HEDGING WITH DERIVATIVES AND VALUE CREATION IN THE SPANISH INSURANCE INDUSTRY

Transcription

1 HEDGING WITH DERIVATIVES AND VALUE CREATION IN THE SPANISH INSURANCE INDUSTRY Luis Otero González Sara Fernández López Department of Financial Economy Faculty of Business Santiago de Compostela Teléfono: , extensión Fax: ABSTRACT: This paper analyses some of the theoretically suggested determinants of the derivatives usage in the Spanish life insurance industry, focusing on the agency theory and the maximization of the firm value. The empirical study is based on data provided by 28 insurers. Apart from being a pioneering work in Spanish insurance industry, this paper also icludes several variables that had not been taken into account in previous studies. Results for Spain in general confirm the findings of other markets researchs.the deteriminants of derivatives usage are size and leverage. KEY WORDS: derivatives, risk management, value cretion, life insurer, logit. 1

2 1.- INTRODUCTION Financial theory has traditionally considered that corporate risk management makes no sense in perfect financial markets. Nevertheless, there exists today wide theoretical support and substantial empirical evidence that justify this activity. Imperfections in markets, conflicts of interest and/or information asymmetries explain hedging as a mechanism that contributes to the maximization of firm value and to the mitigation of agency problems. Corporate risk management is of special interest in the insurance industry. As financial intermediaries who carry out an important activity of transformation of assets, insurers are subject to interest rate risk (Babel and Santomero, 1997). Other risks are linked to the liquidity of their investments as well as to the characteristics of the liabilities, which incorporate options such as surrender. In addition, the internationalisation process has increased the exposure of some insurance companies to exchange risk (Cummins et al., 1997). Also, non-life insurance companies experience high volatility in payments when incidents occur. Nevertheless, companies present different attitudes to risk, hence there are substantial differences in the frequency and intensity of their hedging. Derivatives constitute the main off-balance-sheet instruments used by companies to hedge the risks faced in their daily activity. The aim of this study is to test some of the theories regarding the use of derivatives as instruments of financial risk management by the life insurance companies of the Spanish market. Section Two will provide the theoretical rationales to practice risk management. Section Three will describe previous research that has been done on derivative use in the financial services industry. A empirical model will be developed in Section Four as well as its main results.section Five will show an empirical approximation of the relationship between derivative use and value creation in Spanish life insurance industry. Finally, Section Six will summarize the main conclusions. 2.- THEORETICAL FRAMEWORK The irrelevance theorem of the capital structure of a firm could be applied to risk management issue. According to the MM (Modigliani and Miller) prepositions, since shareholders can replicate the financial policies of the firm with transactions in the capital 2

3 markets, the capital structure has no consequences on firm value. In the same way, corporate risk management does not increase shareholder value, because investors could perform risk management as well as management, or even better as a result of portfolio diversification. However, MM prepositions suppose an assumptions hold (complete capital markets without information asymmetries, taxes, transaction or agency cost) which does not exist in reality. Taking into account capital market imperfections, corporate risk management increases shareholder value, because it reduces the volatility of corporate cash flows and, consenquently, the costs related to these capital market imperfections. An important number of firms allocate resources to hedging. This fact is an sign of the potential of corporate risk management to increase shareholder value (Bartram, 2000). Nevertheless, corporate hedging is only justified if the increase in firm value exceeds the cost of hedging and this value growth cannot be reached by the owners at lower cost AGENCY COSTS Agency costs results from the contractual relationship and different interest between owners on the one hand, and debtholders, managers and employees on the other hand. If a corporation has high financial leverage, problems between shareholders and debtholders arises. Managers may reject profitable projects because their positive NPVs would firstly benefit debtholders (underinvestment problem). Corporate risk management alleviates these conflicts of interest by reducing the volatility of firm value. As underinvestment problems are more importants for companies with a high debt ratio, many investment projects and growth options; it is expected that hedging be observed more often or to a larger extent in firms with these circunstances (Bartram, 2000). If a company carries important amounts of debt, shareholders could be interesting in taking on very risky projects (asset substitution problem). In order to avoid this opportunist behavior, debtholders can both demand a higher compensation for supplying resources and impose debt convenants restricting investment and financial policies. As a consequence, agency costs arise. These can be reduced using corporate hedging to lower the risk of projects. 3

4 Regards the conflicts of interest between shareholders and managers, managers are specially interested in avoiding bankruptcy, because they have concentrated all their efforts (human capital) and, even, a good part of their wealth, on the firm. If it failures, they will be replaced (Stulz, 1984; Smith y Stulz, 1985). Therefore, managers will prefer to use a hedging strategy. This personal attitude towards risk contributes to increase firm value, as postulate in previous paragraphs. The problems arise if managers choose techniques of risk management which reduce shareholder value (e. g. operative diversification of business). In order to prevent this behavior, shareholders have to design incentive structures which link compensation of managers to stock prices. Consequently, it is expected that corporate risk management be observed more often or to a larger extent in firms without this kind of incentives or whose managers have invested a significant part of their wealth in the company (Bartram, 2000). Knowing the size and structure of the corporate financial exposure is necessary to lead an adequate risk management policy. In this sense, managers have access to more and better information than shareholders. These information asymmetries between management and investors explain that risk management can be lead to a corporate level with a lesser cost than if it is individually leaded by shareholders. Consequently, companies is more likely to hegde if the information asymmetries are larger between management and shareholders TRANSACTION COSTS If a firm cannot meet its payment obligations, transaction costs of financial distress arise. These can be: direct (legal fees and court costs, if the firm has already fallen into bankruptcy), indirect (reputational losses, disruption of ralationships with employees, suppliers and customers) and opportunity costs (e. g. underinvestment problem). According to Myers (1977), expected costs of financial distress result from the size of the costs and the probability of falling into a situation of liquidity dificulties. As corporate risk management reduces the volatility of cash flows, it alleviates the probability of getting into financial distress and consequently the associated costs. In addition, corporate risk management increases firm s debt capacity by reducing financial distress costs (Stulz, 1996; Ross, 1997; Leland, 1998). Therefore, firm will have 4

5 higher debt tax shields, increasing the shareholders value. Moreover, according to Leland (1998), a second benefit comes from lower expected default rates and distress costs, due to unused debt capacity. According to Ross (1997), the reduction in expected financial distress costs is less important than the tax savings from increased leverage. These considerations suggest that the closer the firm is to financial distress (because of its financial leverage, excessive dependence on business cycles or high operating leverage), the more it uses hedging strategies. In addition, as indirect costs of financial distress are not proportional to the size of the firm, they will be bigger in small firms, ceteris paribus. So, these will be more inclined to hedge its position. Corporate risk management is justified if the increase in firm value exceeds the cost of hedging. It seems that direct costs of hedging transactions are often almost insignificant. However, indirect costs (as employees, know-how and information services) represent important fixed amounts of money that only big companies can support for them (Nance et al., 1993; Sinkey and Carter, 1997; Cummins et al., 1997b). Consequently, big firms are more likely to lead risk management than small ones. Firms create value by carrying out investment projects with positive NPV. These profitable projects need financing. However, getting financial resources becomes more expensive and difficult, the closer the firm is to an illiquidity situation. According to the pecking order theory (Myers,1984: Myers and Majluf, 1984), a firm should finance its projects with its internally generated funds whenever possible, because they are cheaper than external financing. If external financing is needed, the firm should issue debt first and equity as a last step only. The higher costs result from some of the transaction and agency costs (Froot, Scharfstein and Stein,1993) that have been previously shown. In particular, agency costs due to information asymmetries are especially significant in the insurance industry because managers are likely to have more detailed information about the adequacy of loss reserves than do the shareholders (Cummins et al.,2001). Consequently, companies want to guarantee their internal funds in order to avoid both the higher external funding costs and the rejection of profitable projects. As risk management reduces the volatility of cash flows, it increases the guarantees of having internal funds. Therefore, firms are more likely to hedge if they have liquidity problems. 5

6 2.3. TAXES If corporate income is subject to a convex tax system, variations in annual pre-tax incomes provoke a higher tax liability than more constant incomes. Consequently, as risk management can reduce the volatility of pre-tax income, it cuts down on expected tax payments (Smith and Stulz, 1985). In addition, there are other indirect reasons that relate taxes to hedging. Firms that enjoy important tax benefits (e. g. tax shields of debt financing) is likely to hedge in order to avoid low or negative pre-tax incomes that hinder take advantage of these tax benefits (Smith y Stulz, 1985). These considerations suggest that movements in tax rates could enhance hedging strategies. 3.- LITERATURE REVIEW During the 1990s numerous studies were carried out to determine the variables that explain the use of derivatives by the companies in various industries and markets (Table 1). In the insurance field we highlight the studies by Colquitt and Hoyt (1997), Cummins et al. (1997a, 1997b), Hardwick and Admans (1999) and De Ceuster et al. (2003). Colquitt and Hoyt (1997) found, for American life insurance companies, that the size of the insurer, leverage and reinsurance are positively related to the decision to hedge with futures and options. However, reinsurance seems to act as an indicator of the predisposition to hedge with such products, rather than as a substitute for hedging with derivatives. They also showed that the highly levered insurance companies and those ones with a greater duration gap are likely to use derivatives to a greater level. Similar studies, including non-life insurers as well as a greater number of variables, were carried out by Cummins, Phillips and Smith (1997a,1997b). The authors found that size and leverage were positively related with the decision to use derivatives as a hedging instrument and the level of their use. Reinsurance showed a different relation with the use of derivatives depending on the insurer s type of activity: positive for life companies and negative, though weak, for the rest. Finally, contrary to Colquitt and Hoyt s results, they found a negative relation between the duration gap and the level of hedging through derivatives. 6

7 In the United Kingdom, the study by Hardwick and Adams (1999) of life insurance companies stands out. Like the preceding studies they find that both the decision to use derivatives and the extent of their use are positively related to the size and the leverage of the firm. Nevertheless, unlike what occurs in the American market, these authors observe a negative relation with the use of reinsurance. The positive relation with leverage and the negative one with reinsurance support the hypotheses that in the United Kingdom derivatives are used for purposes of hedging rather than for speculation. Also, mutuals have a greater propensity than stocks to use derivatives. According to these authors, size and form of organisation are the variables that mainly affect the utilization of derivatives in the United Kingdom. In the Australian insurance market, De Ceuster et al. (2003) find that the decision to use derivatives and the extent of their use are positively related to the size of the firm. As in Cummins et al. (1997b) they detect a negative relation between the asset / liability duration gap and the level of use of derivatives. For life companies they observe evidence that, on the one hand, ratifies the hypothesis of leverage in the use of derivatives, but on the other, contradicts the reinsurance hypothesis. United States NON FINANCIAL FIRMS Dolde (1993) Phillips (1995) Bodnar et al. (1995,1996) Table 1.- Empirical studies FINANCIAL FIRMS INSURANCE BANKS COMPANIES Colquitt and Hoyt (1997) Cummins et al. (1997a, 1997b) Sinkey and Carter (1997) Gunther and Siems (1995) United Kingdom Grant and Marshal (1997) Naik and Yadav (2003) Belgium De Ceuster et al. (2000) Finland Hakkarainen et al. (1997) Batten and Mellor (1993) Australia Batten, Mellor and Wan (1994) Batten and Hettihewa (2003) Hardwich and Adams (1999) De Ceuster et al. (2003) 4.- EMPIRICAL ANALYSIS The empirical analysis is based on a sample of 28 life insurance companies operating in the Spanish market. The information was provided by the Insurers Cooperative Research Association (Investigación Cooperativa entre Entidades 7

8 Aseguradoras - ICEA). The data had been collected for the report on the asset liability management in insurance firms (2002). In spite of the limited number of firms it is a very representative sample, sharing more than 50% of the Spanish market. Most of the empirical studies use conditioned probability models in order to test the hypotheses established in the theoretical framework. This study also applies a logit model so the results could be compared with those of earlier studies VARIABLES The use of derivatives (dependent variable) is measured by a dichotomous variable that takes the values 1 for those insurers that have used derivatives to hedge their operations and 0 for those that have not. Unlike other studies, which only take into account futures and options, we have also considered OTC products. We describe below the independent variables which, according to the literature, affect the decision to hedge, as well as the hypotheses regarding the relationship that should exist between these variables and the dependent variable (Table 2). a) Size There are contradictory hypotheses surrounding the effect of size on the hedging decision. According to Warner (1977) and Altman (1984), since costs of an adverse financial situation are greater for small firms, these will hedge more frequently in order to avoid the probability of bankruptcy (Colquitt and Hoyt, 1997). If this hypothesis is fulfilled, there will be a negative relation between size and the use of derivatives. Besides, large firms use to be more diversified through their different lines of business, resorting to hedging to a lesser extent than small firms (Cummins et al., 1997a). Other authors, however (Nance et al., 1993; Sinkey and Carter, 1994; Cummins et al., 1997b) maintain that the high overheads associated with the use of derivatives cause a situation where large firms are more willing to hedge than small ones. In addition, large firms usually have the techniques and human resources necessary to properly manage a portfolio of derivatives. 8

9 Size is calcultated as the logarithm of the total volume of premiums (LOGPREM). As remarked above, the relation of this variable to the use of derivative instruments may be both positive and negative depending on the dominating theoretical argument. b) Leverage Firms tend to hedge to avoid the costs of financial distress which are higher the greater the firm s level of debt. Many studies have tested the relation between the capital structure and the risk management policy. In non-financial firms, Wall and Pringle (1989) showed that those with low ratings were more likely to use derivatives, in particular swaps. Dolde (1996) also found a direct relation between leverage and derivative usage. However, more studies were unable to verify the existence of such a relation (Nance et al., 1993; Mian, 1996; Geczy et al, 1997). The results are no more conclusive in financial firms. Sinkey and Carter (1997) found a weak relationship between the capital structure and the use of derivatives for the case of U.S. banks, but Gunther and Siems (1995) reached contrary results, finding a positive relation between the banks level of capitalization and their use of derivatives. In insurance industry Colquitt and Hoyt (1997), Cummins et al. (1997a, 1997b) and De Ceuster et al. (2001), the latter for the case of Australian life insurers, show a statistically significant positive relation between the leverage of the companies and the use of derivatives, being consistent with the hypothesis of mitigation of the costs of financial insolvency. Leverage (LEVERAGE) is calculate as total liabilities divided by equities. A positive relation can be expected between this variable and the use of derivatives. c) Reinsurance Two contradictory hypotheses also can be put forward. If the number of policies does not reach a minimum, reinsurance will be used by many companies in order to hedge the insurance risk and even interest rate risk. Cummins et al. (1997a) and Colquitt and Hoyt (1997) therefore indicate that it can act as a substitute for derivatives. In this sense, the greater the reinsurance activity of the companies the less should be the use of derivatives. 9

10 On the contrary, Mayers and Smith (1990) maintain that reinsurance is an indicator of a firm s predisposition to hedge, acting as a sign of greater use of derivatives. The empirical results reflect both positions, though on occasions this evidence is weak. Cummins et al. (1997a) find a negative, though weak, relation between reinsurance and the use of derivatives for non-life insurers, and a positive relation for life insurers. The study by Colquitt and Hoyt (1997) sustains, though weakly, this positive relation. On the other hand, Hardwick and Adams (1999) and De Ceuster et al. (2001) observe a negative relation between reinsurance and the use of derivatives. The level of reinsurance (REASSPRE) is measured as the volume of premiums ceded in reinsurance divided by the total premiums. The relation of this variable to the use of derivative instruments may be both positive and negative. d) Mistmatch of asset and liability duration An important element is the level of financial risk assumed by companies on their balance sheets. Staking and Babbel (1995) and Cummins and Weis (1991) indicate that insurers have a positive duration gap, so they are exposed to the variation of interest rates. Therefore, companies with a larger duration gap will be more inclined to hedge with derivatives. Colquitt and Hoyt (1997) found a positive relation between the duration gap and the use of derivatives, so those firms with greater differences hedge to a greater degree. However, the rest of the studies of the insurance industry have not support these results. As the accounting information available does not allow to calculate the duration gaps, we opted to use the average maturity of the asset portfolio (MATURITY) as a proxy variable, since it is associated with the products in which the company assumes greatest interest risk. A positive relation can be expected between the maturity of the asset and the use of derivatives. e) Fixed Income portfolio With this variable we aim to test, as with reinsurance, whether the use of other risk management techniques is complementary to, or substitutes for, derivatives. In Spain it is quite common for firms to use cash flow matching techniques, known as on-balance-sheet 10

11 hedging. It is to be expected that companies that resort to a greater degree to this type of strategies will show less use of derivatives. Nevertheless, on-balance-sheet hedging can reflect the firm s propensity to hedge, acting as a sign of greater use of derivatives. Furthermore, as these techniques occassionally incorporate derivatives into the design of the portfolio, it is possible that a positive relation exists. Also, segmentation is a factor that may favour the use of derivatives that serve to adapt the management to the characteristics of each product (Cox et al., 1996). We use the percentage of asset portfolio invested in fixed income (BONDPORT), because this is related to the use of cash flow matching or immunization techniques (Otero, 2001). The relation of this variable to the use of derivatives may be both positive and negative. f) Variable income and foreign currency portfolio Insurance companies invest in variable income and in foreign currencies, assuming financial and exchange rate risks. Since the profitability of shares is random, if companies have a higher proportion of stocks in their portfolios, they will assume a greater investment risk and be more willing to hedge with derivatives. The same argument could be used for those firms that have a part of their assets invested in foreign currency. To measure the market and exchange rate risk we use the percentage of the asset portfolio invested in variable income (STOCKPORT). The exchange rate risk is measured by the percentage of the asset portfolio invested in foreign currency (FOREINGPORT). A positive relation can be expected between both variables and the use of derivatives. g) Type of product In some products, the insurance company guarantees a certain return by providing to the insured either a regular stream of income (INCOME) or a lump sum payout at some future time (LUMPSUM). On the contrary, others (like life insurance or with profits policies) transfer the risk to the insured. The higher the proportion of those products in liability portfolio, the greater the use of derivatives. We use the percentage of both products in liability portfolio (INCOME and LUMPSUM). h) Legal form of the company 11

12 Since a mutual insurance company lacks effective mechanisms to control the managers behaviour, the latter are more likely to give priority to hedging strategies over maximization of value firm. An alternative hypothesis points out that mutuals are more efficient if they insure less complex risky activities (Mayers and Smith, 1988). Therefore, if they choose to focus on this type of activities, they will have less need of hedging, using derivatives to a lesser extent than stock companies. Both hypotheses are not mutually exclusive, i.e. given equal risk between a company and a mutual, the managers of the latter may adopt more conservative strategies. On the other hand, the motives referring to the maximization of the firm value also offer reasons for thinking that mutuals are more likely to use derivatives to a greater degree than companies. These lie in their difficulties to obtain finance in stock markets, especially after a crisis. In these occasions, mutuals would have to reject profitable projects until they can accumulate enough retained earnings. To avoid underinvestment problems they will hedge to a greater degree than companies. The legal form has been defined as a dichotomous variable (LEGALFORM) taking the values 0 if the firm is a company and 1 if it is a mutual. 12

13 Table 2.- Variables and hypotheses. VARIABLE MEASURE HYPOTHESES Size (LOGPREM) Leverage (LEVERAGE) Reinsurance (REASSPRE) Maturity of the asset portfolio (MATURITY) Fixed income portfolio (BONDPORT) Market risk (STOCKPORT) Exchange rate risk (FOREINGPORT) Type of product (LUMPSUM) (INCOME) Legal form of the company (LEGALFORM) Logarithm of the total volume of premiums Total liabilities divided by equities Volume of premiums ceded in reinsurance divided by total premiums Average maturity of the asset portfolio Percentage of asset portfolio invested in fixed income Percentage of the asset portfolio invested in variable income Percentage of the asset portfolio invested in foreign currency Amount in product i divided by total liability Dichotomous variable taking the values 0 if the firm is a company and 1 if it is a mutual H1: Small firms will hedge more frequently in order to avoid the probability of financial distress (-) H2: There are significant scales and information economies in setting up derivative trading areas, therefore large firms are more likely to establish them (+) H1: The highly levered insurance companies have more interest rate risk and underinvestment problems, therefore they will be more inclined to hedge this position with derivatives (+) H1: Reinsurance can act as a substitute for derivatives (-) H2: Reinsurance may simply show that a firm is predisposed to hedge risk (+) H1: Life insurance companies with a higher positive duration gaps are more exposed to the variation of interest rates, therefore they will be more inclined to hedge this position with derivatives (+) H1: Cash flow matching techniques can act as a substitute for derivatives (-) H2: Cash flow matching techniques may simply show that a firm is predisposed to hedge risk. Besides, immunization techniques some times incorporate derivatives into the design of the portfolio (+) H1: Companies with a higher proportion of stocks in their portfolios will assume a greater investment risk and be more willing to hedge with derivatives (+) H1: Companies with a higher proportion of foreing currency in their portfolios will assume a greater exchange rate risk and be more willing to hedge with derivatives (+) H1: Some insurance products are riskier. Companies whose liability portfolio has a higher proportion of products that guarantee a return (LUMPSUM and INCOME) will be more willing to hedge with derivatives (+) H1: Mutuals will be more willing to hedge with derivatives because of the lack of control tools avalaible to their owners as well as their difficulties to get funding (+) H2: As mutuals are more efficient if they insure less complex risky activities, they will have less need of hedging (-) RESULTS DESCRIPTIVE STATISTICS The sample of companies consists of 28 life insurance companies operating in the Spanish market, of which 50% used derivatives in the year Table 3 presents the 13

14 descriptive statistics of the two sub-samples, grouped according to whether or not they hedge with derivatives. Life insurers non derivatives users (USERS= 0) Table 3.- Descriptive statistics Life insurers derivatives users (USERS= 1) MEAN SD MEAN SD LOGPREM (***) 17, , , , LEVERAGE (***) 10,95, ,55, REASSPRE,057000, ,014769, MATURITY 7, , , , BONDPORT,552100, ,604462, STOCKPORT,059300, ,019369, FOREINGPORT,053000, ,039469, LUMPSUM,248804, ,395868, INCOME,238396, ,246832, Note: *** indicates statistical significance at the 1% level Table 3 offers some preliminary support for several of the previously raised hypotheses. The firms with a higher level of hedging are those of largest size (LOGPREM) and present a higher level of leverage (LEVERAGE). They also show a greater average maturity (MATURITY) in their investment portfolios. The higher extent of reinsurance (REASPRI) in non users seems to indicate a substitutory relationship between the two products. Although the sample analysed does not contain a significant number of mutuals, none of them hedges with derivatives. Asset portfolios of non users show a lower percentage of fixed income securities (BONDPORT) and a higher of equity securities (STOCKPORT) and the foreign currency assets (FOREINGPORT). These variables behave contrary to what we assumed a priori. However, assets are always associated with liabilities, so the risk must be analysed through the relation between both. Generally, if the company guarantees a return (INCOME and LUMPSUM products) higher financial risk is compesated by investing in fixed income securities to immunize the portfolio. The difference of means between groups was significant at 5% level of significance in size, leverage and legal form variables. 14

15 According to Cummins et al. (1997a), the asset and liability portfolios may play a very important role in the hedging decision. As a consequence, the assets portfolio associated with each type of product is a valuable piece of information. Table 4 shows as a higher proportion of assets portfolio in equity securities is linked to life insurance and with-profits policies in which the insurer assumes less investment risk, transferring it to the taker. On the contrary, if policies with guaranteed returns are mostly offered, equities portfolio is drastically reduced and conservative investments in fixed income products and deposits predominate, attempting to reduce the investment risk through matching techniques. Life Insurance Table 4.- Asset - liability portfolio With Profits Policies Garanteed return (Lump sum payout) Garanteed return (Incomes) CASH 4,72% 10,50% 7,78% 4,18% FIXED INCOME 22,86% 70,86% 60,99% 64,64% - Domestic 16,43% 60,03% 40,57% 49,70% Public 12,47% 39,06% 22,51% 23,02% Private 3,96% 20,97% 18,06% 26,68% - Euro Area (excluding Spain) 5,32% 9,54% 19,66% 13,50% Public 0,43% 1,42% 0,23% 1,28% Private 4,89% 8,12% 19,43% 12,22% - Foreign 1,12% 1,29% 0,76% 1,44% BANK DEPOSITS 4,23% 3,58% 10,45% 25,13% MORTGAGE LOANS 0,00% 2,84% 2,24% 5,07% EQUITY SECURITIES 11,26% 6,66% 2,53% 0,11% - Domestic 9,69% 6,47% 2,49% 0,10% - Euro Area (excluding Spain) 0,86% 0,15% 0,04% 0,01% - Foreign 0,70% 0,03% 0,00% 0,00% SECURITIES INVESTMENT FUNDS OTHER FINANCIAL INVESTEMENTS 36,33% 4,25% 14,30% 0,12% 4,91% 0,98% 0,72% 0,56% REAL INVESTMENTS 15,69% 0,33% 0,99% 0,20% TOTAL INVESTMENTS 100,00% 100,00% 100,00% 100,00% Matching techniques are summarised in the asset - liabilitiy duration, allowing us to analyse the level of interest rate risk assumed. Since only some companies (11) offered this information, the duration gap could not be used as a variable in the analysis, and we opted 15

16 for the average maturity of its asset portfolio (MATURITY). Nevertheless, Table 5 shows the data of the companies that did facilitate such information. Life Insurance With Profits Policies Table 5.- Duration gaps Garanteed return Garanteed return (Lump sum payout) (Incomes) TOTAL Asset duration 4,9 8,0 5,6 8,4 7,2 Liability duration 5,0 8,3 7,0 7,1 8,4 Duration gap -0,1-0,4-1,4 1,3-1,2 In life insurance and with-profits policies, the duration gap is very small because the companies try to immunize their portfolios by matching techniques, fundamentally cash flow matching and immunization. These techniques may act as substitutes for off-balancesheet hedging. The higher interest rate risk (mismatching) corresponds to products with guaranteed returns which, as we shall see, concentrate most investment in derivative securities. Finally, the use of derivatives has not become general among Spanish insurers and most operations are aimed at hedging the investment risk of long term operations. As in other markets, most operations (99,36%) are carried out in OTC markets. Since most operations are long term, the resort to organized exchanges is not significant. Practically all trading is concentrated in interest rate swaps (94,12%) and in FRAs (5,17%)(Figure 1). Figure 1.- Derivatives used in hedging Financial Futures 0,64% Floors Sw aps OTC 99,36% 0% 20% 40% 60% 80% 100% 16

17 Table 6 shows that the use of derivatives is closely linked to the products offered by the company, to the investment risk assumed and to the use of alternative hedging techniques. Thus, a very substantial percentage of operations (77,72% of the notional value) are aimed at covering products that guarantee future incomes. This situation is logical since it is in the products of longest maturity that the company assumes a substantial investment risk. On the contrary, since with profits policies transfer part of the risk to the insured and life insurance ones are generally taken out for the short term and with a lower investment component, these products are not hedged with derivatives. Table 6.- Derivatives and liability portfolio Life Insurance With Profits Policies Garanteed return (Lump sum payout) Garanteed return (Incomes) OTC Markets 0,00% 99,66% 100% 100% FRAs 0,00% 44,14% 0,00% 0,00% Swaps 0,00% 52,48% 99,49% 100% Caps 0,00% 0,00% 0,51% 0,00% Floors 0,00% 3,04% 0,00% 0,00% Organized Exchanges 0,00% 0,34% 0,00% 0,00% Financial futures 0,00% 0,00% 0,00% 0,00% Options 0,00% 0,34% 0,00% 0,00% Total Notional Value 0,00% 100% 100% 100% % of Notional Value 0,00% 9,21% 13,07% 77,72% MULTIVARIATE ANALYSIS BY A LOGIT MODEL The analysis of correlations shows that size, leverage and legal form present a correlation with the independent variable (significant to 1%). Also, the first two present a high correlation with each other, which may affect the techniques employed. To test the determinants of the use of derivatives in Spanish life insurance industry as well as the preceding hypotheses we have applied multivariate analysis (application SPSS ). Specifically we have used a binomial logit model that relates the hedging decision to the independent variables. Different methods have been followed: introducing the variables all together and step by step. The results in general presented good levels of fit, but the existence of multicollinearity meant that the parameters were not significant when different variables were considered, even working with centered data. On the other 17

18 hand the use of different methods step by step excluded important variables and only included within the model the size variable. The theoretical importance of the size, leverage and legal form variables, their correlation with the dependent variable, their individual significance and the level of fit of the model at an overall level led us to firstly present the model that takes into account them (Table 7), although we do not consider it the definitive one. We are aware of the problems due to the small sample size even though it is highly representative of the Spanish life insurance industry. Table 7.- Logit regression results (all variables) Coefficient S.E. Wald Fd Sig. Exp(B) Step 1(a) LOGPREM,307,631,236 1,627 1,359 LEGALFORM,101,085 1,425 1,233 1,107 LEVERAGE -20, ,670,000 1,999,000 C -7,322 10,816,458 1,498,001 a Variable(s) introduce(s) in step 1: LOGPREM, LEGALFORM, LEVERAGE. As verified in Table 8 incorporating the above mentioned variables into the model enables us to achieve a significant increase in overall fit. The final regression produced a model with a log likelihood of 18,970. A Nagelkerke R 2 was calculatesd as 0,677. Table 8.- Statistics of fit of the model (all variables) Chi-square df Sig. log of likelihood R 2 Cox and Snell R 2 Nagelkerke Step 1 Step 18,189 4,001 18,970,508,677 Togheter 18,189 4,001 Model 18,189 4,001 A further test of the goodness of fit of the model is the classification table (Table 9). This shows how well the model predicted the actual values of the dependent variable. The Logit model correctly predicted both, non-users and users, in 85,7% of the cases. Thus it classifiyes 85,7% of the cases correctly. 18

19 Table 9.- Classification table Step 1 Actual Non Users 0 Users 1 Non Users 0 Prediction Users 1 % Correct Total 85,7 Finally, Table 10 shows the model that we have considered as the definitive one. This takes into account only the size variable, excluding both leverage and legal form and reducing multicollinearity problems. Table 10.- Logit regression results (step by step) Coefficient S.E. Wald Fd Sig. Exp(B) Step 1(a) LOGPREM 1,204,481 6,264 1,012 3,333 C -22,815 9,174 6,185 1,013,000 a Variable(s) introduce(s) in step 1: LOGPREM It can be deduced that the size variable is highly significant, ever thoug, the goodness of fit is lesser (log likelihood of 25,602 and Nagelkerke R 2 of 0,5), classifiying 85,7% of the cases correctly (Table 11). Table 11.- Classification table (step by step) Step 1 Actual Non Users 0 Users 1 Non Users 0 Prediction Users 1 % Correct Total 85,7 Like Hardwick and Adams (1997) for the British market, Cummins et al. (1997a, 1997b) for the U.S. market, and De Ceuster et al., (2001) for the Australian market, we verify the existence of a positive and statistically significant relation between the size variable and the hedging decision, implying a greater propensity on the part of large life insurance companies to hedge with derivatives. This is, furthermore, the most important variable, since using it exclusively permits discrimination with a high level of accuracy 19

20 between companies that do not hedge and those that do. This would uphold the hypothesis of the existence of scale economies in the use of derivatives and the need for technical and human resources capable of putting such techniques into practice. Although leverage variable is excluded from last model (step by step) because of its high correlation, it is individually significant. It presents a positive sign, which shows that the institutions that most resort to derivatives are those that present highest values of debt. This result would uphold the hypothesis that firms wish to reduce their insolvency costs. This hypothesis was defended both from the standpoint of agency theory, as a mechanism to protect managers jobs, and from that of the maximization of value, as it reduces the problems of underinvestment. 5.- DERIVATIVES AND VALUE CREATION As we indicated in the theoretical framework, various studies support the hypothesis that hedging increases firm value. This study also aims to analyse whether the firms that use derivatives as a hedging tool show better indicators of value creation. We have found several limitations that make the analysis more difficult. Firstly, value creation can be measured as increasing stock prices. Nevertheless, the sample companies are not listed on the stock market. Therefore, we have opted to use the classical measures, such as ROA (return on assets) and ROE (return on equity), as well as the EVA (economic value added), because of the widespread use since it was developed by Stern & Stewart in the mid-1990s. Stewart (1991) indicates that EVA takes into account the creation or destruction of firm value. He also maintains its superiority as a measure of profitability, compared to the traditional EPS (earnings per share), ROE or ROA, because it explains at least 50% better the variations in the shareholder s wealth. In this sense, O Byrne (1996) demonstrates the link between EVA and the firm market value, by relating this to different indicators (Nopat, EPS, Income, etc) by means of a regression. He concludes that, unlike all the other measures, EVA is linked to market value and is a better predictor of it. Hall (1998) also try to test the theoretical relation between EVA and MVA (market value added) upheld by Stern & Stewart. They analysed the indicators of internal management (EVA, Standardised EVA, ROA, ROE, EPS, DPS) that had a higher correlation with MVA, in 135 industrial firms on the Johannesburg stock exchange (10 years period). They found that of all these 20

21 measures the highest correlation coefficient was between MVA and EVA, coming to the conclusion that a relatively strong relation exists between MVA and EVA. Nevertheless, internal measures have several problems that avoid them to be considered true indicators of the value creation. Shareholder s value creation is closely linked to the variation in firm value, and this in turn depends on the expectations of the future behaviour of cash flow and of the changes in the firm s risk. Since internal measures are yearly constructed on the accounting results, they can scarcely incorporate expectations as to future results and consequently cannot measure the value creation (Fernández, 2001; Biddle et al., 1997). To test the hypothesis that increases firm value we decided to analyse whether there are significant differences between the companies that hedge with derivatives and those that do not. As indicators of the value creation we calculated ROE and ROA referring to the year We carried out a variance analysis of one factor, considering as variables the indicators mentioned and as factor the hedging variable. If the null hypothesis is rejected we will be able to affirm that the companies that hedge obtain better results, confirming the link between the value creation and the corporate risk management with derivatives. Table 12 shows that the groups present differences in average returns, both if we relate them to total assets and to capital. The group of companies that hedge present better results in general terms, i.e. a higher return on assets and on capital, as well as higher average return. However these differences are only significant when we consider the financial return, so it is necessary to evaluate a higher sample. Table 12.- Analysis of variance between groups Sum of the squared deviations df Mean square F - ratio Sig. ROA Between,001 1,001,375,546 Whithin,072 26,003 Total, ROE Between,097 1,097 3,223,084 Whithin,784 26,030 Total,

22 6.- CONCLUSIONS The aim of this study has been to test the theories on the use of derivatives as instruments of financial risk management by Spanish life insurance companies. We analysed data on the asset / liability management of 28 companies. In spite of the limited number of firms, which is the main limitation of this study, is a very representative sample, sharing more than 50% of the Spanish life insurance industry. To analyse the decision of using derivatives, we took as a basis two economic arguments: the theory of agency and the search for the maximization of the firm value. On occasions, it is difficult to establish a clear separation between the two, as the corporate risk management could reduce the costs of financial distress at the same time as it alleviates the underinvestment problems. In general, the use of derivatives has not become widespread among Spanish insurers and most operations are aimed at hedging the investment risk of long term operations. Nevertheless, different characteristics can be appreciated depending on whether or not the companies use derivatives. Thus the descriptive analysis shows that only size (LOGPREM) and leverage (LEVERAGE) are significantly different between the users and non users, confirming the hypotheses established. The companies that use derivatives are those of greater size and highly levered. The results of this investigation in general agree with those taken from other markets. As a consequence, it can be deduced that the reasons driving Spanish life insurance companies to use derivatives are related fundamentally to the reduction of financial risks (LEVERAGE) and to the availability of human and material resources for the use of derivatives, resources which are more abundant in companies of larger size (LOGPREM). In our opinion, this study carries out an analysis that has not been done in this country, incorporating variables that have not been taken into account by earlier studies. Also, by contributing disaggregated data that relate hedging to the asset and liability portfolios, it makes a deeper analysis of hedging. 22

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