David W. Sommer

PROPERTY-LIABILITY INSURER FINANCIAL STRENGTH RATINGS: DIFFERENCES ACROSS RATING AGENCIES

Regulators, investors, consumers, and insurance brokers use insurer financial strength ratings to evaluate the insolvency risk of insurers. This article investigates the factors influencing the decision to obtain a rating or multiple ratings, the determinants of ratings for the three major insurer rating agencies, and reasons for differences in ratings across agencies. This study indicates that insurers obtain ratings to reduce ex ante uncertainty about insolvency risk. It also provides evidence that specific rating determinants and their weights differ across agencies. Evidence of sample selection bias is found only in relation to Bests ratings.

MONITORING, OWNERSHIP, AND RISK-TAKING: THE IMPACT OF GUARANTY FUNDS

ABSTRACT This study provides evidence regarding the risk-subsidy and monitoring hypotheses by investigating the relation between insider ownership and risk-taking in the property-liability insurance industry. The structure of guaranty funds provides incentives for owners to encourage insurer risk-taking. However, the ex post funding mechanism and incompleteness of guaranty funds may create monitoring incentives that inhibit risk-taking. Moreover, the extent to which managers engage in risk-taking may depend on how well their interests are aligned with those of the owners. The empirical results provide support for the risk-subsidy hypothesis and demonstrate the essential link between insider ownership and risk-taking. INTRODUCTION The institutional details of insurance industry guaranty funds have the potential to create competing incentives regarding risk-taking by insurers. Guaranty funds use an ex post financing mechanism to assess surviving insurers for the losses generated by insolvent insurers, and, at the same time, the assessments do not account for the riskiness of the insurers. Lee, Mayers, and Smith (1997) use the risk-neutrality and ex post funding of guaranty funds to develop two hypotheses regarding the impact of guaranty funds on the risk-taking behavior of insurers. They refer to these hypotheses as the risk-subsidy hypothesis and the monitoring hypothesis. They examine the relative strength of these hypotheses, and their empirical evidence leads them to conclude in favor of risk-subsidy. This study complements the work of Lee, Mayers, and Smith (1997) and addresses several additional issues. For stock market-based measures of risk, the evidence shows that the risk-subsidy hypothesis appears to hold, and the extent of risk-subsidy-related behavior is directly related to insider ownership. This point is related to the ownership structure hypothesis advanced by Lee, Mayers, and Smith (1997). [1] In addition, the authors are able to validate this result by exploiting the option characteristics of the risk-subsidy. Specifically, the study shows that the relation between risk and ownership is stronger for insurers whose put option is closer to being in the money. Finally, as monitoring and risk-subsidy are not mutually exclusive, the authors attempt to avoid a complete dismissal of the monitoring hypothesis by examining a series of piecewise linear relations between risk and ownership. This approach effectively relaxes the condition under which the authors might conclude in favor of the existence o f monitoring. The results appear to have important implications for the effectiveness of guaranty funds and other financial institution insurance programs. BACKGROUND, THEORETICAL ARGUMENTS, HYPOTHESES The Insurance Guaranty Fund System During the years 1969 to 1981, all states enacted laws to establish guaranty funds to protect the policyholders of insolvent insurance companies. [2] The protection provided by these state guaranty funds, however, is far from complete. [3] For instance, the funds typically limit the maximum amount that can be recovered to

Agency Theory and Life Insurer Ownership Structure

300,000 per claim (

Determinants of Cash Holdings by Property-Liability Insurers

100,000 in some states), including all loss adjustment and defense costs. Deductibles are also common. In addition, certain lines of insurance typically have no coverage (e.g., reinsurance and marine insurance), and some states provide no protection for commercial insureds that exceed a particular net worth limit. Beyond these restrictions, payments from a guaranty fund are likely to be delayed compared to payments from a solvent insurer. In addition, guaranty funds do not provide reimbursement for the risk management services that the solvent insurer would have provided. The funding method used by insurance guaranty fund programs is also very important. Guaranty fund programs are funded on a post-insolvency assessment basis. [4] Thus, surviving insurers are responsible for paying the guaranty fund obligations created when one of their peers becomes insolvent. …

The Effectiveness of Public and Private Sector Summary Risk Measures in Predicting Insurer Insolvencies

This article uses the insights of agency theory to analyze ownership structures in the life-health insurance industry. We examine operational, financial, and institutional determinants of ownership structure. We simultaneously test hypotheses regarding the owner-manager incentive conflict and the owner-policyholder incentive conflict. Our results demonstrate systematic differences between the activity choices of stock life insurers and mutual life insurers, consistent with the managerial discretion hypothesis. We also find that mutuals are more likely to be licensed in New York, stock firms are more likely to be organized as groups, mutuals are more likely to have high A. M. Best ratings, and older insurers are more likely to be mutuals.

Separation of Ownership and Control: Implications for Board Composition

ABSTRACT This study investigates the differences in cash holdings across property-liability insurers. We conclude that relative cash holdings are less for insurers with better access to cash through capital markets and/or other group members. We also conclude that larger insurers, higher quality insurers, insurers that write longer tail lines of business, and firms with higher degrees of leverage hold less cash. Also, we find that insurers with a higher variance of cash flows tend to hold more cash. Another interesting finding is that, contrary to what managerial discretion arguments might suggest, stock insurers tend to hold more cash than do mutuals. INTRODUCTION This article examines the variation in cash holdings across property-liability insurers during the three-year period from 1993 to 1995. For the property-liability insurer, virtually all business transactions occur in cash. Premiums are received in cash, and claims are paid in cash. As a result, the insurers decision regarding the amount of cash to hold is critical to its operations and therefore to its overall financial stability. In making that decision, an insurer may choose to hold a large amount of cash; such a strategy affords much flexibility to the insurer, but the flexibility gains are offset by the opportunity costs resulting from the lower returns generated by cash compared to less liquid assets (Amihud and Mendelson, 1986). On the other hand, an insurer may choose to hold a small amount of cash; such a strategy maximizes returns by investing the cash in higher yielding assets but exposes the insurer to transaction costs--and potentially unfavorable economic conditions--when assets must be liquidat ed to meet obligations. Because there are competing costs and benefits of holding cash, the insurer must compare the marginal costs of holding cash to the marginal benefits of holding cash when determining its optimal level of cash (Opler, Pinkowitz, Stulz and Williamson, 1999). Cash holdings vary considerably across insurers. [1] Such differences can be expected for a number of reasons, including the degree of agency conflict among the insurers management, owners, and policyholders; the ability of the insurer to generate cash from alternative sources; the nature of the insurers operations; and the composition of the insurers portfolio of non-cash assets. In order to determine which insurer characteristics affect the extent of cash holdings, we employ regression analysis on a large sample of property-liability insurers over a three-year period. Our examination of cash holdings by property-liability insurers serves several purposes. First, it contributes to the large body of literature investigating corporate cash holdings (Chudson, 1945; Baumol, 1952; Meltzer, 1963; Frazer, 1964; Vogel and Maddala, 1967; Gertler and Gilchrist, 1994; Kim, Mauer and Sherman, 1998; Opler, Pinkowitz, Stulz and Williamson, 1999). Because prior literature has excluded the analysis of financial firms, investigation of insurer cash holdings provides the opportunity to evaluate the extent to which past findings hold for a totally different class of firms. Perhaps more importantly, the unique aspects of the insurance industry, such as the different organizational forms available to insurers and the phenomenon of insurer groups, provide the opportunity to generate additional insights into cash holdings. Additionally, the examination complements previous research investigating other components or aspects of insurer investment portfolios (Colquitt and Hoyt, 1997; Cummins, Philli ps and Smith, 1997; Lee, Mayers and Smith, 1997; Cox, Gayer and Wells, 1998). Finally, the examination demonstrates that insurers choose cash balances systematically based on their organizational and operational characteristics. This information should benefit stakeholders, regulators, and academics in their attempts to understand and predict insurer behavior. …

The Role of Internal Capital Markets in Financial Intermediaries: Evidence from Insurer Groups

This article investigates the abilities of four key summary risk measures to predict property-liability insurer insolvencies. The four summary risk measures studied are the NAICs risk-based capital ratios, the NAICs financial analysis solvency tools (FAST) scores, A.M. Bests Capital Adequacy Relativity ratios, and A.M. Bests ratings. The empirical tests find that the risk measures produced by the private sector are superior in predictive ability to the measures produced by regulators, perhaps because of the qualitative adjustments made by private sector analysts. The results also demonstrate that overall measures of risk are substantially better than risk-based capital measures in predicting insolvencies. Another finding is that the predictive ability of the NAICs RBC ratios can be improved substantially if ranks are used rather than the ratios themselves.

Earnings Smoothing, Executive Compensation, and Corporate Governance: Evidence from the Property-Liability Insurance Industry

This article investigates the implications of separation of ownership and control for board composition over a spectrum of ownership structures present in the U.S. property–liability insurance industry. We hypothesize that agency costs associated with manager–owner conflicts increase with the degree of separation of ownership and control. Greater agency costs imply a greater need for monitoring by outside directors on the board. Therefore, use of outside directors is expected to increase as the separation of ownership and control gets larger. Employing a sample of property–liability insurers exhibiting different degrees of separation of ownership and control, we find support for our hypothesis.

The Impact of CEO Turnover on Property–Liability Insurer Performance

We exploit the transparency of internal capital markets (ICMs) within insurance groups to investigate the activity and efficiency of ICMs within insurance groups. Specifically, we compare the relationship between internal capital transfers and investment to that between capital from other sources and investment. The ability to track the actual ICM transactions allows for more direct analysis of ICM activity than most previous studies. Consistent with theory, we find evidence that ICMs play a significant role in the investment behavior of affiliated insurers. We then use these detailed data to execute a more direct test of ICM efficiency than currently exists in the literature. Consistent with ICM efficiency, results suggest that capital is allocated to subsidiaries with the best expected performance.

Separation of Ownership and Management: Implications for Risk‐Taking Behavior

Unlike studies that estimate managerial bias, we utilize a direct measure of managerial bias in the U.S. insurance industry to investigate the effects of executive compensation and corporate governance on firms’ earnings management behaviors. We find managers receiving larger bonuses and stock awards tend to make reserving decisions that serve to decrease firm earnings. Moreover, we examine the monitoring effect of corporate board structures in mitigating managers’ reserve manipulation practices. We find managers are more likely to manipulate reserves in the presence of particular board structures. Similar results are not found when we employ traditional estimated measures of managerial bias.