Cost of Equity and Property Insurance:Evidence from China

This thesis addresses the question of whether corporate risk management adds value to a firm by examining the linkage between the cost of equity capital and property insurance in China. Over the last decade or so, several studies have examined the direct impact of risk management (derivatives or insurance use) on firm value. Utilizing an agency theory framework, the present study adds to the extant literature by investigating the corporate risk management-value relation from a more focused and novel perspective using a panel data set of 395 publicly listed Chinese companies (PLCs) for the period 2003-2007. The capital asset pricing model (CAPM) and modified price earnings growth (MPEG) models are employed to estimate the cost of equity. The results of the study suggest that Chinese PLCs purchasing property insurance tend to have lower costs of equity. Also a non-linear U-shape relation between the cost of equity and the extent of property insurance use is found. Given the inflection point occurs above the 90th percentile of the sample of firms, property insurance appears to be beneficial to most Chinese PLCs. The present study also shows that property insurance reduces the cost of equity by mitigating agency problems such as the managerial risk aversion incentive. Indeed, this is the first study that finds evidence that agency theory-based arguments appear to be appropriate in explaining the relation between property insurance use and the cost of equity. The empirical results are further robust to within-firm and cross-firm variations and unlikely to be driven by endogeneity problem. Therefore, the present study contributes new and important insights on the role of insurance - a pure risk hedging (indemnity) contract - in contributing to improvements in the market value of firms. This aspect of the research is particularly important in major emerging markets, such as China, that are attracting increasing attention from domestic and foreign investors but still suffer from severe market imperfections (e.g., information asymmetry) and an undeveloped financial and legal infrastructure compared with Western countries. Therefore, it is concluded that the results of this study could have potentially important commercial and/or public policy implications for corporate stakeholders with an interest in the Chinese corporate sector.