How Does the Use of Credit Default Swaps Affect Firm Risk and Value? Evidence from US Life and Property/Casualty Insurance Companies (original) (raw)

2012, Financial Management

This study uses a unique credit default swap (CDS) transaction data set of insurers to examine the effects of CDS usage on the risk profile and firm value of US insurance companies for the period 2001-2009. Applying a Heckman two-stage model to adjust for the potential endogeneity of CDS usage with respect to firm risk and firm value, we find consistent evidence that the utilization of CDS for income generation purposes is associated with greater market risk, deterioration of financial performance, and lower firm value, for both Life and Property/Casualty insurers. This study examines the effects of credit default swap (CDS) usage on the risk profile and performance of Life and Property/Casualty (PC) insurance companies. The CDS market has grown enormously in recent years. The notional amounts of credit derivatives reached 17.1trillionasoftheendof2005,a25−foldincreasefromthelevelatmidyear2001(ISDA,2008),andpeakedatover17.1 trillion as of the end of 2005, a 25-fold increase from the level at midyear 2001 (ISDA, 2008), and peaked at over 17.1trillionasoftheendof2005,a25−foldincreasefromthelevelatmidyear2001(ISDA,2008),andpeakedatover60 trillion by the end of the first half of 2008 (BIS, 2008). 1 According to the British Bankers' Association (2006), insurers worldwide held an 18% market share for selling CDS protection in 2006 and 6% of the CDS market for buying credit protection. CDS markets provide insurers a tool for risk management and risk taking. While the prior insurance literature documents evidence that insurers rely on financial derivatives to manage various sources of risk (interest rate risk, market risk, credit risk, and liquidity risk), there is no evidence that CDS, as a category of financial derivatives, helps to reduce or increase the risk of insurers. Another strand of literature on CDS usage has primarily focused on risk-hedging and/or risk-taking behaviors by banks and hedge funds (Minton, Stulz, and Williamson, 2009; Shao, 2009; Chen, 2010). Since insurers are another major group of active participants in CDS markets, it is important to examine how CDS affects the risk and firm value of insurance companies.