1

Which Firm Gets Burned?Rachel J. Huang

Larry Y. TzengKili C. Wang

2

The main purpose of our paper

• We intend to examine the theory of De Meza and Webb (2001) directly.

Risk Probability

Market Insurance

Self-Protection

3

Asymmetric information: theory

• Hidden Information– Adverse selection

• Hidden Action– Moral hazard

• Both of them predict that the higher the coverage, the higher the probability of risk.

4

Empirical evidence

• Many papers didn’t find the evidence of adverse selection or moral hazard. For example,– Auto insurance: Chiappori and Salanie (1997,

2000), Dionne, Gourieroux and Vanasse (2001)

– Life insurance: Cawley and Philipson (1999)– Health insurance: Cardon and Hendel (2001)

5

Some papers even found that…

• A negative correlation between the coverage of the insurance and the occurrence of the risk– Finkelstein and McGarry (2003): long-ter

m care insurance– Gronqvist (2004): dental care insurance

6

Another theory: advantageous selection• De Meza and Webb (2001)

– hidden risk preference – A separating equilibrium:

• Timid individuals purchase market insurance as well as make an effort to reduce the loss probability, whereas bold individuals neither purchase market insurance nor make an effort to reduce the loss probability.

7

Make sure the negative correlation is not

reflecting the underwriting ability…

Risk Probability

Market Insurance

Self-Protection

+

(+)

(-)

(+)

--

8

Our data set• Target: Commercial Fire Insurance• Through the Fire Department, we hand-

collect the data:– market insurance– self protection activities – records of fire accidents – other relevant variables on which

insurance companies usually collect data to underwrite commercial fire insurance

• Observations: 2,592.

9

Are firms risk aversion?• Most of the literatures focus on individual

insurance.• Risk attitude of a firm:

– The classic finance literature: risk neutral – Recent studies:

• The value function of a firm could be concave due to– bankruptcy costs (Greenwald and Stiglitz, 1990; Stiglitz,

2002)– taxes (Eeckhoudt, Gollier, Schlesinger, 1997)

• Thus, a risk-neutral firm will behave as if it is risk averse.

10

Why not from insurance companies?

• Drawbacks to the data obtained from insurance companies:– Insurance companies do not have

information on the non-insured. – Insurance companies may not have

information on individuals’ self protection activities.

11

Self-protection variables

• The proxy must satisfy two criteria:– A non-market risk reduction activity to reduce

the probability of a loss. – This activity to reduce risk is unobservable to

insurers.

• Two proxy variables:– the operations of self-defense fire organizations – the qualified operation of fire safety equipment

12

Summary statistics• 42.47% of the firms purchase commercial

fire insurance.• 5.79% of the firms face a fire accidence in

the last year.• 74.6% of firms have self-defense fire

organization operated in the last half year• 75.3% of firms have qualified operation of

fire safety equipment in the last half year

13

Summary statistics: business type

• Class-A places

24.48%

9.49%

9.32%

11.87%

30.55%

13.46%0.83%

Movie projection places, singing room, club, restaurant, etc.Bowling alley, indoor screen-type golf training field, game-playing ground etc.Sightseeing hotel, restaurant, guesthouse, rest house (with bedrooms).Store, market, department store, supermarket, retail market, exhibition fieldDining room, catering shop, coffee bar, tearoomHospital, sanitarium, long-term nursing home, health care institution, elderly service institution, etc.Sauna, public baths

14

Summary statistics: Location

100103

104

105

106

108110

111

112

114

115

116

800

801

804

806

807 811812813 100103104105106108110111112114115116800801804806807811812813

15

Empirical Empirical Methodology and Methodology and

Results Results

Empirical Empirical Methodology and Methodology and

Results Results

16

Conditional dependency test

• Gourieroux, Monfort, Renault, and Trognon (1987)

• Probit regressions:

• Estimated residuals:

)1()()1(Prob yii Xy

)2()()1(Prob zii Xz

)3()()1(Prob sii Xs

)4()(

)()1(

)(

)()|(ˆ

ji

jiii

ji

jii

ji

ji X

Xjj

X

XjE

szyj ,,

17

W statistic

• If is significant, we reject H0:

n

i

ki

ji

n

i

ki

ji

jkW

1

22

2

1

)ˆ()ˆ(

)ˆˆ(

)1(~ 2

jkW

0),cov( ki

ji

szykj ,,, kj

18

Conditional correlation coefficient

• We predict that

0ys

0yz0zs

Risk Probability

Market Insurance

Self-Protection

19

Table 3

jkW jk

Items

Panel A: Self-Defense Fire Organization as a Proxy for Self-Protection

Market insurance vs. Loss occurrence 122.035*** -0.1252***

Self-protection vs. Loss occurrence 398.908*** -0.0475**

Self-protection vs. Market insurance 30.5324*** 0.4426***

Panel B: Qualified Operation of Fire Safety Equipment as a Proxy for Self-Protection

Market insurance vs. Loss occurrence 122.035*** -0.1252***

Self-protection vs. Loss occurrence 460.523*** -0.3481***

Self-protection vs. Market insurance 10.1094*** 0.2042***

20

4. Conclusion (1/2) • Our paper contributes to the literature by

providing more direct evidence to support the existence of the advantageous selection theory derived by De Meza and Webb (2001).

• We simultaneously examine the pair-wise correlations among the purchase of market insurance, the efforts made to engage in self-protection, and the occurrence of accidents.

21

4. Conclusion (2/2) • We find that

– (1) firms that purchase market insurance have a greater tendency to make an effort to engage in self protection;

– (2) firms that make an effort to engage in self protection are less likely to suffer a fire accident;

– (3) firms with commercial fire insurance have a lower chance of suffering a fire accident than those without such insurance.

Thank you