#06-13
Capital Allocation and the Pricing of Financially Intermediated Risks: An Empirical Investigation
J. David Cummins, Yijia Lin, and Richard D. Phillips, June 2006
Abstract: Under perfect market conditions, standard capital budgeting theory predicts that the discount rates on
projects should reflect only non-diversifiable risk and be constant across firms. However, theoretical
research by Froot and Stein (1998), among others, suggests that when firms invest in non-hedgeable
assets under conditions where capital is costly, project pricing should reflect the covariability of the
project with the firm’s existing portfolio, even if this covariability represents non-systematic risk.
They argue that their theory is especially applicable to financial institutions pricing intermediated
risks. Theoretical research also suggests that the prices of intermediated risks will reflect the capital
strain that such risks place on the intermediary and hence reflect implicit allocations of capital to the
intermediary’s business lines (Myers and Read 2001, Zanjani 2002). We test these theoretical
predictions by analyzing the prices of insurance risks for U.S. property-liability insurers over the
period 1997-2004. Specifically, we regress insurance price variables on capital allocations by line,
measures of insurer insolvency risk, and other risk and control variables. The results provide strong
support for theoretical predictions that prices of intermediated risks vary across firms to reflect
insolvency risk, marginal capital allocations, and non-systematic covariability.
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