Application of cost of equity models to property-casualty insurance firms: An empirical analysis

Scope and Method of Study: This study employs correlation analysis to determine if similarities exist between four cost of equity models. The four models used are 1) the capital asset pricing model, 2) the discounted cash flow model, 3) the equity versus debt spread model, and 4) the earnings/price ratio. Equity estimates are obtained for 20 property-casualty insurance firms utilizing each model. The sample consists of insurance companies that wrote less than 25% of total premiums in life insurance during any of the years 1977-1980, or were designated as "Fire, Marine and Casualty Insurance Firms" by the Value Line Million Dollar Directory. Data for the models are historical stock prices between December, 1975 and December, 1980 obtained from Standard and Poor's Daily Stock Price quote books, and dividend and earnings per share data listed in Moody's Dividend Record and the Standard and Poor's Stock Guide.Findings and Conclusions: Upon calculating equity estimates for each firm utilizing each model, it was found that few firms displayed a range of equity costs narrow enough to permit insurance regulatory authorities to make a decision regarding the "correct" equity cost for use in insurance rate-setting. Correlation analysis revealed that of the six possible combinations of correlations between the models; four were not statistically significant, leading to the conclusion that the models are not estimating the same cost of equity