Optimal Capital Utilization by Financial Firms: Evidence from the Property-Liability Insurance Industry

TLDR: This paper investigated the use of capital by insurers to provide evidence on whether the capital increase represents a legitimate response to changing market conditions or a true inefficiency that leads to performance penalties for insurers.

Abstract: Capitalization levels in the property-liability insurance industry have increased dramatically in recent years—the capital-to-assets ratio rose from 25% in 1989 to 35% by 1999. This paper investigates the use of capital by insurers to provide evidence on whether the capital increase represents a legitimate response to changing market conditions or a true inefficiency that leads to performance penalties for insurers. We estimate “best practice” technical, cost, and revenue frontiers for a sample of insurers over the period 1993–1998, using data envelopment analysis, a non-parametric technique. The results indicate that most insurers significantly over-utilized equity capital during the sample period. Regression analysis provides evidence that capital over-utilization primarily represents an inefficiency for which insurers incur significant revenue penalties.