Policyholder Dividend Policy and the Costs of Managerial Discretion

INTRODUCTION Costs associated with managerial discretion reduce the value of a corporation. Self-interested managers make corporate decisions that maximize their own utility of wealth rather than that of corporate owners. As explained by Jensen (1986) and Stulz (1990), these costs arise from managers attempting to invest corporate cash below the cost of capital, or wasting it on organizational inefficiencies rather than distributing cash to corporate owners. Mutual policyholders, in their dual role as customers and owners, are likely to be susceptible to these costs. Unlike publicly traded corporations for which external capital and labor markets provide inexpensive monitoring and a mechanism for the removal of ineffective managers, mutual life insurers make relatively little use of capital markets.(1) Thus, takeovers are impossible and scrutiny of firm performance by capital markets is weak. Likewise, while the costs of managerial discretion between owners and fixed claimholders are common among stock firms, they are not significant for mutual insurers. Although, Demsetz and Lehn (1985) contend that regulatory scrutiny can mitigate the costs of managerial discretion, empirical evidence on the efficiency of regulation of life insurers is equivocal (Record, Society of Actuaries, 1989; BarNiv and Hershbarger, 1990; Babbel and Hogan, 1992; Klein, 1995). Furthermore, Boose (1990) and Wells, Cox, and Gaver (1995), respectively, do not find a relationship between regulatory intensity and insurer performance, or regulatory intensity and the size of the insurer's free cash flow (i.e., cash in excess of what is required to invest in all available positive net present value projects). This study investigates whether the payment of policyholder dividends is related to the costs of managerial discretion in mutual life insurers. As Mayers and Smith (1988) point out, the costs of managerial discretion in mutual insurers (property and liability) are generated by manager-policyholder (owner) conflicts. Although the individual equity of policyholder dividend distributions has been investigated by Winters (1978), Belth (1978), Cody (1981), and Larsen (1981) none of these studies investigates the relationship between the payment of policyholder dividends and the costs of managerial discretion in mutual life insurers.(2) Garven and Pottier (1995) argue that just as the payment of stockholder dividends reduces the costs of managerial discretion in noninsurance corporations, the payment of policyholder dividends also reduces the costs of managerial discretion in stock life insurers. But, Garven and Pottier are silent on whether the payment of policyholder dividends also reduces the costs of managerial discretion in mutual life insurers. However, Formisano (1978) finds that the payment of policyholder dividends is a tradeoff between retaining cash as surplus and paying it out as dividends. Indeed, Wells, Cox, and Gaver (1995) find that managers of mutual life insurers hold more free cash flow as compared to managers of stock life insurers. This implies greater costs of managerial discretion in mutual life insurers, which Well, Cox and Gaver suggest can be mitigated by policyholder dividends. This study demonstrates an empirical relationship between the payment of policyholder dividends and the costs of managerial discretion in mutual life insurers, using data on 80 mutual life insurers for 1985 through 1993. The findings are consistent with an environment where managers pay increased policyholder dividends in order to bond the usage of free cash under their control. The findings hold under different specifications of the estimated model, and for a control sample of stock life insurers with participating policies. Background literature is described in the next section. Following a description of data and the research design, results and conclusions are presented. BACKGROUND LITERATURE Effectiveness of Managerial Control Managers can neutralize internal controls by seeking fixed salaries (Walsh and Seward, 1990). …