Review of Quantitative Finance and Accounting, 10 (1998): 235–267
© 1998 Kluwer Academic Publishers, Boston. Manufactured in The Netherlands.
Alternative Models for Estimating the Cost of Equity
Capital for Property/Casualty Insurers
ALICE C. LEE
KPMG Peat Marwick LLP
J. DAVID CUMMINS
Wharton School, University of Pennsylvania
Abstract. This paper estimates the cost of equity capital for Property/Casualty insurers by applying three
alternative asset pricing models: the Capital Asset Pricing Model (CAPM), the Arbitrage Pricing Theory (APT),
and a uniﬁed CAPM/APT model (Wei (1988)). The in-sample forecast ability of the models is evaluated by
applying the mean squared error method, the Theil U2 (1966) statistic, and the Granger and Newbold (1978)
conditional efﬁciency evaluation. Based on forecast evaluation procedures, the APT and Wei’s uniﬁed CAPM/
APT models perform better than the CAPM in estimating the cost of equity capital for the PC insurers and a
combined forecast may outperform the individual forecasts.
Key words: property/casualty, insurance, CAPM, APT, cost of equity capital, asset pricing
It is well known that the cost of capital for an industrial ﬁrm may include cost of debt, cost
of preferred stock, cost of retained earnings, and cost of a new issue of common stock.
Cost of equity capital is made up of cost of retained earnings and cost of a new issue of
common stock. Financial theory suggests that returns of industrial ﬁrms should be a
function of risk, but because the management principles of ﬁnancial institutions are not
necessarily identical to those of industrial ﬁrms, applications of ﬁnancial theory to non-
industrial ﬁrms (such as banks, savings and loans, and insurance ﬁrms) must be theoreti-
cally and empirically investigated. What ﬁnancial institutions must consider are exposure
to different types of risk, the relative importance of various risks, and the existence of
market imperfections and constraints such as regulation.
For industrial ﬁrms, their production function and the return from their production
capabilities are the main indicators of their value to investors in the market. Investments
made by industrial ﬁrms are generally for the purposes of increasing and improving
production capabilities. While, for ﬁnancial institutions such as insurance companies,
there are no production outputs to serve as an indicator of ﬁrm value. Output measure-
ments for ﬁnancial institutions are more difﬁcult to measure because service sector output
is intangible. For instance, an insurance company is in the business to manage the risk of
others, as well as the ﬁrm’s own risk in ﬁnancial investments.
@ats-ss5/data11/kluwer/journals/requ/v10n3art1 COMPOSED: 02/06/98 8:12 am. PG.POS. 1 SESSION: 6