Policyholder Dividend Policy and the Costs of Managerial Discretion

Abstract

This study examines whether mutual life insurers pay policyholder dividends in response to the costs of managerial discretion. The insurer's free cash flow and the variation in free cash flow explain over 85 percent of the variation in policyholder dividends for a time-series, cross-sectional sample of mutual life insurers. The findings hold under different specifications of the estimated model and for a control sample of stock life insurers.

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

“…Recognizing this, managers of mutual insurers may voluntarily issue (policyholder) dividends and thereby reduce the free cash flow at their disposal. Consistent with this view, Scordis and Pritchett (1998) find that mutual life insurers with a larger free cash flow choose to pay more dividends in order to reduce the agency costs arising from managers' discretionary use of free cash flow. Myers and Pritchett (1983) document that policyholders tend to realize higher long-run returns (in the form of dividends received) from purchasing participating (life) insurance policies from mutuals than buying non-participating insurance policies and invest the savings in premiums from stock insurers.…”

“…On the other hand, mutuals' disadvantages in mitigating owner-manager incentive conflicts imply that mutual managers have more opportunities to divert free cash flow to perquisite consumption and so the agency costs of equity in mutuals are likely to be higher than in stocks, other things being equal. Scordis and Pritchett (1998) argue, and find support for the argument (using a sample of mutual life insurers), that in order to relieve the concerns of policyholders, managers of mutuals may practice a more liberal dividend payout policy than stocks. While this is possible, many prior studies (e.g., Wells et al 1995) also report that the poor control mechanisms present in mutuals (e.g., the lack of market for corporate control and stock options as managerial incentive compensation) often result in little pressure being exerted on managers to distribute profits.…”

“…2.2, we discussed the implications of differences in agency costs between stocks and mutuals. However, agency costs associated with free cash flow may also vary from firm to firm of the same organizational form (Scordis and Pritchett 1998). A firm with a large free cash flow faces greater agency costs between managers and owners, which can be lowered by paying more dividends.…”

“…This is necessary because the changes in dividend payouts may be perceived by the market as important signals and may induce strong reactions (e.g., see Akhigbe et al 1993). Following Bradley et al (1984) and Scordis and Pritchett (1998), earnings volatility (EARISK) is measured by the standard deviation of the first difference in net earnings before dividends over the previous 5 years scaled by the average book value of total assets in the same period. For example, the earnings volatility of 1994 is calculated using the earnings of 1989-1993.…”

“…He suggests that ownership structure and capital constraints are potentially important factors affecting insurers' dividend decisions. Using a sample of US mutual life insurers, Scordis and Pritchett (1998) show that dividend decisions of mutual life insurers are motivated by a desire to reduce the agency costs arising from managers' discretionary use of free cash flow. However, with few exceptions (e.g., Forbes 1980, 1982), dividend decisions of P-L insurers have not been rigorously investigated, particularly from the perspective of organizational forms.…”