represent increasing proportions of the total capital
structure. Yet, to infer that managers of stock
property-liability insurance companies can be indif-
ferent about the cost of and rewards to outside capi-
tal is to overstate a case.

"The unearned premium reserve, the loss reserve, and
related accounts as of the end of 1966 for the 792
stock companies reported in Best's Aggregates and
Averages offset only about 55 percent of the assets
of these companies, leaving the other 45 percent to
be financed either through retained earnings or out-
side capital. For the mutual sector the comparable
figure was about 62 percent. It is easy to see that,
except for a purely post-assessment type of operation,
the industry cannot each year generate enough capital
to support its premium volume with much if any margin
of assets out of which to meet extraordinary demands
for funds.

"The crucial point, therefore, is that the rate of
return has to be sufficiently high to keep the capital
in the property-liability insurance industry, whatever
the source of the capital or the time of its genera-
tion. Capital will flow from the industry if the long-
range rate of return drops below the proper risk-adjusted
level as reflected by alternative investment opportuni-
ties. Dr. Plotkin's reference to the formation of 327
holding companies among insurers is evidence in point.
Recent events have demonstrated that even a mutual
insurer can use some of its assets to establish 'an-
cillary' stock subsidiaries. Thus, the question of
long-range capacity of the property-liability insurance
industry and the effect of the rate of return on attract-
ion and maintenance of the necessary capital is, as the
Plotkin paper and the Little report imply, very much in
relevance."6

For similar reasons, we commented on the current relation between the insurance industry and the capital market as follows:

6John D. Long, "Comments on a paper by Irving H. Plotkin, Entitled 'Rates of Return in the Property and Liability Insurance Industry: A Comparative Analysis, presented at the Annual Meeting of the American Risk and Insurance Association, Atlanta, Georgia, August 29, 1968, pp. 21-22; Journal of Risk and Insurance, June 1969, issue forthcoming.

"CURRENT STATUS

"Validation of this theoretical result can be seen in the
present occurrences in the industry. Although it is
hard to point to direct capital outflow, for the in-
dustry still is growing, there are strong signs of
capital unrest. The formation of over 350 holding
companies on the part of insurance companies, the
spreading out into mutual funds, the purchasing of
credit card companies by certain insurance companies
are all signs of dissatisfaction with the present
returns allowed by the economics and regulatory
structure of the property and liability industry.

"Some have been able to look at the low rates of re-
turn, the diversification and holding company moves,
and the low market values relative to portfolio values
and still maintain that the rates of return in insurance
are excessive or that the insurance industry is isolated
from the rest of the economy and the capital markets.

"Pointing to the fact that the insurance industry can raise 50% of its funds through the sale of its products, they argue that there is no need to be concerned with the rate of return on the total assets or even the rate of return on net worth because of the capital generated through retained earnings. Such analyses show a fundamental misunderstanding of the nature of financial intermediaries, the way in which the capital markets function, and the social efficiency criteria for the allocation of capital.

"It may be argued that it does not matter at all what
return is earned in the property and liability insur-
ance industry, because most of its new capital comes
from the equivalent of debt money or internally gen-
erated retained earnings. Were that true, such reason-
ing could then be extended to almost all segments of
the economy where most new investments are either fi-
nanced by debt or, as has more often been the case,
financed by internally generated re-invested earnings.
In fact, in the early 1960's, the net flotation of
corporate stock was negative; that is, corporations
in this country brought back from the investing public
more of their common and preferred stock than they
issued to the public. Would one then want to argue
that corporations are completely isolated from the

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capital market?

Some have pursued this line of

thought, but it does not seem to maintain its

validity in the face of generally accepted economic
theory and the actual financial practices of Ameri-
can industry."7

Hofflander and Mason conclude their discussion of the dependence of the insurance industry on the capital markets with the following remarkable paragraph: "In the case of the stock company, the willingness of new investors to subscribe to stock issues, or the willingness of management to reinvest retained earnings, is clearly not dependent upon the rate of return on assets" (p. 7). This statement contradicts almost all financial-economic theory and practice.

We did not undertake our study, nor do we present this reply, merely as an academic exercise. The results uncovered have serious implication. We fully agree with the New York State Insurance Department which, in discussing insurance rates of return, stated:

"What is most important to the insurance consumer,
however, is that insurance shareholders and manage-
ments are acting as if the rate of return is inade-
quate. They are disinvesting by forming holding
companies, by restricting markets, by extremely
selective underwriting, by canceling policies and by
terminating entire agency and brokerage accounts.
Such market behavior says that they think their enter-
prises are not earning, or will not earn, a sufficient
return on the resources invested. Government can
properly be concerned with these socially undesirable
manifestations of perceived or anticipated unprofit-
ability without completing the scholastic endeavor of
determining precisely how profitable or unprofitable
the business has been."8

'Irving H. Plotkin, "Rates of Return in the Property and Liability Insurance Industry: A Comparative Analysis," paper presented at the Annual Meeting of the American Risk and Insurance Association, Atlanta, Georgia, August 26, 1968, pp. 41-42; Journal of Risk and Insurance, June 1969, issue forthcoming.

8State of New York Insurance Department, The Public Interest Now in Property and Liability Insurance Regulations, January 7, 1969, p. 101.

V. INSURANCE STOCKS' BEHAVIOR

The reviewers then ask: Why ADL did not undertake "a study of the opportunity costs of holding insurance company stocks." We reply (as clearly stated in the ADL Report, p. 33) that the relationship between risk and return to security holders is of little use in deciding whether or not real assets are being efficiently employed in any industry. This relationship simply says that the securities of the various industries studied are being distributed so that the rewards and risks to security holders are as described by the risk/return trade-off. This would not rule out the possibility that the assets which these securities represent in any industry are not earning monopolistic returns or, on the other hand, are failing to earn minimal returns sufficient to protect the industry from capital outflow. For this reason, we made no attempt to construct a property and liability insurance industry point on the market risk/return graph.

Norgaard and Schick in their review of our work agree that market rates of return have no relevance in the evaluation of the social efficiency of asset utilization. They point out that the book rate of return "is interpreted as a ratio denoting the efficiency of management in using the company's assets based on their original cost" (p. 5).9 The market rate of return, they continue, "bears almost no resemblance to [the book rate of return], for it is the total return that the suppliers of capital to a company receive. It carries with it an evaluation not only of current yield but also of expected future yield. A general interpretation of market rate of return would be as follows: The higher the relative ratio the greater the market considers the company's effectiveness in making profits. This is not necessarily an efficiency ratio because it automatically incorporates such items as monopoly control, diversification and superior management into the numerator by recognizing changes in value for the firm's securities" (p. 5).

Our study was aimed at a socioeconomic question. It did not seek answers from the parochial point of view of investors, rather it asked a catholic question: Would society be better off if assets were taken away from the insurance industry and applied to other economic endeavors? This is one of the difficult questions which a regulator must ask himself in trying to determine the reasonableness of the rate of return from society's point of view.

9It is not true that book value measures must be based on original cost: Assets may be carried on the books at current (market) value, as in the insurance industry. The important point is that internal or book rate of return (at historic or current cost) measures efficiency, while the external returns to security holders do not.

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Nevertheless, one can answer the question posed by the reviewers. The performance of insurance stocks has indeed shown the capital market's evaluation of assets used in the insurance business. Shares of companies primarily engaged in property and liability insurance were selling at significant discounts from their net worth (book value) per share. When one recalls that this book value per share is based on current market value of their assets, one must consider such discounts a significant indictment. Recently, there has been a revival of interest and an increase in the prices of insurance stocks. However, in almost every case the reason for the increase in price has been the formation of holding companies or other means on the part of the companies involved for channelling funds out of the insurance industry and into other economic endeavors.

In this regard, the recent history of the Hartford Fire Insurance Company is typical. The stock of the Hartford Company had been selling at about one half of its adjusted book value per share. The price quickly rose to book value per share when it was announced that various companies were negotiating to take over Hartford and employ its capital surplus in other businesses. When these negotiations were broken off, the stock price dropped. It returned to its book value on the announcement by the Board of Directors that the company:

(1) Is applying for listing on the New York Stock Exchange;

(2) "Will seek to diversify in other fields where it appears
to be in the best interest of all shareholders and policy-
holders and promises to contribute to the company's further
earnings, growth, and progress";'

10

(3) Will devise methods for passing on more fully to stock-
holders the company's large unrealized capital gains.

Even these announced intentions were not sufficient to enable the Hartford's Board of Directors to resist an offer to merger Hartford into the International Telephone and Telegraph Corporation.

The rise in Best's Fire and Casualty Insurance Stock Index can be attributed almost wholly to similar situations occurring in other large insurance companies. Dissatisfied with the rates of return earned in property and liability insurance, corporate management has been seeking ways of channelling funds out of this industry and into other economic endeavors. Were it not for the legal restrictions on capital movement out of the insurance business, this outflow might well have been even greater.

10H.V. Williams, Chairman of the Board and President, Hartford Fire Insurance Company, letter to stockholders, October 21, 1968.