Doron Nissim

Implied Cost of Equity Capital in the U.S. Insurance Industry

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Abstract:
This article derives and evaluates estimates of the implied cost of equity capital of U.S. insurance companies. During most of the period December 1981 through January 2010, the monthly median implied equity risk premium ranged between 4% and 8%, with a time-series mean of 6.2%. However, during the financial crisis of 2008–2009, the equity premium reached unprecedented levels, exceeding 15% in November 2008. Consistent with investors demanding relatively high expected returns in periods of poor economic performance or high uncertainty, the premium was positively related to the VIX, inflation, and unemployment, and negatively related to the 10-year Treasury yield, production, consumer sentiment, and prior industry stock returns. The cross-sectional correlations between the implied equity risk premium and firm-specific risk factors were similarly consistent with expectations: the equity premium was positively related to market beta, idiosyncratic volatility, and the book-to-market ratio, and negatively related to co-skewness, size and the equity-to-assets ratio. Finally, consistent with the strong correlations between the implied equity risk premium and the macro- and firm-specific risk factors, the premium performed well in predicting stock returns in both time-series (industry) and cross-sectional (stock) tests.

Source: The Journal of Financial Perspectives
Exact Citation:
Nissim, Doron. "Implied Cost of Equity Capital in the U.S. Insurance Industry." The Journal of Financial Perspectives 1 (2013): 87-104.
Volume: 1
Pages: 87-104
Date: 2013