Optimal Weights for Accounting Earnings and Cash Flows for Explaining Stock Return of Insurance Companies

The objective of this paper is to derive a composite index from earnings and cash flows that could be used to better evaluate insurance companies.
One significant difference between earnings and cash flows is depreciation, and in the case of insurance industry, the timing of recognition of premium income and expense paid out to claims can also cause significant difference between earnings and cash flows. Thus, there might be important components that are found in earnings of insurance companies but not in cash flows, or vice versa.We propose to create a composite index which is a weighted average of accounting earnings and cash flows that can explain stock return better than either earnings or cash flow alone. The advantage of this approach is that full information would be utilized for evaluating performance of insurance companies. Using this approach, we found that the optimal weight for earnings and cash flow for the insurance industry is found to be approximately 79% and 21%, respectively. Suchinformation may help managers of insurance firm to better manage the cash flow in order to maximize value of the firm for shareholders.