Incentive Contracting and the Role of Participation Rights in Stock Insurers

Abstract

Corporate limited liability creates incentives for owners to shift risks onto creditors by substituting high-risk assets for low-risk assets because it rewards owners with the benefits of risky activities while penalizing them with only a portion of the costs. However, since rational creditors understand these incentives, the ensuing agency cost is borne ex ante by owners, unless they can credibly precommit themselves not to shift risk onto creditors. This article considers one specific contractual arrangement that helps resolve the risk shifting problem in stock insurers: the inclusion of participation rights in insurance policies. We assume that the insurer chooses between two mutually exclusive investment portfolios, where the riskier portfolio is a mean preserving spread of the less risky portfolio. The primary purpose of this analysis is to demonstrate that participating insurance policies resolve the risk shifting problem for stock insurers. We also present empirical evidence on policyholder participation that is consistent with our theory.

Adverse Selection and the Opaqueness of Insurers

“…A measure of insurance underwriting risk, known as underwriting leverage (Garven and Pottier, 1995;Black and Skipper, 2000), therefore can be estimated with the ratio of underwriting revenues to insurer surplus. This ratio reflects the risk of surplus depletion when adverse claims experience develops.…”

Dividend decisions in the property and liability insurance industry: mutual versus stock companies

“…Notably, Lee and Forbes (1982, p. 285) conclude that P-L stock insurers seem to make their earnings payout decisions on the basis of total policyholder and stockholder dividends rather than considering these dividends separately. On the other hand, Garven and Pottier (1995) note that the use of participating policies (and thereby the issue of policyholder dividends) is generally limited for P-L stock insurers compared with stock life insurers. Therefore, we only use dividends to owners in computing DIV 2 as an alternative proxy for dividend payout ratio.…”

“…Moreover, no significant difference in the growth rate of net premiums written is found between mutuals and stocks. Garven and Pottier (1995) note that the use of participating policies (and thereby the issue of policyholder dividends) is generally limited for P-L stock insurers. This view is also confirmed by our data.…”

“…In contrast, owners (i.e., stockholders) and policyholders of stocks are separate parties. Stocks may issue participating policies to allow policyholders to share insurers' profits via the payment of policyholder dividends, which to some extent help mitigate the incentive conflicts between stockholders and policyholders (e.g., see Garven and Pottier 1995). However, Garven and Pottier (1995) report that the use of participating policies (and thereby the issue of policyholder dividends) is generally limited and less common for stock P-L insurers compared with stock life insurers.…”

Analyst Earnings Forecasts for Publicly Traded Insurance Companies

“…This may lead to a lower level accuracy in forecasts for property-casualty insurers. However, the widespread use of participating policies among life insurers allows some of the volatility in earnings to be borne by the policyholder when the insurer adjusts policyholder dividends (Garven and Pottier, 1995;Krishnaswami and Pottier, 2001). This practice also contributes to less volatile earnings and generally more predictable earnings for life insurers.…”