Regulation, Capital Structure and Organizational Form in U.S. Life Insurance by George Zanjani¤ Federal Reserve Bank of New York 33 Liberty Street New York, New York 10045 Phone: 212-720-6320 Email:
[email protected] Abstract This paper studies organizational form choice in the life insurance industry between 1900 and 1949. It questions the prevailing wisdom about the decline of the mutual—that consumer protection regulation enabled the stock …rm to rise by engendering consumer con…dence. Instead, the evidence suggests that 1) organizational form choices were made with an eye to avoiding regulation when possible, and 2) regulation favored the stock form by requiring large deposits or minimum capital from start-up companies, which were di¢cult for mutual companies to provide. The paper models the mutual’s disadvantage in raising capital, showing the theoretical in‡uence of capital considerations on form choice at incorporation time. This helps to explain the in‡uence of regulation evident in the data, as well as the connection between “tight” capital market conditions and mutuality.
¤
I thank Gary Becker, Pierre-Andre Chiappori, Ken Garbade, Charlie Himmelberg, Jim Mahoney, Anup Malani, Hamid Mehran, Tomas Philipson, and seminar participants at the Federal Reserve Bank of New York for helpful comments and discussions. Errors are mine. The views expressed in this article are those of the author and do not necessarily re‡ect the position of the Federal Reserve Bank of New York or the Federal Reserve System.
1
Introduction
Taken as a group, mutual life insurance companies rank among the most important consumer-owned businesses in the history of the United States. Yet, the latter half of the 20th century was one of terminal decline. The mutual form was rarely chosen for new incorporations after the early 1950’s and declined dramatically in terms of absolute numbers and market share. It is hard to view the survivors of today as anything other than vestiges of the past. The common view is that the mutual’s decline was driven by the spread of consumer protection laws. As states took over insurance supervision, the alignment of owner with consumer incentives o¤ered by the mutual declined in importance. Firm owners were no longer able to expropriate policyholder wealth, and the path was cleared for the stock form, which was in other respects more e¢cient than the mutual form, to ascend to dominance in the U.S. life industry (Hansmann [5], p. 271; Swiss Re [23], p. 11). This paper studies the record of life company incorporations in the …rst half of the 20th century and …nds evidence contradictory to the common view. The record suggests that entrepreneurs made incorporation decisions with an eye to avoiding regulation, instead of embracing the supposed bene…ts of third-party oversight and regulatory enforcement. Indeed, mutuals enjoyed relative success in situations where they were subjected to less stringent regulations than stock companies. However, in situations where strong consumer protection laws applied to both forms, stock …rms were clearly preferred; this suggests that the laws posed greater adjustment costs for mutuals than for stocks. The likely explanation lies in the nature of the laws. The linchpins of consumer protection regulations were minimum capital, asset, and deposit requirements. These laws struck at the heart of the mutual form’s inferior access to the capital markets. When applied evenly across organizational types, these laws tended to favor the stock …rm, which, unlike the mutual …rm, was able to raise large amounts of capital up front. Since mutuals enjoyed relative success in states where minimum funding laws were applied only to stock …rms, it seems unlikely that consumer con…dence was the source of the laws’ e¤ects. Instead, the e¤ects appear to have derived from the di¤erences between stock and mutual company access to capital. Beyond challenging the accepted view of the mutual’s decline, these results call to attention the importance of compliance costs in the “legal approach” to corporate governance (La Porta et al. [11], [12], [13]). Economists 1
have tended to view both investor and consumer protections favorably from the standpoint of corporate governance—as “enablers” of more e¢cient forms of organization. However, the protections granted to claimants are not free, and the evidence from the U.S. life industry suggests a more complex picture. Here, consumer protection regulations did eventually aid in the ascent of the stock …rm, but they also engendered substitution and even outright ‡ight1 toward unregulated or less regulated alternatives before laws were harmonized across organizational forms. Entrepreneurs appear to have been inclined toward the path of least regulatory resistance at incorporation time, if and when such a path existed. This inclination suggests that the stock life insurance company was not necessarily more e¢cient than its non-proprietary competitors: It was merely better suited to operate within the constraints imposed by the regulators. Put di¤erently, the stock …rm may have been the most e¢cient way to deliver consumer protection in the form demanded by regulators, but not necessarily more e¢cient than the alternative of unregulated non-proprietary production. The rest of this paper is organized as follows. Section 2 presents data on company formation between 1900 and 1949. It shows a strong association between regulatory capital requirements and choice of organizational form. Mutual incorporations tended to be observed under state laws featuring minimal initial funding requirements and rarely in states that required signi…cant deposits or initial surplus. The evidence also documents the e¤ects of the …nancial distress of the 1930’s, during which mutual incorporations increased signi…cantly relative to stock incorporations. Section 3 develops a theory to explain the patterns in the data, borrowing heavily from and synthesizing the works of Jensen and Meckling [8], Mayers and Smith [14], and Hansmann [5], [6]. The theory focuses on the trade-o¤ between the superior alignment of incentives o¤ered by the mutual form and the superior access to capital of the stock form. In this framework, organizations needing strong capitalization will …nd the stock form attractive, while organizations needing little capital will …nd it easier to retain the mutual form. This leads to implications for the e¤ects of regulation and risk: Minimum capital requirements and higher aggregate claims uncertainty increase the importance of capital and thus tend to encourage the stock form. It also illuminates the connection between “hard times” and mutuality: Increases in the cost of capital encourage …rm incorporators to substitute toward the 1
See Zanjani [25] on the rise and fall of fraternal life insurance.
2
mutual form, which is more e¢cient at lower levels of capitalization. Section 4 concludes.
2
Data and Evidence
2.1
The Big Picture — Mutuals and Stocks since 1850
Figure 1 shows the history of the mutual share of the legal reserve market since 1850.2 Mutuals burst onto the scene in the 1840’s and achieved dominance by 1850 with a market share exceeding 85%. Stock …rms rebounded during the period surrounding the Civil War, grabbing 46% of the market by 1870. Rough parity between stock and mutual market share existed until the 1910’s, after which the mutualizations of Metropolitan, Equitable, and Prudential pushed mutual market share to 75 percent. This share held until 1950, after which it declined steadily. By 2000, mutuals held less than one-third of the market. The tug-of-war between stocks and mutuals can also be seen in the company counts. According to Stalson [24], there were 33 mutuals, representing about 40% of all legal reserve companies, operating in 1900. A spurt of stock company formation in the century’s …rst decade lowered mutual share to 20% by 1910, but the mutual form held its ground between 1910 and the early 1950’s. Growth in company counts was healthy. The peak arrived in 1953, with 171 mutuals in existence—representing 20% of total companies in operation. Alas, mutuals were rarely chosen for new incorporations after the early 1950’s, and their numbers dropped steadily. In 2000, fewer than 100 mutuals were in operation in the United States—a mere 5% of the total number of companies.3 2
Estimates are based on insurance in force and are provided at (approximate) 5-year intervals starting in 1850. Estimates for 1850 through 1945 are constructed using Stalson [24] and Spectator Company [21], [22]. Stock and mutual companies were classi…ed using information in Stalson’s Tables A, E, F, and 15; the “Reports” section of the Spectator [22]; any reference in the historical texts; and (as a last resort) whether or not the company was listed as having a capital stock in the “History” section of the Spectator [22]. Estimates for 1950 and forward were based on American Council of Life Insurance [1]. Comparison of the estimates from the di¤erent sources in overlapping periods showed only small discrepancies. 3 The source for the post-1950 data is ACLI [1]. This overstates the case somewhat, as the group form of organization (in which multiple insurance companies belong to a similar parent) became popular after 1950. On a consolidated basis, mutuals comprised a much
3
Thus, the mutual life insurer may not have disappeared in the latter half of the 20th century, but it certainly ceased to be the form of choice. Consequently, while it is still possible to study mutual company behavior with current data, it seems unlikely that recent experience will yield much insight about how and why these organizations rose to prominence. For such insight, we must turn to a time when the war for organizational dominance was still in progress.
2.2
Incorporations at the State Level — 1900-1949
The company formation data was collected from the annual issues of the Spectator Life Insurance Year Book, from 1900 to 1952. The primary source was the “Reports of Life Insurance Companies” section, although earlier issues simply listed the companies in tabular form. The type of company (mutual or stock) and the state and year of incorporation were noted. In cases where the year of incorporation was not listed, the “year commenced” was taken to be equivalent to the year incorporated. It was also noted whether the company was reincorporating as a legal reserve company (such moves were often made by fraternal insurers and assessment companies) or starting “fresh.” As can be seen in Figure 2, the popularity of mutuals in the …rst half of the 20th century was far from uniform. Stock …rms were the dominant choice for new incorporations in most states. But in a handful of states, mostly located in the Midwest, mutuals were near or above parity when it came to new company formations. The di¤erences among neighboring states are striking. Mutuals made up more than half of the 87 companies formed in Iowa and Nebraska between 1900 and 1949, but only two of 87 in Missouri, Oklahoma, and Colorado. They comprised 10 of the 30 companies formed in North Carolina, but none of 36 in Kentucky and Virginia. In the West, mutuals accounted for 30% of new incorporations in Washington, but only 7% in California and Oregon. Di¤erences in state regulation seem a likely culprit. States hold the power to regulate insurance in the U.S., and the exercise of that power led to substantial state-level variation in the law regarding the incorporation and operation of insurance companies. In particular, states di¤ered as to the nature and level of …nancial requirements imposed on incorporating companies larger share of the total.
4
during this time period. These requirements took the form of mandatory deposits, assets, or capital and were applied unevenly within states in the sense that the requirements for mutual companies were often di¤erent than those for stock companies. To examine the connection between state law and the form chosen by incorporating companies, statute compilations and session laws for the 48 mainland states and the District of Columbia were used. In each case, the statutes were used to determine the …nancial requirements for the incorporation of domestic legal reserve stock and mutual companies for any years in which companies were formed in a given state or jurisdiction. The requirement of interest is the capital, assets, or deposit that the company needed to provide before starting business.4 Precise dates (day and month) of company formation were not collected, so, in cases where a company was formed in the year of a law enactment, it was assumed that the new law applied to the incorporation if it was enacted in the …rst half of the year in question.5 Tables 1 and 2 break down the incorporations according the …nancial requirements that existed for stock and mutual companies in the relevant state and year. The requirements are simpli…ed to the total amount of cash that was necessary to start the company, regardless of whether this cash represented capital or premiums.6 Table 1 shows that “start-up” mutual incorporations were concentrated in circumstances characterized by 1) a low initial cash requirement for mutuals ($25,000 or less) and 2) a high initial cash requirement for stock …rms ($100,000 or more). Of the 138 start-up mutuals in the sample, 114 were formed under these circumstances—accounting for 4
The initial requirement was not the only deposit required during operation. Some states required periodic deposits subsequent to starting business, either to fund the liabilities incurred through issuing contracts or to meet a …xed level of security deposit. However, the later deposits could generally be funded out of operating cash ‡ow, so, for reasons discussed in the theoretical portion of the paper, they were likely to be less of a burden for start-up companies. 5 Some quali…cations are necessary. Although the data collection exercise is straightforward on paper, insurance codes of this period usually lacked clarity and were sometimes littered with con‡icting provisions. It was not uncommon to encounter ambiguity when determining which provisions applied to legal reserve companies as opposed to the assessment companies, associations, fraternal orders, and the myriad other organizations that participated in the life industry. Discretion was used in cases that were unclear. 6 Thus, some di¤erences in the stringency of the requirements are masked. For example, a $100,000 capital/surplus requirement would be equated to a $100,000 asset requirement in this table, although the former is a tougher hurdle than the latter.
5
about one-third of total incorporations under these conditions. By contrast, only 14 start-up mutuals were formed in situations with high initial cash requirements for mutuals, less than 4 percent of the total …rms formed under such conditions. Thus, …rm organizers were more inclined to opt for the mutual form when the …nancial hurdles associated with mutual incorporation were lower than those associated with stock incorporation. Table 2 examines the reincorporation patterns of assessment companies, fraternal orders, and other associations involved in the life business. As the states grew hostile toward alternative methods of life insurance production in the …rst half of the 20th century, many of the “alternative” organizations chose to reincorporate as old line legal reserve corporations. As a group, these reincorporators were much more likely to adopt the mutual form than their start-up counterparts: Nearly half of the reincorporators in the sample chose the mutual form. The in‡uence of …nancial requirements, however, is still clear. When the …nancial requirement for mutuals was low, reincorporators mutualized more than two-thirds of the time. When the requirement was high, reincorporators chose the mutual form less than one-third of the time. Two features of the reincorporators are important for understanding the di¤erences between Table 1 and Table 2. First, minimum asset or capital requirements were likely to be less problematic for reincorporators, since they had been operating for some period of time prior to reincorporation and thus had had a chance to accumulate assets. Second, they were more likely to be non-pro…t in nature and operation and, therefore, may have been more philosophically inclined toward the mutual form than the start-up companies. Table 3 breaks down incorporations by decade, o¤ering insight into the relationship between the status of the capital markets and the viability of the mutual form. The Depression years stand out as a period of exceptionally high preference for the mutual form relative to that seen in the neighboring decades. Mutuals accounted for about one-third of the incorporations made in the 1930’s, a level not seen since the 1890’s (Stalson [24]). To investigate these e¤ects more rigorously, we use a logit speci…cation to test the relationship between the propensity to form a mutual and the law variables discussed above. Table 4 presents summary statistics and Table 5 presents the regression results. The dependent variable takes a value of one when the company formed is a mutual and zero when it is a stock. The results con…rm the patterns suggested by the cross-sectional averages presented in the earlier tables. The mutual and stock requirements were negative and positive, respectively: Higher cash requirements for mu6
tuals tended to discourage mutual formation (relative to stock formation), while higher cash requirements for stocks did the opposite.7 Furthermore, the e¤ect of the mutual requirement is larger than the e¤ect associated with the stock requirement; this is consistent with the idea that initial …nancial hurdles are more problematic for mutual companies than stock companies. The reincorporation dummy is strongly positive, con…rming the stronger inclination of reincorporators to choose the mutual form. In addition, the interaction between the mutual cash requirement and the reincorporation dummy is positive and signi…cant, indicating that mutual cash requirements were a less signi…cant barrier for reincorporators than for start-ups. Finally, the time dummies provide some indication that mutual formation rebounded during the Depression years.
2.3
Other Laws
An alternative explanation for these …ndings is that …nancial requirement laws were not the driving force behind incorporation decisions but merely proxied for other laws or environmental conditions that were important. For example, if high …nancial requirements were associated with regulatory regimes that o¤ered strong oversight and restrictions on managerial (mis)behavior, it is possible that the latter aspects of regulation were the real factors behind organizational form decisions. Although state …xed effects (see Table 5) control for some of the di¤erences in regulatory regimes, the regimes did change over time. This section presents regression results with controls for other insurance laws included. Indeed, the …rst decades of the 20th century brought signi…cant changes in insurance regulation in the wake of the Armstrong Committee investigation of 1905. The Armstrong reforms addressed a vast range of insurance activities, including company investments, policy forms, management expenses, and state oversight. Not all of the recommended reforms were innovations, nor were they adopted universally by the states. For example, the Armstrong Committee a¢rmed the wisdom of annual valuations of insurance company 7
The connection between minimum capital requirements and organizational form may extend beyond the insurance market. In a cross-country study, La Porta et al.[13] …nd a large negative relationship between a “legal reserve” (i.e., capital) requirement for corporations and concentration of ownership. A possible interpretation of this …nding is that organizations needing higher capitalization found it optimal to sacri…ce control by tapping into the equity markets.
7
liabilities, but this was a common feature of state insurance codes before 1905. On the other hand, few state codes required board approval of investment decisions and o¢cer salaries before Armstrong. To control for other regulatory changes, statute compilations and session laws were consulted to identify important (and easily veri…able) types of insurance laws in the states, as well as their enactment dates.8 Table 6 describes the laws identi…ed by this exercise and …les them into categories. “Oversight” laws concern the obligations of the insurance department (e.g., examination, valuation) and rules that facilitate supervision (e.g., annual statements, vouchers). “Policy” laws concern regulations on policy forms, especially required provisions. “Conduct” laws concern investments, expenses, and other aspects of production behavior. “Board” laws are ones that require board of director review of management actions. The “Other” category is for laws that regulated fraternal orders. The “Constructed” category refers to variables that were generated by the author. The table also classi…es the laws as to whether they were explicitly endorsed by the Armstrong Committee and provides statistics on the fraction of the sample (and states) with the laws. Table 7 presents the regression results. As can be seen, adding the additional controls does not in‡uence the basic results on …nancial requirements. More surprising, however, is the fact that the additional regulations do not appear to have been associated with stock company formation. Taken as a whole, the coe¢cients on the regulation variables are positive, suggesting that their enactment was associated with higher rates of mutual formation. This puzzling …nding may be partly explained by other aspects of Armstrong legislation not contained here—such as the provisions concerning policyholder rights and elections in mutual companies. But it could also indicate that the regulations e¤ected transfers from owners to consumers, thereby making the stock …rm less viable relative to the mutual form. At any rate, this exercise reveals only two candidate factors to explain the trend toward the stock form: urbanization and rising …nancial requirements. 8
Again, some quali…cations are necessary. First, unless compilation or session law indices indicated otherwise, only the insurance code was consulted. Thus, relevant laws buried in sections of the general corporate law or the criminal code may have been missed. Second, not all session laws and compilations were reviewed; thus, it was possible to miss laws that were enacted and subsequently repealed within the …ve decade period.
8
3
Theory
The empirical work suggests that …nancing issues had an important impact on organizational form choice. Mutual formation was seen mostly in situations where initial …nancial requirements were minimal and appears to have been discouraged by high requirements. It also appears to have been associated with tight capital market conditions in the Great Depression—a repeat of a regression toward non-proprietary organizational forms witnessed in other times of capital market turmoil, such as the 1840’s and 1870’s (see, e.g., Smith and Stutzer [20]). This section attempts to explain these results with a simple model of the trade-o¤ between the superior alignment of owner with consumer incentives o¤ered by the mutual form and the superior access to capital o¤ered by the stock form. These basic building blocks are well-known in the theoretical and empirical literature.
3.1
Context and Related Literature
Alignment of incentives has been stressed by Mayers and Smith [14] and Hansmann [5], [6] as the principal advantage of the mutual form. Since the …rm’s owners are the consumers, there will be less pressure on management to increase pro…ts at the expense of product quality. For example, a pro…t-motivated owner might encourage management to increase leverage by pursuing a high-growth policy, while a policyholder-owner would reject such a strategy—recognizing that any increase in the value of her equity would be o¤set by an impairment in the value of her policy. Access to capital is a well-known advantage of the stock form and has been studied in several contexts. For example, Cummins and Subramanian [3] argue that access to capital is a primary motivation for demutualization. Another is Harrington and Niehaus [7], who show evidence that the relatively poor capital market access of mutuals leads to conservative capital targets and adjustment policies relative to stock …rms. The trade-o¤ between incentives and capital access is widely recognized but rarely emphasized in organizational form analysis.9 This section explores the implications generated by sticking these building blocks together in a 9
There are some exceptions. In addition to the prominence given capital access in analyses of demutualization, Philipson and Zanjani [18] and Remmers [19] note the potential importance of capital issues in explaining organizational form choice.
9
theoretical context. The “glue” will be the agency, monitoring, and …nancial distress costs discussed by Jensen and Meckling [8]. These costs provide a basis for understanding the di¤erences in capital market access of di¤erent organizational forms.
3.2
General Model
Much of the value of an insurance policy is revealed well after the policy is bought. The consumer will not know whether the company will meet its obligations until she …les a claim. The consumer can, however, form an expectation by assessing the …nancial resources available to the …rm and the likely future behavior of management. Formally, let K be the surplus or equity capital—the “cushion” available if results turn out to be worse than expected. Total capital is composed of capital contributions from consumers (E) and contributions from outside investors (I); so that K = E + I: Let a 2 [a; a¹] be the expected action of company management. The action could represent a variety of choices— regarding the company growth rate, claims-handling practices, investment strategies, or other activities—that increase company pro…tability (owner value) but decrease the value of consumer policies. The key idea, common to analysis of organizational form, is that the action is taken after the policy is purchased and cannot be speci…ed in the policy terms. With these de…nitions in place, denote the consumer’s valuation of the insurance policy as V (K; a): Valuation is increasing in capital (VK ¸ 0); as this adds to the likelihood that the company will meet its obligations. Similarly, the valuation is decreasing in management action (Va · 0): Total production costs depend on the organizational form chosen and are determined by 1) the amounts of and sources for capital and 2) management action. Furthermore, management action is determined by the control rights and incentives implicit in the organizational form chosen. Accordingly, we write production costs as C j (E; I; aj ); where j is an index of organizational form type. (In later analysis, we consider the stock (j ´ s) and mutual (j ´ m) forms, although other types can obviously be accommodated in the general problem.) The cost function is increasing in the …rst two arguments, which represent the costs of raising capital from consumers and investors, respectively. With fair pricing, the problem of optimal insurance production can then be reduced to one of choosing an organizational form and capital levels con10
ditional on the form chosen: n
o
max V (E + I; aj ) ¡ C j (E; I; aj ) : j;E;I
(1)
The potential for trade-o¤s in the organizational form choice are evident. Di¤erent forms exhibit di¤erent cost functions and produce di¤erent kinds of management behavior. For example, the stock …rm might be cost-e¢cient relative to the mutual …rm, but be less attractive with respect to management action. Of course, the devil is in the details. More structure is needed to develop the comparative statics of organizational form. To this end, we study the stock and mutual forms by importing the organizational advantages discussed in the literature and adding assumptions to the value and cost functions.
3.3
Application: Stock and Mutual Firms
This section considers two polar cases of organizational form for insurance. At one pole is the pure mutual company, where the owners are the policyholders. Policyholders control management actions and own the pro…ts. Capital is raised from policyholders in the form of equity and from investors in the form of subordinated debt. At the other is the stock company, where the owners are outside investors. The investors control management actions and own pro…ts. The investors may include policyholders, who own stock along with their policies, but it is assumed that voting control rests with outsiders. These idealized organizations are simpli…ed in several respects. For example, the extent to which owners actually control managers and how such control is a¤ected by organizational variables is the subject of debate, but is not the focus here. Furthermore, “hybrid” organizations can be imagined and did exist. Some life companies featured boards split between investor nominees and policyholder nominees. Others included dividend limitations in the charter, apparently aimed at restricting expropriation. Another possibility is a company controlled by policyholders, but where capital is raised from outside investors in the form of non-voting equity rather than subordinated debt. Considering such alternatives alters and complicates the form of the analysis, but does not change the basic ideas. Throughout the application, we assume twice-di¤erentiable functions and: 1. V (K; a) is concave and separable: V (K; a) ´ u(K) + w(a): 11
2. a a¤ects costs through the convex function z(:); which is decreasing at a and has an interior minimum on [a; a ¹]: 3. The cost of raising capital from investors, re‡ecting any transaction costs and the opportunity cost of capital, is a constant ri per unit of capital. The analogous rate for consumers is an increasing and convex function of the amount raised: re (E): 4. Debt is associated with additional costs of monitoring or …nancial distress. These are denoted as an increasing and convex function of leverage, d( EI ); with d(0) ´ 0: The …rst assumption is for simplicity. The second sets up the basis for a con‡ict of interest between residual owners and consumers. The third and fourth are discussed in more detail below. Capital can be raised from both consumers or investors. The costs of obtaining capital from consumers may be much di¤erent than the costs associated with accessing investors through the capital markets. At small levels of capital, it may be advantageous to rely on consumers, even in the absence of any di¤erences in investment opportunities. Since capital is used after the product is sold, there are economies of scope in the selling the product together with equity in the enterprise. However, at larger levels of capital, borrowing constraints and diversi…cation issues appear—the depth of the broader capital markets is a luxury sacri…ced when consumers are the sole source of capital. The third assumption captures these ideas. The gross return required by investors is independent of the amount raised, re‡ecting the “smallness” of the insurance company relative to the capital markets. The rate required by consumers is increasing, re‡ecting the growing burden of the capital contribution as it gets larger relative to consumer wealth. Economies of scope may cause the initial marginal cost of raising capital from consumers to be lower than the marginal cost of raising capital from investors, re (0) < ri ; but this advantage will diminish with the amount needed. The fourth assumption concerns additional costs that must be considered when deciding how much equity to issue to policyholders. If the company retains the mutual form and issues subordinated debt to the outside investors, it incurs costs of monitoring and …nancial distress, as described by Jensen and Meckling [8]. Thus, even in regions where re > ri ; it may be bene…cial to sell extra equity to policyholders in order to reduce debt leverage. 12
No distinction is made here between equity sold to policyholders and equity sold to investors. This is not problematic in the case of stock …rms, some of which did in fact sell common shares to policyholders at formation. However, it ignores the di¤erence between the equity held by policyholders in mutual companies, which cannot be fully liquidated or transferred, and common shares held by policyholders in stock companies, which can be sold. Ignoring this distinction simpli…es the analysis, but it should be remembered as a reason why the capital costs faced by outside investors need not move in tandem with those faced by policyholder-investors. 3.3.1
The Mutual Firm
With the above assumptions, the cost function of the mutual form can be described as: I C m (E; I; am ) = re (E)E + ri I + d( ) + z(am ): (2) E To see how am is chosen, consider the incentives of the policyholderowners, who control management action and own all pro…ts. If pm is the price paid, pro…ts are I ¼ m (E; I; pm ; am ) = pm ¡ z(am ) ¡ ri I ¡ d( ): E After capitalizing the …rm, the policyholder-owner’s utility is given by u(K) + w(am ) ¡ pm ¡ re (E)E + ¼ m (E; I; pm ; a);
(3)
(4)
which reduces to I u(K)+w(am )¡re (E)E¡z(am )¡ri I¡d( ) ´ V (K; am )¡C m (E; I; am ): (5) E Evidently, the choice, am ; will satisfy wa ¡ za = 0:
(6)
In other words, the policyholder-owner instructs management to balance the marginal addition to pro…ts from cost reductions (za ) with the marginal loss in policy values, wa : The policyholder-owner’s objective here is not to maximize …rm pro…ts by minimizing costs, since cost reductions come at the 13
expense of reductions in policy values. Since the policyholder-owners own both the …rm’s equity and the …rm’s policies, they must consider both when directing the actions of management. 3.3.2
The Stock Firm
A pure stock company issues equity instead of debt, and it avoids the monitoring and distress costs present in the mutual form: C s (E; I; as ) = re (E)E + ri I + z(as ):
(7)
However, by adopting the stock form, the company cedes control to outside investors and may incur costs associated with the loss of policyholder direction over management action. To see how management action will differ, consider the pro…t function of the stock form (where ps is the price of insurance): ¼ s (ps ; as ) = ps ¡ z(as ):
(8)
This pro…t function lacks the monitoring and interest costs present in the mutual analog. Pro…t maximization implies that as satis…es za = 0:
(9)
Contrasting this result with (6) above reveals the crucial and familiar aspect of behavior ascribed to stock …rm management: Stock …rms maximize pro…ts without concern for the e¤ect of pro…t maximization on policyholder welfare. This is not a complete loss for the policyholders, as they may be partial owners of the …rm. To see this, write the utility of the policyholder as: E s s s ¼ (p ; a ): (10) K The last term is the fraction of pro…ts owned by policyholders, who own pro…ts according to the proportion of total …rm capital that they contributed. If pricing is competitive and capital earns only the fair rate of return, ri ; (10) reduces to u(K) + w(as ) ¡ ps ¡ re (E)E +
u(K) + w(as ) ¡ re (E)E ¡ z(as ) ¡ ri I ´ V (K; as ) ¡ C s (E; I; as ): 14
(11)
3.3.3
The Choice of Organizational Form
Comparing (5) and (11) reveals the trade-o¤ involved in choosing between the stock and mutual forms. The cost of adopting the stock form comes in the form of less attractive (from the perspective of the policyholder) management behavior, quanti…ed as a …xed cost Qa : [w(am ) ¡ z(am )] ¡ [w(as ) ¡ z(as )] ´ Qa > 0:
(12)
The bene…t comes in the form of cheaper capital, quanti…ed as a varying cost QK (I s ; E s ; I m ; E m ) : [u(K s )¡u(K m )]¡ri (I s¡I m )¡[re (E s )E s ¡re (E m )E m ]+d(
Im ) ´ QK > 0; (13) Em
where I s and E s maximize (11), I m and E m maximize (5), K s = I s + E s ; and K m = I m + E m : Thus, the stock …rm’s has a disadvantage with respect to management actions, but an advantage with respect to capital issues. Its greater capital e¢ciency leads to higher levels of overall capitalization at lower per unit costs for any level of capitalization chosen. To see this, consider the optimality conditions for capitalization, derived by maximizing(5) and (11) with respect to I and E: For mutuals, the condition reduces to uK = ri +
d0 d0 I = re0 E + re ¡ 2 : E E
(14)
For stocks, the condition is uK = ri = re E + re :
(15)
These conditions directly imply that, relative to mutual …rms, stock …rms will have higher overall levels of capital (K s > K m ); higher levels of capital contributed by outside investors (I s > I m ); and lower levels of capital contributed by policyholders (E s < E m ): The choice of organizational form amounts to a comparison of QK with Qa : If the “capital” bene…t outweighs the “management behavior” cost (QK > Qa ); the stock form will be chosen. If the reverse holds, the mutual form will be preferable.
15
This choice has a parallel with the debt-equity choice faced by the JensenMeckling entrepreneur. In that model, equity issuance mitigates the entrepreneur’s incentives to limit perquisite consumption, leading to an impairment of the …rm’s value. Debt issuance maintains the entrepreneur’s consumption incentives, but introduce risk-taking incentives and the attendant monitoring costs. In this model, the policyholders resemble the Jensen-Meckling entrepreneurs. They trade o¤ a loss of control over management (when equity is issued) against monitoring costs (when debt is issued). In practice, the policyholders will opt for debt and the mutual form if their capital needs are small. If their capital needs are large, they are more likely to choose equity and the stock form.10 As the amount raised from outside investors increases, capital costs and issues tend to become more important than the …xed costs associated with changes in owner incentives. The comparative statics of form choice boil down to an analysis of how QK ¡ Qa changes in response to a parameter change. If it increases, this means that the capital bene…t has increased relative to the management action cost, implying a shift toward the stock …rm. If it decreases, a shift toward mutuality is implied. We now analyze the e¤ects of such changes on the form choice. Capital Needs and Organizational Form An increase in the value placed on capital by consumers will tend to favor the stock form. This is shown graphically in Figure 3; when the marginal bene…t curve shifts upward from uK to u0K ; the capital bene…t (QK ) increases from A to A + B: Intuitively, the increase in the capital needs of the organization will encourage a shift toward the capital-intensive organizational type. The advantages of the stock …rm in lowering capital costs become more important relative to its disadvantages when capital becomes a bigger part of the picture. This result has at least two immediate empirical applications. The …rst concerns the e¤ect of regulatory requirements on the organizational form choice. An increase in minimum capital requirements is analogous to an increase in the consumer need for capital. If the requirements are raised, the company must meet them. Accordingly, higher …nancial regulatory requirements will tend to favor the stock …rm. The second concerns the need for capital across lines of insurance. The 10
These predictions mirror those of the “pecking order” theory (Myers and Majluf [15]).
16
volatility of loss liabilities di¤ers substantially across lines of insurance. As that volatility increases, the value of capital (to the consumer) can be expected to rise. This implies that the organizational form choice will be related to the volatility in insurance liabilities; we should see the stock …rm being relatively successful in lines of insurance with high loss volatility. Capital Costs and Organizational Form An increase in capital costs— the gross returns that must be paid to capital contributors—will tend to favor the mutual form. This intuition holds when the increase occurs in ri alone and when the increase applies evenly to ri and re : In the former case, the shift toward mutual organization is easily interpreted as a shift away from investor-based capital. In the latter case, the shift toward mutual organization represents a shift away from capital and toward a form that is more e¢cient at lower levels of capitalization. This suggests that changes in capital market conditions will have an important e¤ect on organizational form choices. When conditions are tight, company owners will be encouraged to utilize the mutual form for new incorporations, and mutualizations may also be encouraged. When capital market conditions are favorable, we can expect the stock form to be preferred.
4
Conclusion
The mutual’s decline in the latter half of the 20th century may be attributed, in part, to the factors discussed in this paper. The regulatory noose tightened considerably, as the exemptions granted to mutuals became fewer and less substantial. By 1974, all states required capital or surplus (rather than assets) to start a life insurance company, and the median state required $600,000 in surplus to start a mutual, a substantial increase (in both real and nominal terms) from 1949. Furthermore, only 12 states had incorporation laws that favored domestic mutuals with respect to initial surplus, and, of those, only two had requirements that were comparable (in real terms) to the requirements that had fostered mutual formation in the 1900-1949 period. By 1999, only 4 states showed any favoritism to domestic mutuals and, of those, two had “low” requirements. The days of being able to start a mutual with next to nothing were over.11 11
The source for 1974 is Carter [2], and the source for 1999 is NAIC [16]. The “low” states in 1974 were North Dakota ($10,000) and North Carolina ($100,000). The “low”
17
The growth of liquidity in the equity market may also have contributed to the e¢ciency of proprietary ownership versus mutual ownership during this period. Stock life insurance companies in the …rst half of the 1900’s tended to be closely-held private companies, while many are listed on major stock exchanges today. The relative calm in the …nancial markets witnessed in recent decades, as well as the decline in transaction costs over the past century (Jones [9]), may have improved the position of investor-held equity relative to policyholder-held equity. Yet, capacity shortages can be associated with shifts toward mutuality12 in the property-casualty market even in the present day; the connection between tight capital market conditions and mutuality may not be entirely in the past. Regulation’s e¤ects are often complex and di¢cult to disentangle. A law may serve as an enabler in one context and as a hindrance in another. Both notions have been explored and documented in other markets. To take one example, FDA regulation was seen as a boon by meat packers in the early 1900’s, who desperately needed third party quality certi…cation (Friedman [4], pp. 60-61); however, it was seen as a bane by dietary supplement producers in the 1990’s, who wished to market health-related products without submitting to the rigorous pre-approval process required of pharmaceuticals (Nestle [17]). The e¤ects of law on corporate organization are likely to share this complexity. As this paper demonstrated, identi…cation of legal e¤ects can be challenging. Since insurance supervision as originally conceived had little to do with organizational form, its impact on organizational form was incidental to the intent of the law. New York’s pioneering Deposit Law of 1849 (which required a $100,000 deposit from all …rms) was drafted in an era when the state did not recognize a distinction between stock companies and mutual companies, but few would argue that it had a signi…cant impact on the organizational form environment. How it changed the environment is another question. Did it work by building consumer con…dence in stock …rm management? Or perhaps it “...virtually prohibited the formation of any new mutuals” (Knight [10], p. 128). In an attempt to distinguish between these views, this paper studied the pattern of company formations across states with di¤erent laws. The …ndings, together with the rise and fall of the fraternal life sector (see Zanjani [25]), states in 1999 were North Carolina ($200,000) and New York ($150,000). 12 A prominent example is found in the medical malpractice market of the late 1980’s.
18
suggest that regulation’s hindering e¤ects were at least as prominent as its enabling e¤ects in shaping the organizational structure of the industry. These …ndings a¢rm the notion that the legal environment is a primary determinant of corporate organization and governance. While interpretation may be di¢cult, the e¤ects are too large to be ignored. The insurance industry, with its rich variety of organizational forms and legal environments, seems to be an excellent laboratory for the further study of the relationship between law and the corporation.
19
Figure 1 - Mutual Share of Legal Reserve Insurance In Force, 1840-1995.
20
Figure 2 - Legal Reserve Formations by State, 1900-1949.
21
22
23
24
25
Figure 3 - Impact of an Increase in the Need for Capital
26
References [1] American Council of Life Insurance (various years), Life Insurance Fact Book ACLI. [2] Carter, W.M. (1977), “Capital and Surplus Accounts,” in Life Insurance Accounting Strain, R. (ed.), Santa Monica: IASA. [3] Cummins, J.D., and Subramanian, K. (2002), “Ownership Structure Changes in the Insurance Industry: An Analysis of Demutualization,” mimeo, Temple University. [4] Friedman, L.M. (2002), American Law in the Twentieth Century New Haven and London: Yale University Press. [5] Hansmann, H. (1996), The Ownership of Enterprise Cambridge and London: The Belknap Press of Harvard University Press. [6] Hansmann, H. (1985), “The Organization of Insurance Companies: Mutual versus Stock,” Journal of Law, Economics, and Organization 1, 125-153. [7] Harrington, S.E., and Niehaus, G. (2002), “Capital Structure Decisions in the Insurance Industry: Stocks versus Mutuals,” Journal of Financial Services Research 21, 145-63. [8] Jensen, M.C., and Meckling, W.H. (1976), “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure,” Journal of Financial Economics 3, 305-60. [9] Jones, C. (2002), “A Century of Stock Market Liquidity and Trading Costs,” mimeo, Columbia University Graduate School of Business. [10] Knight, C.K. (1920), The History of Life Insurance in the United States to 1870 doctoral thesis, University of Pennsylvania. [11] La Porta, R., Lopez-de-Silanes, F., Shleifer, A., and Vishny, R. (2000), “Investor Protection and Corporate Governance,” Journal of Financial Economics 58, 3-27.
27
[12] La Porta, R., Lopez-de-Silanes, F., Shleifer, A., and Vishny, R. (1999), “Corporate Ownership Around the World,” Journal of Finance 54, 471517. [13] La Porta, R., Lopez-de-Silanes, F., Shleifer, A., and Vishny, R. (1998), “Law and Finance,” Journal of Political Economy 106, 1113-1155. [14] Mayers, D., and Smith, C.W. (1981), “Contractual Provisions, Organizational Structure, and Con‡ict Control in Insurance Markets,” Journal of Business 54, 407-34. [15] Myers, S.C., and Majluf, N.S. (1984), “Corporate Financing and Investment Decisions when Firms Have Information that Investors Do Not Have,” Journal of Financial Economics 13, 187-221. [16] NAIC (1999), NAIC Compendium of State Laws on Insurance Topics Kansas City: NAIC. [17] Nestle, M. (2002), Food Politics: How the Food Industry In‡uences Nutrition and Health University of California Press. [18] Philipson, T., and Zanjani, G. (2002), “The Production and Regulation of Health Insurance: Limiting Opportunism under Asymmetric Information,” in Individual Decisions for Health, forthcoming. [19] Remmers, B. (2002), “Viability of the Mutual Organizational Form,” mimeo, Pamplin College of Business. [20] Smith, B.D., and Stutzer, M. (1995), “A Theory of Mutual Formation and Moral Hazard with Evidence from the History of the Insurance Industry,” Review of Financial Studies 8, 545-577. [21] Spectator Company (1911), Life Insurance History 1843-1910 New York and Chicago: Spectator Company. [22] Spectator Company (various years), Insurance Year Book: Life New York, Chicago, and Philadelphia: Spectator Company and Chilton Company. [23] Swiss Re (1999), “Are Mutual Insurers an Endangered Species?” Sigma No.4. 28
[24] Stalson, J.O. (1969), Marketing Life Insurance: Its History in America Homewood: Richard D. Irwin, Inc. [25] Zanjani, G. (2001), “Regulation and the Rise and Fall of NonProprietary Organizations in U.S. Life Insurance,” mimeo, Federal Reserve Bank of New York.
29
