The relationship between leverage, interest rate risk and firm value is investigated in the property-liability insurance industry. The market reward for financial structure measured using Tobin's q, the ratio of market value to replacement value of surplus is found to be related to a firm's choice of financial structure. Firm value at first increases with leverage but then declines at higher levels of leverage. This is hypothesized to be related to the trade-off between the tax shield associated with leverage and the cost of financial distress which exists for financial intermediaries. Interest rate risk has the opposite effect. Insurer value declines with interest rate risk, but there is some evidence that high levels of interest rate risk are associated with increased value. This is consistent with the hypothesis that value, for most insurers, declines as interest rate risk increases the cost of financial distress (without an offsetting tax shield) while some insurers, possibly those with low charter value, are able to increase value by increasing volatility--expropriating value from policyholders or state guarantee funds. The results are consistent for both an empirical, regression-based measure and an analytic measure of surplus duration. In order to determine replacement value, a methodology is developed to calculate the present value of insurer loss reserves based on historical loss patterns, inflation rates and the interest rate term structure.
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