 47
companies.

Number of CDS users. 32 27

CDS participation (%). 54.24 57.45
CDS buyers (%) 28.13 70.37
CDS sellers (%) 71.88 29.63
 33

In table 2 below the brief statistics is outlined for the Life and PC insurance
companies’ samples. Several points are eminent. Firstly, the systematic mean of the
Life insurance companies is larger compared to that of the PC insurance companies
that is 68.7% and 59.90% respectively. Secondly, in terms of the investment
decisions the P&C insurers generally invest 68.28% of the total assets in bonds
whilst the Life insurers invest 59.9% of the total assets. Life insurers invest a higher
percentage in stocks (40.10%) compared to the P&C insurance companies’ sample
(31.72%).From the Life insurance companies have a tendency to utilise other
derivatives (67.77%) compared to the P&C insurance companies
(13.00%).Moreover, concerning their underwriting behaviour the Life insurance
companies have a higher expense ratio, which refers to the percentage of
acquisition and underwriting expenses, (17.63%) and the 9.18% for the P&C
insurance companies. The Life insurers use less reinsurance to shift their
underwriting risks compared to the P&C insurers that is the reinsurance ratio is
14.54% and 4.0562% respectively. Also, the average firm size of life insurance
companies (7.947) are larger compared to that of the P&C insurance companies
(4.727).
 34

Table 2: Brief Statistics for Life and P&C Insurance Companies.

Life Mean Media Std P&C Mean Median Std.

n
Idiosyncratic 0.056 0.033 0.06 Idiosyncratic 0.068 0.042 0.056
risk. risk.
Market risk. 0.687 0.539 0.404 Market risk. 0.537 0.528 0.389
Total risk. 0.087 0.069 0.091 Total risk. 0.092 0.074 0.085
Tobin's Q. 0.944 0.956 0.039 Tobin's Q. 0.93 0.972 0.42
ROE. 0.042 0.116 0.202 ROE. 0.046 0.087 0.197
H_ ratio. 0.468 0.402 1.29 H_ratio. 0.056 0.245 0.245
Ig_ ratio. 0.068 0.202 0.189 Ig_ratio. 0.025 0.193 0.087
N_ buy. 0.131 0.006 0.31 Net_buy. 0.518 0.082 0.917
N_sell. 0.452 0.157 0.891 N_sell. 0.813 0.028 2.925
B_ ratio. 0.669 0.682 0.207 B_ratio. 0.625 0.697 0.188
S_ ratio. 0.033 0.024 0.052 S_ratio. 0.116 0.056 0.138
O_derivatives 0.678 1 0.438 O_derivatives 0.13 0 0.417
P_ratio. 0.717 0.683 0.321 P_ratio. 0.792 0.971 0.472
RBC_ratio. 30.45 5.893 98.34 RBC_ratio. 22.90 4.91 128.9
6 2 2 1
R_ratio.(%) 14.50 37.00 22.50 R_ratio.(%) 40.60 30.30 37.20
L_ratio. 0.944 0.956 0.39 L_ratio. 0.619 0.628 20.15
6
E_ratio. 0.176 0.122 0.263 E_ratio. 0.092 0.129 0.183
F_size. 7.948 6.88 7.46 F_size. 4.727 2.944 5.743
Total_assets( 1596 526 2313 Total_assets( 113 19 312
M Euros) M Euros)
 35

Table 3 below depicts the univariate comparison of the means and medians of
descriptive statistics across the CDS users and non-users for the Life insurance
companies’ samples .In the Life insurance Companies’ full sample there are 32 CDS
users and 27 non-users. The findings point out that Life insurance companies
involved in the CDS transactions they have a larger systematic risk than those that
don’t. The value of market risk is notably larger for the CDS users (0.9087) than the
non-users (0.545). Furthermore, non-CDS users have a higher Tobin’s Q compared
to the CDS users (that is 0.9992 and 0.8456 respectively).

To sum it up, the mean and median differences can be used to test the significance
of a variable in two samples using the t-statistics, at a given level of significance. For
instance, In table 3, the market risk (0.9087) of the CDS users is larger compared to
the market risk for the CDS non-users (0.545) and the difference is 0.3637, while the
for the CDS user idiosyncratic risk (0.056) and for the non-users is (0.053) and the
mean difference is 0.3637.The market risk mean difference is significant based on a
1% level t-statistic, whilst the idiosyncratic mean is not statistically significantly.

The univariate description provides a slight perception on the differences concerning

risk and value across the CDS users and non-users samples. Furthermore, they
appear to vary in several other dimensions .For instance, the firm size of the CDS
users is generally larger, they have a higher expense ratio compared to the non-
users and, it is probable for them to use other derivatives compared to the CDS non-
users.
 36

Table 3: Attributes of Life Insurance Companies.

Statistics CDS CDS Diff CDS CDS Diff

user non- (1)-(2) user non-user (3)-(4)
Mean user Median Median
(1) Mean (3) (4)
(2)
Idiosyncratic 0.056 0.053 0.003 0.0301 0.0216 0.0085
risk.
Market risk. 0.9087 0.545 0.3637 0.892 0.5367 0.3553
Total risk. 0.09267 0.08778 0.00489 0.0573 0.0468 0.0105
Tobin’s Q. 0.8456 0.9992 -0.1536 0.80501 0.9546 -0.1495
ROE. 0.074 0.039 0.035 0.1245 0.1092 0.0153
B_ ratio. 0.68 0.62 0.06 0.65 0.70 -0.05
S_ratio . 0.05 0.02 0.03 0.0325 0.0167 0.0158
O_derivatives. 0.9723 0.35617 0.61613 1 0 1
P_ratio. 0.68217 0.63781 0.04436 0.76189 0.6718 0.09009
Total _assets. 1782 651 1131 1892 718 1174
L_ratio. 0.8171 0.5617 0.2554 0.6712 0.7181 -0.046
E_ ratio. 0.7615 0.5617 0.1998 0.8018 0.6718 0.13
F_size. 7.5617 4.671 2.8907 6.167 5.819 0.348
R_ratio(%) 20.718 24.5617 -3.8437 18.91 21.091 -2.181
RBC_ratio 0.105 0.658 -0.553 0.082 0.224 -0.142

Table 4 below shows the descriptive statistics of results for the P&C insurance
companies. In the P&C category there were e 27 CDS users and 22 non-users. The
CDS users have a higher market risk (0.66152) than the non-users (0.35921). Also,
CDS non-users have a larger Tobin’s Q at a mean value of 0.9992 than that of users
(0.8456).
 37

Table 4: Attributes P&C Insurance Companies.

CDS CDS
CDS non- CDS non-
user user user user
Statistics Mean Mean Diff Median Median Diff
Idiosyncratic
risk 0.05617 0.049182 0.006988 0.03561 0.03 0.00561
Market risk 0.66152 0.35921 0.30231 0.56289 0.4516 0.11129
Total 0.07182 0.056172 0.015648 0.08671 0.03561 0.0511
Tobin’s Q 0.66271 0.73912 -0.07641 0.67182 0.7451 -0.0732
ROE 0.041627 0.031425 0.010202 0.03526 0.02516 0.0101
B_ratio 0.549 0.652 -0.103 0.667 0.689 -0.022
S_ratio 0.238 0.259 -0.021 0.301 0.249 0.052
O_derivatives 0.93627 0.56721 0.36906 1 0 1
P_ratio. 0.72619 0.671425 0.054765 0.70781 0.5622 0.14561
Total assets 101 95 6 78 34 44
F_size 4.15627 3.1672 0.98907 3.901 2.893 1.008
L_ratio 0.7816 0.56271 0.2189 0.71625 0.45162 0.26463
E_ratio 0.06718 0.05627 0.01091 0.04617 0.0561 -0.0099
R_ratio(%) 46.8145 56.9102 -10.0957 56.8192 52.781 4.0382
RBC_ratio 0.151 0.528 -0.377 0.106 0.469 -0.363

The descriptive findings clearly shows that the Life insurance companies invest more
on stocks which are a safer form of investment compared to the bonds. The
statistics also show that the Life insurance companies are more of sellers of the
CDS than buyers and that they are larger unlike the P&C insurance companies. This
means that Life insurance companies compared to the P&C insurance companies
have a better credit risk rating in the financial industry. Rating refers to the measure
of risk class and strength in finance of insurers; also it represents the reputation of
an insurer and its franchise value (Pottier & Sommer, 1999). The descriptive
analysis results also show that the systematic risk in the Life insurance companies’
 38

sample is higher compared to that of the P&C insurance companies’, this is probably
because of there are more Life insurance companies participating in the CDS market.
A number of researchers concluded that firms that used CDS increased their
systematic risk. Concerning, the expense ratio the Life insurance have a higher
average, this could be because of the expenses incurred in underwriting for instance
the hiring of expertise who are proficient in the pricing of the derivatives that they sell
to investors. The P&C insurance companies have a lower reinsurance ratio, this
means that the P&C insurance companies use less reinsurance to shift their
underwriting risks to the reinsurers to reinsurance companies to minimise
unexpected losses compared to the Life insurance companies. This is possibly
because the Life insurers need to hedge the losses that may occur to their active
participation in the CDS market.

To sum it up, the mean and median differences can be used to test the significance
of a variable in two samples using the t-statistics, at a given level of significance. For
instance, In table 3, the market risk (0.9087) of the CDS users is larger compared to
the market risk for the CDS non-users (0.545) and the difference is 0.3637, while the
for the CDS user idiosyncratic risk (0.056) and for the non-users is (0.053) and the
mean difference is 0.3637.The market risk mean difference is significant based on a
1% level t-statistic, whilst the idiosyncratic mean is not statistically significantly.

The univariate description provides a slight perception on the differences concerning

risk and value across the CDS users and non-users samples. Furthermore, they
appear to vary in several other dimensions .For instance, the firm size of the CDS
users is generally larger, they have a higher expense ratio compared to the non-
users and, it is probable for them to use other derivatives compared to the CDS non-
users. The rest of the chapter will be on the empirical data analysis and findings.

4.3 Empirical Findings

4.3.1 Risk Models

 39

The researcher hypothesized that there exist a relationship between CDS and risk
and firm value. This relationship was explored by performing the Heckman two-
stage logit regression.

The Likelihood analysis for use of CDS by an insurance company

This data analysis was carried out on the both the Life and P&C insurance
companies to test the likelihood for the insurance companies to participate in the
CDS market. Table 5 below shows the Heckman first-stage logit regression results.
In the first phase, the researcher used logit regression model with firm fixed effects
to evaluate how market factors and firm attributes affect the odds of CDS use by
insurers. The results suggest that there is a high probability of both the Life insurer
and P&C insurer to use CDS if they are larger firms, if they have the higher
reinsurance ratio and if the if the insurers participate in transactions of other
derivatives. For the Life insurance companies with a lower percentage in bond
investment are more likely to participate in CDS market. Also, with respect to the
market CDS beta the Life insurance companies have a higher probability of
participation in the CDS market, unlike the P&C insurance companies in the attempt
to minimize the component of systematic risk of CDS on them. Lastly, from the
regression results it is seen that for the P&C insurance companies with lower RBC
ratios are likely to participate in the CDS market.
 40

Table 5: The Heckman first-stage logit regression results.

Panel A:Life Panel B:P&C

Insurance Insurance
Parameter Coefficient Chi- Parameter Coefficient Chi-
square square
Intercept -20.781* 25.901 Intercept -14.67* 16.78
Beta. -13.891* 12.78 Beta. 3.901 0.98
B_ ratio. -3.0172* 17.891 B_ ratio. -11.811 1.78
S_ ratio. 2.918 0.17 S_ ratio. 1.1672 1.08
O_Derivatives. 6.181* 15.91 O_Derivatives. 2.981* 17.91
P_ ratio. 0.781 0.11 P_ ratio. -1.891 0.34
RBC_ ratio. -0.245 1.23 RBC_ ratio. -1.452* 9.16
F_ size. 2.672* 28.9 F_ size. 4.178* 12.923
L_ ratio. 6.189 0.05 L_ ratio. 0.272 0.12
E_ ratio 2.901 0.02 E_ ratio -0.89 0.16
R_ratio. 2.901* 13.89 R_ratio. 9.190* 27.89
*Significant at 1% level.

This table reports the results of the Heckman first-stage logit regression model for
the Life and P&C Insurance Companies. The results can be summarised in the
following equations:

Equation for Life Insurance Companies.

Equation for P&C Insurance Companies.

 41

In the Likelihood analysis of the CDS usage the findings clearly indicate that the
larger the firm, both the Life and P&C insurance companies, the higher the
probability of participating in the CDS market. Normally, it is believed that the risk of
bankruptcy is lower for larger firms. According to Wijn and Bijnen ( 2001) firm size
has an influence on the bankruptcy on a firm and that small firms having an average
of 10-20 employees are extra to the economic climate than the rest. In addition,
firms that have a higher reinsurance ratio and participate in other derivatives’
transactions. This is because the firms that are participating in the CDS market
hedge against any unforeseen losses. For firms those firms that invest more on
stocks have a higher likelihood of involving in the CDS market. This is because
these firms have a better rating than those that invest more on bonds. Bonds are a
more risky investment compared to the stocks. Also, firms with a lower beta tend to
participate more in the CDS market. This is an attempt to minimise the component of
systematic risk of CDS in them. The logit regression results shows that the lower the
RBC_ratio the higher are the chances of the insurer to participate in the CDS market.
These firms use CDS to hedge risk by the use of CDS because they do not have
enough capital for this.

Risk Analysis

After controlling for biasness caused by sample selection, the effects of the risk
profile on those firms that use CDS was investigated that is total risk, market risk
and idiosyncratic risk were analysed. In the reported results, regarding the inverse
Mills ratio (Mills_ ratio), the negative co-efficient indicates that the insurance
companies have a likelihood to participate in the CDS market.

Total Risk Model.

Table 6 below shows the results for the Heckman second-stage regression. After
controlling for sample selection bias, Life insurance companies sample, depicts that
 42

both variables for the CDS trading motives are related significantly to total risk.
Firstly, the H_ ratio (4.901) has a positive relationship with the total risk of the Life
insurance companies, which is statistically significant at a 1% level. The results
suggest that the total risk of the Life insurance companies increases with the CDS
buy motive. Also, the Life insurance companies are positively related to the proxy for
the income generation incentives, Ig ratio, which is statistically significant at 1% .To
sum up, the Life insurance companies’ involvement in the CDS market regardless of
the incentive results to an increase in their total risk.

Concerning other insurance characteristics, the involvement in other derivatives is

negatively (-0.423 and t-value -4.782)related to the Life insurance companies total
risk, which is also significant at 1%.This also applies to the reinsurance (R_ratio), it
is negatively related to the total risk of the Life insurance companies (-2.901 and t-
value -11.894),which is significant at 1%.This means that the Life insurance
companies with a lower R_ratio and involvement in the transaction with other
derivatives have a higher total risk. The F_ size is negatively related to the total risk
of the Life insurance companies (-0.145 and t-value -5.904) and it has a significant
effect on the total risk at 1% level. Probably the large Life insurance companies have
a lower total risk.

For the other firm characteristics, B_ ratio, S-ratio and P_ ratio (0.844, 3.026and
0.672) are positively related to the total risk for the Life insurance companies, while
the RBC_ ratio, L_ ratio and E_ ratio (-0.540,-0.267 and -0.02) are negatively related
to the total risk for the Life insurance companies. These firm characteristics have no
significant effect on the total risk.
 43

Table 6: Statistics of Life and P&C Insurance Companies on Total Risk Model.

Life P&C
Companies. Companies.
Parameter Coefficient t-value Parameter Coefficient t-value
Intercept. 2.091* 6.903 Intercept. 1.837 1.32
N_ buy. 10.678 0.169 N_ Buy. -2.948 -1.95
N_ sell. 3.891 1.892 N_ sell. 0.01 0.11
H_ ratio 4.901* 9.263 H_ ratio 0.672 1.23
Ig_ ratio. 7.564* 5.782 Ig_ ratio. 5.892* 7.29
B_ ratio 0.844 -0.29 B_ ratio -0.001 1.98
S_ ratio 3.026 -1.236 S_ ratio -8.478 0.03
O_derivatives -0.423* -4.782 O_derivatives -1.001 -0.1
P_ ratio. 0.672 0.573 P_ ratio. 0.002 1.02
RBC_ ratio. -0.54 -0.892 RBC_ ratio. 1.092 0.67
F_ size. -0.145 -1.004 F_ size. -2.907 -1.11
L_ ratio. -0.267 -1.973 L_ ratio. 0.983 0.11
E_ ratio. -0.02 -2.037 E_ ratio. -3.892 -0.83
R_ratio (%). -2.901* -11.894 R_ratio (%). 1.903 2.03
Mills_ ratio. -0.438* -4.738 Mills_ ratio. 0.563 0.78
*Significant at the 1% level.

The table reports the second-stage Heckman Total Risk model estimates for the Life
and P&C Insurance Companies. The results can be summarised in the equations as
follows:
 44

Equation for Life Insurance Companies.

Equation for P&C Insurance Companies.

Market Risk Model.

Table 7 represent the results of the market risk model after controlling for
endogeneity. The H_ ratio (2.673) and IG_ ratio (5.367) are positively related with
the market risk of the Life insurance companies. The results also indicate that
participation in other derivatives is negatively related to the systematic risk (-0.782*
and t-value -4.782) and has a significant effect on the systematic risk of the Life
insurance companies at 1%.

In view of the control variables, the results show that the higher the involvement in
the bond (B_ ratio) and stock (S_ ratio) investments the lower the market risk. The
coefficients of relationship to the market risk are (0.844and 3.026) .As for the
Premium growth (P_ ratio) is positively related to the market risk (0.672 and t-value
0.573) and has no significant effect on the market risk of Life insurance companies.
The lower the RBC_ratio, the firm size (F_size) and expense ratio in the insurance
company the lower the market risk it has.

In P&C insurance companies we see a positive relationship for the N_sell,H_ ratio
and Ig_ ratio ,and they are all statistically significant at 1% . This reveals that the
market views the CDS market as risky when it’s CDS net sale position is higher and
when the P&C insurance companies participate in the CDS market regardless of the
incentive (either hedging or income generation).As reported on the table the lower
 45

the premium growth that is P_ ratio (-1.459 and t-value -6.38) the higher the market
risk of the P&C insurance companies, the market risk has a significant effect on the
insurance companies at 1%.

As for the rest of the control variables, the lower the B_ ratio, participation in other
derivatives, RBC_ ratio, F_ size ,L_ ratio, E_ ratio and R_ratio (-0.28,-3.901,-2.635, -
1.093, -2.563 and-2.671 respectively) the minimum the market risk which is
experienced by the P&C insurance companies. Consequently, the higher the S_
ratio (0.063) the less the market risk that is experienced by the P &C insurance
companies. There are no significant effects of the market risks on the P& C
insurance companies.

Table 7: Statistics of Life and P&C Insurance Companies on Market Risk Model.

Life P&C
Companies. Companies.
Parameter Coefficient t-value Parameter Coefficient t-value
Intercept 1.635 1.21 Intercept 0.852 0.54
N_ buy. 7.198 0.02 N_ buy. -3.822 -1.01
N_ sell. 10.829 1.67 N_ sell. 8.902* 9.02
H_ ratio. 2.673* 6.9 H_ ratio. 15.893* 4.03
Ig_ ratio. 5.367* 17.03 Ig_ ratio. 5.903* 18.92
B_ ratio. 0.02 0.1 B_ ratio. -0.345 -0.28
S_ ratio. 4.902 0.01 S_ ratio. 0.063 1
O_derivative -0.782* -7.9 O_derivative -3.901 -1.18
P_ ratio. -0.453 -8.02 P_ ratio. -1.459* -6.38
RBC_ ratio. -3.892 -0.32 RBC_ ratio. -2.635 -1.59
F_ size. -0.356 -1.45 F_ size. -2.671 -0.06
L_ ratio. -0.267 -0.82 L_ ratio. -1.093 -0.18
E_ ratio. -1.284 -0.04 E_ ratio. -2.563 -1.94
R_ratio(%). -1.673 -0.62 R_ratio(%). -0.893 -0.67
Mills_ ratio. 1.563 1.2 Mills_ ratio. -2.673* -5.9

*Significant at 1% level.
 46

The table reports the second-stage Heckman Market Risk model estimates for the
Life and P&C Insurance Companies. The results can be summarised in the
equations as follows:

Equation for the Life Insurance Companies.

Equation for the P&C Insurance Companies.

Idiosyncratic Risk Model.

Table 8 shows the results of the idiosyncratic risk model for the Life insurance
companies. The table reports that the market risk is positively related to the H_ratio
(0.782* and t-value 6.89) and Ig_ ratio (1.827* and t-value 17.03), which are
statistically significant at 1%.

In terms of the P&C insurance companies, idiosyncratic risk is positively related to

the Ig_ ratio.
 47

Table 8: Statistics of Life and P&C Insurance Companies on Idiosyncratic Risk

Model.

Life P&C
Insurance Insurance
Companies. Companies.
Parameter Coefficient t-value Parameter Coefficient t-value
Intercept 1.278 0.78 Intercept 0.684 1.02
N_ buy. 0.672 1.09 N_ buy. 0.495 1.1
N_ sell. 1.893 0.93 N sell. 1.13 0.01
H_ ratio. 0.782* 6.89 H_ ratio. 6.71 1
Ig_ ratio. 1.827* 10.6 Ig_ ratio. 0.692* 1.09
B_ ratio. 1.782 0.02 B_ ratio. 0.001 0.6
S_ ratio. 2.973 0.95 S_ ratio. 5.893 1.01
O_derivative -0.024 -1.02 O_derivative -2.478 -0.74
P_ratio. -1.782 -0.38 P_ ratio. -3.746 -1.33
RBC_ratio. -1.624 -1.31 RBC_ratio. -0.53 -0.4
F_size. -0.972 -1.64 F_size. 0.973 0.84
L_ratio. -1.892 -0.56 L_ratio. -3.403 -1.23
E_ratio. -0.167 -1.23 E_ratio. -6.509 -0.58
R_ratio. -1.38 -0.49 R_ratio. -0.027 -0.02
Mills_ratio. -2.438 -6.95 Mills_ratio. 0.363 -0.75
*Significant at 1% level.

The table reports the second-stage Heckman Idiosyncratic Risk model estimates for
the Life and P&C Insurance Companies. The results can be summarised in the
equations as follows:

Equation for the Life Insurance Companies.

 48

Equation for the P&C Insurance Companies.

Firstly, from the findings the total risk model it is clear that there is an increase in the
total risk, regardless of the Life insurer’s incentive to participate in the CDS market.
Total risk is a summation of market risk and idiosyncratic risk. Usually, it is known
that CDS use will lead to increase in the market risk thus increasing the total risk.
Life insurance companies which are smaller in size have a higher total risk. The
findings also indicate that the Life insurance companies with a lower R_ ratio and
involvement in the transaction with other derivatives have a higher total risk. These
results suggest that reinsurance and the minimization of financial risk by involvement
in other derivatives can therefore reduce insurance’s total risk, thus managing the
underwriting risks. Secondly, the hedging and income generating ratios are both
positive to the market risk in the Life and P&C insurance companies. The findings
suggest that the market view of engagements in the CDS market by the Life
insurance as risky regardless of their incentive. This evidence is consistent with the
findings of Intefjord (2005), they argue that CDS transactions (buy or sell) as risk
taking in the Bank industry. In view of the participation in other derivatives by the Life
insurance companies the results clearly indicate that the market views that firms that
use CDS should hedge against systematic risk. In addition, a firm that investments
more on stocks has a lower systematic risk. This is because stocks are less risky
compared to the bonds, thus reducing the risks caused by investments. This reveals
that the market views the CDS market is risky when its CDS net sale position is
higher. The higher N_ sell ratio indicates that there were more CDS transactions
done by the buyers in the P&C insurance companies sample. Therefore, this
increases the systematic risk in these insurance companies. An insurance company
 49

with low premium growth shows that there is a probability it will incur losses in the
long run that is a negative profit. This explains the result that lower P_ ratio has a
significant effect on the market risk in the P&C insurance companies’ sample.

Thirdly, the results hint the market’s view, regardless of the Life insurers’ incentive of
participating in the CDS market, it is a risky venture thus will result to an increase in
idiosyncratic risk. This evidence is consistent with the findings of Hung-Gay, Min-
Ming Wen, and Gaiyan Zhang (2012), they argue that the market views Life insurers’
CDS participation as a greater degree of opaqueness and, as such, a higher degree
of idiosyncratic.

Table 8 shows the results of the idiosyncratic risk model for the Life insurance
companies. The table reports that the market risk is positively related to the H_ratio
(0.782* and t-value 6.89 )and Ig_ ratio (1.827* and t-value 17.03) ,which are
statistically significant at 1%.The results hint the market’s view, Regardless of the
Life insurers’ incentive of participating in the CDS market ,it is a risky venture. This
evidence is consistent with the findings of Hung-Gay, Min-Ming Wen, and Gaiyan
Zhang (2012),they argue that the market views Life insurers’ CDS participation as a
greater degree of opaqueness and, as such, a higher degree of idiosyncratic risk.
Concerning the P&C insurance companies the income generating ratio has a
significant effect on their idiosyncratic risk. This hints that CDS utilization for income
generating maximizes private information and results to increased firm-specific risk.

4.3.2 Market Value and Performance Analysis

Market-Based Tobin’s Q Model

As reported on Table 9, For the Life insurance companies’ the Net_ buy (-1.836 and
t-value -6.27), Ig_ ratio (-19.037 and t-value -10.83) and RBC_ ratio (-8.748 and t-
value -9.29) are negatively related to the Tobin’s Q value and they all significantly
have an effect on the Market- based Tobin’s Q value for the Life insurance
companies at a 1% level. Also the lower L_ ratio (-0.202 and t-value -8.67) and a
larger F_ size (2.039 and t-value 21.81) result to a higher value of the Tobin’s Q
 50

value, they are also statistically significant at 1 %.This imply that a smaller firm with
higher liability ratio results to a lower value of Tobin’s Q value of the firm.

The results show, Ig_ ratio is negatively related to the Tobin’s Q value (-15.903 and
t-value -6.41). For the control variables, it is evident that the lower RBC _ ratio (-
2.904 and t-value -12.12) and the E_ ratio (-1.420 and t-value -7.01) the higher the
value of the Tobin’s Q value. In addition, larger P&C insurance companies with
higher reinsurance ratio have a higher Tobin’s Q value.

Accounting-based Performance Model

There is the use of the accounting-based Model to investigate the impacts of CDS
usage on the insurance’s financial performance. As reported in Part A2 panel of
Table 6, the Net_ sell, Ig_ ratio and RBC_ ratio are negatively (-1.784 ,-0.754 and -
1.569) and significantly related to the Return On Equity for the insurance companies.
In Part B2, In regard to the P&C insurance companies the Ig_ ratio, P_ ratio and E_
ratio are negatively related to the Return On equity and are statistically significant at
1%.

Tobin’s Q Ratio

The researcher used Tobin’s Q ratio as one of the measures of value. The N_ buy
ratio, Ig_ ratio, E_ ratio, R_ ratio and RBC_ ratio have a significant effect on the
Tobin’s Q ratio. The five ratios cause a decrease in the firm value. This can be
caused by the indulgence of the insurance companies in the CDS market which
increases the counterparty risk of a firm causing the value of the firm to decrease.
As see before, the hedging and income generating purposes have increase the
market risk in Life insurance companies, results to a discounting of the market value
of these companies. Also, L_ ratio and F_ ratio affect the firm value. This simply
means a smaller firm with higher ratio increases the systematic risk of the firm, thus
decreasing the value of the firm. It was previously evident that CDS triggers greater
market risk for the Life and P&C insurance companies, and this can result to lower
firm value. Shareholders are expected to require a higher rate of return for bearing
 51

higher risk arising from CDS participation, which is expected to result in lower firm
value (Hung-Gay, Min-Ming Wen, and Gaiyan Zhang, 2012).

Table 9: Statistics of Life and P&C Insurance Companies on Tobin's Q Model.

Life P&C
Insurance. Insurance.
Parameter Coefficient t- Parameter Coefficient t-
value value
Intercept. 2.818* 9.01 Intercept. 5.167* 17.9
N_ buy. -1.836* -6.27 N_ buy. -2.819 -0.01
N_ sell. 5.892 0.38 N_ sell. 0.901 1.02
H_ ratio. -3.808 -1.09 H_ ratio. -0.278 -0.37
Ig_ ratio. -19.037* -10.83 Ig_ ratio. -15.903* -6.41
B_ ratio. 0.024 0.2 B_ ratio. -0.01 -1.09
S_ ratio. 2.903 0.38 S_ ratio. 2.873 0.02
O_derivatives. -1.467 -1.01 O_derivatives. -3.209 -0.57
P_ ratio. 0.934 0.01 P_ ratio. 0.892 0.64
RBC_ ratio. -8.748* -9.29 RBC_ ratio. -2.904* -12.12
F_ size. 2.039* 21.81 F_ size. 1.038* 9.22
L_ ratio. -0.202* -8.67 L_ ratio. -1.907 -1.04
E_ ratio. 0.003 0.02 E_ ratio. -1.420* -7.01
R_ratio. 4.801 1.13 R_ratio. 0.090* 11.02
Mills_ ratio. 2.683 0.3 Mills_ ratio. -1.801* -7.9

*Significant at the 1% level.

The table reports the second-stage Heckman Tobin’s Q model estimates for the Life
and P&C Insurance Companies. The results can be summarised in the equations as
follows:

Equation for Life Insurance Companies.

 52

Equation for P&C Insurance Companies.

Return on Equity

Finally, there was the use of return of equity to measure the value of firm. The Net_
sell, Ig_ ratio and RBC_ ratio affect the Life Insurance companies’ ROE, whilst Ig_
ratio, P_ ratio and E_ ratio affect the P&C insurance companies’ ROE. The
explanation behind this phenomenon is that the variables increase risk in the firm.

There is the use of the accounting-based Model to investigate the impacts of CDS
usage on the insurance’s financial performance. As reported in Part A2 panel of
Table 6, the Net_ sell, Ig_ ratio and RBC_ ratio are negatively (-1.784 ,-0.754 and -
1.569) and significantly related to the Return On Equity for the insurance companies.
In Part B2, In regard to the P&C insurance companies the Ig_ ratio, P_ ratio and E_
ratio are negatively related to the Return On equity and are statistically significant at
1%.

From the data analysis, CDS participation increases the risks in both the Life and
P&C insurance companies. Specifically, CDS participation regardless of the
incentive (either hedging or income generating purposes) increases the systematic
risk, idiosyncratic risk or total risk either for the Life insurance or P&C insurance
companies or both. In addition, income generation purpose in CDS trading is
associated to higher market risk, lower financial performance hence resulting to a
 53

lower market value for both the Life and P&C insurance companies sample,
therefore reducing the value of the firm.

Table 10: Statistics of Life and P&C Insurance Companies on ROE Model.

Life P&C
Insurance. Insurance.
Parameter Coefficient t- Parameter Coefficient t-
value value
Intercept. 2.83 0.37 Intercept. 3.782 1.11
N_ buy. 0.672 1 N_ buy. 5.937 0.23
N_ sell. -1.784* -6.63 N_ sell. 0.536 1.01
H_ ratio. 0.329 0.55 H_ ratio. -2.189 -0.99
Ig_ ratio. -0.754* -7.09 Ig_ ratio. -1.637* -15.02
B_ ratio. -0.026 0.7 B_ ratio. 0.021 0.22
S_ ratio. -0.182 1.3 S_ ratio. 0.352 1.03
O_derivatives. -2.163 -0.72 O_derivatives. -1.031 -0.01
P_ ratio. 0.084 0.64 P_ ratio. 1.786* 12.9
RBC_ ratio. -1.569* -7.83 RBC_ ratio. 0.981 1.24
F_ size. -0.048 -1.15 F_ size. 2.267 0.15
L_ ratio. 0.374 0.33 L_ ratio. -1.223 1.33
E_ ratio. 0.019 1.28 E_ ratio. -1.090* -10.82
R_ratio. -0.067 -1.11 R_ratio. 0.133 0.29
Mills_ ratio. 0.238 0.71 Mills_ ratio. 0.065 0.8

*Significant at 1% level.
 54

The table reports the second-stage Heckman ROE model estimates for the Life and
P&C Insurance Companies. The results can be summarised in the equations as
follows:

Equation for the Life Insurance Companies.

Equation for the P&C Insurance Companies.

Chapter Five: Conclusions and Recommendations

5.1 Conclusion

Credit default swaps were a predominantly used financial instrument up to the recent
financial crisis. The increase in the CDS market in terms of its notional value was
experienced within the time period of 2001 and 2009, when it peaked. The
escalating demand for CDS caused by financial institutions and investors was a
major reason for the expansion of the CDS market. In addition, the CDS became
more complicated which was as a result of the evolving in CDS contracts. Though
CDS is principally a transfer of risk and theoretically should not introduce into the
firms any risk of whatever kind, the above discussion clearly shows that these
transactions as a matter of fact introduced probably unanticipated risk into the firms
that participated in the CDS market. They were not only used for hedging but also
for speculation.

The study was on examining the effects caused by the participation in the CDS
market on the risk profile and value of a firm. The study was limited to CDS data
 55

from publicly listed insurance companies which limited the sample size. Given that
CDS is an over the counter traded financial instrument and the effect of sharing
confidential data, there were limitation in data access. In this line the researcher
used the CDS market returns data from Bloomberg as a proxy for CDS return for the
insurance companies. In addition there was missing data from 2001- 2004. The
researcher used moving average values for these companies.

The results demonstrated that the perception of the market concerning the
participation of insurance companies in the CDS market for income generating
purpose as a risk-taking venture and affects the value of the firm accordingly. The
analysis was carried out on Life and P&C insurance companies’ samples separately
using different econometric methods.

For the Life insurance companies’ sample, the findings show that the CDS
transactions for purposes of hedging or income generation are related to greater
total risk, market risk and idiosyncratic risk. This is clearly shown on table 6, in the
results of the Life insurance companies’ sample it depicts that both variables for the
CDS trading motives are related significantly to total risk. Firstly, the H_ ratio (4.901,
t-value 9.263) has a positive relationship with the total risk of the Life insurance
companies, which is statistically significant at a 1% level. The results suggest that
the total risk of the Life insurance companies increases with the CDS buy motive.
Also, the Life insurance companies are positively related to the proxy for the income
generation incentives, Ig ratio (7.564, t-value 5.782), which is statistically significant
at 1%. Similarly, Table 7 shows that the H_ ratio (2.673, t-value 6.90) and IG_ ratio
(5.367, t-value17.03) are positively related with the market risk of the Life insurance
companies. The results suggest that the market view of engagements in the CDS
market by the Life insurance as risky regardless of their incentive. Finally, Table 8
reports that the market risk is positively related to the H_ratio (0.782* and t-value
6.89 )and Ig_ ratio (1.827* and t-value 17.03) ,which are statistically significant at
1%.The results hint the market’s view, Regardless of the Life insurers’ incentive of
participating in the CDS market ,it is a risky venture. For the P&C insurance
companies CDS transactions affects risk, significantly and positively, for the income
generation purpose. This is clearly shown on table 6, Ig_ratio (5.892, t-value 7.29) is
positively related to the total risk and statistically significant. Similarly, table 7 shows
In P&C insurance companies’ sample we see a positive relationship for the Ig_ratio
 56

(5.903, t-value 18.92). Also, table 8 shows that in terms of the P&C insurance
companies, idiosyncratic risk is positively related to the Ig_ ratio (0.692, t-value 1.09)
and significant at 1%.

In addition factors that increase market risk will decrease the value of the firm
accordingly; this is consistent with the results from data analysis. In particular, the
income generating purpose of an insurance company to use CDS significantly and
negatively impact on both the market value and financial performance of both Life
and P&C insurance companies. This is evident in the findings, in tables 6,7,8 the
Ig_ratio increases the market risk in the P&C insurance companies’ sample,
consequently in table 9 Ig_ratio (-15.903, t-value -6.41) is negatively related to the
Tobin’s Q value and statistically significant at 1% . Similarly, in table 10 Ig_ratio (-
1.637, t-value -15.02) is negatively related to the ROE value and significant at 1%.

Generally, the study found that there is an increase in the risks of both Life and P&C
insurance companies as a consequence of CDS use. This will also lead to a lower
value of the firm due to a higher capital cost. The researcher used the data set of
non-positive total assets there were 59 life insurers and 47 P&C insurance
companies from the European Economic Area countries. As seen from literature
review there is no systematic study that has been done on the effects of CDS usage
on the Life and P&C insurance companies in the European Economic Area countries
within 2001-2009. From the results the CDS usage increased the risk in these
insurance companies causing a decrease in their firm value. Consequently, this
decrease in the firm value also shows how the global financial crisis severely
affected insurers’ performance.

The aim of the study was to explore the effects of CDS use on risk for Life and P&C
insurers. The risk evaluated was in three facets namely; market risk, total risk, and
idiosyncratic risk. Total risk includes both idiosyncratic risk and market risk. This was
achieved by evaluating the following objectives:

I. To explore the effect of CDS use on firm risk of European Life and
Property/Casualty Insurance Companies
II. To explore the effect of CDS use on firm value of European Life and
Property/Casualty Insurance Companies.
 57

Whilst the research questions were:

I. Does CDS use affect firm risk of European Life and Property/Casualty
Insurance Companies?
II. Does the use of CDS affect firm value of European Life and
Property/Casualty Insurance Companies?

The findings from the study addressed the aim, objectives and research questions
that were set by the researcher. Specifically, the results show that the CDS
participation that are initiated by purpose of hedging or income generation bring
about increased market risk, total risk and idiosyncratic risk for the life Insurance
Companies’ sample. While, P&C Insurance Companies’ samples CDS participation
for income generation incentive significantly and positively affects risk. Therefore,
use of CDS affects the risk profile of European Life and P&C Insurance Companies.

Also, the findings on value of a firm analysis show that the income generation
incentive has a significant and negative impact on the market value and the firm’s
financial performance of the Life and P&C Insurance Companies.

Generally, the researcher found out that using of CDS increase the risks of the Life
and P&C insurance companies, resulting to decreased value of the firm.

5.2 Recommendations

Firstly, convert trading of CDS to an exchange from OTC trading product. This will
not only reduce the opaqueness of the CDS market but also offset probable
counterparty risk by means of centralised clearing-house as counterparty to all
participators. This will also help the data to be accessible to those financial
institutions and investors who want to engage into the CDS market. Secondly, this
can be achieved by requiring those investors and financial institutions that are
considered “too large to fail” never to take up unhedged CDS positions in the market
and require them to allocate sufficient economic capital to cover their positions. If
capital obligations were increased on investing in CDS and CSO the investors would
be less attracted to them, and the market would experience a smoother demand
 58

growth. Thirdly, the issue of empty creditor problem can be solved by making
mandatory for holders of both the debt securities and the CDS to disclose their
investments during negotiations on restructuring; this will result to their incentives to
be known as well. Similarly, creditors should be made to ask for approval from the
debtors that prevent them to over insure their holdings. In addition, it should also be
mandatory that the buyer of the CDS should have ownership on the underlying
object that is the reference entity that is being insured. Lastly, the mentioned
technique will ensure transparency is required in the CSO market, since high ratings
misled the parties because they were not indicative of performance.

There is a need for further research on solving the problems on how CDS have been
used while allowing the investors and financial institutions take advantage of the
benefits CDS can offer. This will help minimise the risk that they cause to the firms
that indulge in the CDS market, thus will result to an increased value of the firm. The
following techniques can be used to ensure that the investors get the most from the
CDS market
 59

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Appendix

Appendix A: Variable Definitions and Data Sources

Idiosyncratic Risk. Standard deviation of residuals, after regressing the capital

asset pricing model.
Source: Data Stream University of Southampton.
Market Risk. Represented by the co-efficient of regression, β, after
regressing the capital asset pricing model.
Source: Data Stream University of Southampton.
Total Risk. The standard deviation of the everyday returns for specific
insurance company.
Source: Data Stream University of Southampton.
Tobin’s Q. Summation of the equity’s market value and the liabilities as
recorded in their books divided by the assets.
Source: Data Stream University of Southampton.
ROE. Net income to the equity value.

Source: Data Stream University of Southampton.

Beta. Represents the co-movements in the market level between

the indices of the CDS market and portfolio returns.
Source: Bloomberg.
H_ratio. Ratio of covariance of the returns of the CDS market and the
returns of the bonds to the variance of the returns of the CDS
market .i.e cov(returns of the CDS market and the returns of
the bonds)/var(returns of the CDS market)

Source: Data Stream University of Southampton.

Ig_ratio. Ratio of the covariance of the returns of the CDS market and
the returns of the equities to the variance of the returns of the
CDS market. i.e cov(returns of the CDS market and the
returns of the equities)/var(returns of the CDS market)

Source: Data Stream University of Southampton.

N_buy. CDS Price of buyer/ Risky bonds; as the CDS price of the
buying insurance company divided by the non-governmental
bond investments by that specific insurance company (buyer).
Source: Data Stream University of Southampton.
N_sell. CDS Price of seller/ Liabilities, as price for the CDS divided
by the liabilities of that particular insurance company(seller).
Source: Data Stream University of Southampton.
B_ratio. Ratio of the bond investment to the total assets invested for
each insurance company.
Source: Data Stream University of Southampton.
S_ratio. Ratio of investments in stocks to the total assets invested for
each insurance company.
Source: Data Stream University of Southampton.
 71

O_derivatives. Dummy variable for an insurer’s utilization of other

derivatives. Source: Data Stream University of Southampton.
P_ratio. Represent the percentage change in premiums with respect
to the earlier year’s level. Source: Data Stream University of
Southampton.
RBC_ratio. Proportion of the actual RBC to the RBC of authorised
regulatory. Source: Data Stream University of Southampton.
R_ratio(%). Ratio of the underwriting ratio was transferred to reinsurers.
Source: Data Stream University of Southampton.
L_ratio. Ratio of the value of liabilities to the value of assets for each
insurance company. Source: Data Stream University of
Southampton.
F_size. Used to control for the effect of size i.e the natural logarithm
of the value of assets. Source: Data Stream University of
Southampton.
E_ratio. Represent the ratio of the expenses used in underwriting.
Total_assets. Represents the total assets in the Life and P&C insurance
companies’ samples. Source: Data Stream University of
Southampton.
Mills_ratio. Represents a self-selection parameter from the regression of
the logit regression model of the first-phase of the Heckman
two-phase model.

Appendix B: Summary of the models and statistical tests

Model produced Input Output Purpose Use

First-stage logit model. -Beta and -Logit(π) -Logit -The findings

Control regression clearly show

variables. model that insurance

where the companies

fixed that are larger

effects of in size, have

the firms higher R_ratio,

 72

are used to use other

investigate derivatives,

how factors higher S_ratio,

in the lower Beta

market and and lower

attributes RBC_ratio

of the firm have a higher

have an probability of

influence participating in

on the the CDS

probability market.

of usage of

CDS by an

insurance

company.

-Compute

a self-

selection

parameter

(Mills_ratio)

which will

be used in

the other

equations.

Second-stage model -N_buy, Idiosyncratic Regression CDS

 73

for Risk. N_sell, risk, Market model to participation

H_ratio, risk and explore increase the

Ig_ratio, Total risk. how the risks in both

Mills_ratio, risk profile the Life and

Control of a firm is P&C

variables. affected by insurance

the CDS companies.

usage. Also, CDS

participation

regardless of

the incentive

(either

hedging or

income

generating

purposes)

increases the

systematic

risk,

idiosyncratic

risk or total

risk either for

the Life

insurance or

P&C
 74

insurance

companies or

both.

Second-stage model N_buy, Tobin’s Q Regression Income

for Value. N_sell, and ROE. model to generation

H_ratio, explore purpose in

Ig_ratio, how the CDS trading is

Mills_ratio, value of a associated to

Control firm is higher market

variables. affected by risk, lower

the CDS financial

usage. performance

hence

resulting to a

lower market

value for both

the Life and

P&C

insurance

companies

sample,

therefore

reducing the

value of the

firm.
 75

Control variables:H_ratio, Ig_ratio, N_buy, N_sell, B_ratio, S_ratio, O_derivatives,

P_ratio, RBC_ratio, R_ratio, L_ratio, E_ratio, F_size.