The effect of predation risk on cash holdings: Empirical evidence from the U.S. property‐liability insurance industry

• Author: Stephen G. Fier,Andre P. Liebenberg,Xin Che
• DOI: http://doi.org/10.1111/rmir.12131
• Date: 01 September 2019
• Published date: 01 September 2019

© 2019 The American Risk and Insurance Association

Risk Manag Insur Rev. 2019;22:329–358. wileyonlinelibrary.com/journal/rmir

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329

Received: 14 December 2018

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Revised: 11 July 2019

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Accepted: 16 August 2019

DOI: 10.1111/rmir.12131

FEATURE ARTICLE

The effect of predation risk on cash holdings:

Empirical evidence from the U.S.

property‐liability insurance industry

Xin Che

1

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Stephen G. Fier

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Andre P. Liebenberg

2

1

Department of Finance, Mihaylo College

of Business and Economics, California

State University, Fullerton, California

2

Department of Finance, School of

Business Administration, University of

Mississippi, Booneville, Mississippi

Correspondence

Stephen G. Fier, Department of Finance,

School of Business Administration,

University of Mississippi, Booneville,

Mississippi 38677‐1848.

Email: sfier@bus.olemiss.edu

Abstract

Corporate cash holdings play a significant role in the

U.S. property‐liability insurance industry yet the topic of

insurer cash holdings policy has largely been overlooked

by prior empirical research. While a number of studies

have investigated firm‐specific factors related to cash

holdings in the insurance industry, prior research has

not examined how market concentration and potential

predation risk impact cash holdings. We propose a new

measure of market concentration and provide evidence

in support of the predation risk theory. Specifically, we

show that insurers exposed to more concentrated

markets tend to hold more cash. Furthermore, the

relation between market concentration and cash hold-

ings is influenced by access to internal capital. While

unaffiliated insurers without access to internal capital

hold greater levels of cash in more concentrated

markets, group insurers with access to internal capital

do not hold greater levels of cash to mitigate predation

risk.

KEYWORDS

predation risk, cash holdings, market concentration, insurance

industry

JEL CLASSIFICATION

G22; G32

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INTRODUCTION

A growing body of literature indicates that important corporate decisions are influenced by

market concentration (e.g., Botosan & Harris, 2000; DeFond & Park, 1999; Fee & Thomas, 2004;

Harris, 1998; Haushalter, Klasa, & Maxwell, 2007; Hou & Robinson, 2006; Kale & Shahrur,

2007; Karuna, 2007). One such decision revolves around corporate cash holdings, where prior

literature has shown that market concentration plays an important role in shaping a firm’s cash

holdings policy (e.g., Haushalter, Klasa, & Maxwell, 2007; Hoberg, Phillips, & Prabhala, 2014).

1

One explanation for the relation between market concentration and cash holdings is the

predation risk theory, which argues that cash holdings provide an important source of financial

flexibility that helps firms mitigate the risk of losing investment opportunities and market share

to rivals (e.g., Bolton & Scharfstein, 1990; Haushalter, Klasa, & Maxwell, 2007). Given that

predation is more likely to occur in more oligopolistic industries (e.g., Froot, Scharfstein, &

Stein, 1993; Kovenock & Phillips, 1997; Zingales, 1998), the predation risk theory implies that

firms operating in more concentrated markets will hold greater levels of cash (e.g., Haushalter,

Klasa, & Maxwell, 2007; Shleifer & Vishny, 1997).

While the predation risk theory of cash holdings has been tested in a variety of settings, the

relation between market concentration and cash holdings policy has yet to be empirically

examined in the U.S. property‐liability insurance industry. We contend that there are a number

of important reasons why such an analysis focusing on the insurance industry is warranted.

First, while the insurance industry is highly reliant on cash transactions (Colquitt, Sommer, &

Godwin, 1999) and the degree to which a firm holds liquid assets can impact an insurer’s ability

to meet outstanding financial obligations, the topic of cash holdings largely remains

overlooked.

2

The general absence of research into insurer cash holdings policy is of particular

note given the considerable differences in cash holdings across firms within the industry.

3

Second, while studies have investigated various aspects of market competition within the

insurance industry, to our knowledge no prior research has explicitly investigated predation

risk in the industry and how it might influence corporate decision‐making and strategy. The

insurance industry is characterized by significant variation across firms in terms of market

concentration and the degree to which firms are exposed to potential predation should

influence how those firms operate. Third, the general nature of the industry allows us to give

consideration both to how market concentration affects cash holdings and to how access to

other sources of capital impact the relation. In particular, because the insurance industry is

composed of insurance groups and unaffiliated firms, we are able to study whether access to

internal capital influences the cash holdings and market concentration relation.

4

While access

to capital can have a significant effect on how a firm operates, to our knowledge no prior study

has examined how internal capital markets impact the relationship between cash holdings and

predation risk. Finally, the unique regulatory reporting requirements that exist in the insurance

1

A strand of closely related literature is focused on the effects of market concentration on the value of cash holdings. For example, Alimov (2014) shows that the

relation between the value of cash holdings and market concentration is negative. Alternatively, Chi and Su (2016) report that different Herfindahl indices

(HHIs) give different value implications for cash holdings, and the negative and significant relation is constrained to only a limited set of concentration

measures.

2

Some studies examining cash holdings in the insurance industry include Colquitt et al., (1999), Hsu, Huang, and Lai (2015) and Xie, Wang, Zhao, and Lu

(2017).

3

For example, Hsu, Huang, and Lai (2015) report that the average ratio of cash and short‐term investments to total invested assets in their sample is 8.9% with a

minimum of 0.00% and a maximum of 90.7%.

4

Prior research finds that insurance groups actively use internal capital markets and that internal capital is used to achieve a variety of objectives (e.g., Niehaus,

2018; Powell & Sommer, 2007; Powell, Sommer, & Eckles, 2008).

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CHE ET AL.