Risk-Preferences and Tax-Induced Dividend Clienteles: Evidence from the Insurance Industry

ABSTRACT This study investigates the effect of differential tax treatment between life and property-liability insurers on their common stock investments. The empirical methodology is based on an after-tax mean-variance model which predicts life insurers prefer higher dividend yields than property-liability insurers at any systematic risk level. After controlling for regulation, liquidity, and risk effects, test results show that each group of insurers forms a distinct tax-induced dividend clientele. Introduction Investments are an important source of income for insurance companies; therefore, insurers are very concerned about investment decisions. The insurance literature supports the notion that investment income affects the pricing of insurance contracts. For example, Hill (1979) and Fairley (1979) note that double taxation of investment income results in higher insurance premiums in order to provide adequate returns to a company's stockholders. Also, Ang and Lai (1987) argue that asset-liability hedging (i.e., matching investment income with claims payments) can reduce insurance premiums. Although the investment activities of insurers have been of great interest to academic researchers, the existing literature has not adequately addressed insurers' investments in common stocks. The purpose of this article is to provide more insight into this issue. Common stocks are viewed by insurance regulators as much riskier than bonds, preferred stocks, money market securities, or other typical insurance investments. An investigation of insurers' common stock investments should consider the risk factor. Moreover, since an insurer is taxed as a corporation, the effect of taxes on insurers' common stock investments should also be considered. Because of the concern over risk and tax effects on insurers' common stock investments, an after-tax mean-variance model is used to predict insurers' common stock portfolio decisions. These predictions are then tested empirically. The empirical investigation focuses on the tax-induced dividend choices of life and property-liability insurers at related risk levels. The effects of non-tax factors, such as safety regulations and liquidity requirements, on both insurers' common stock investments and dividend yields are also examined. The Life Insurance Company Income Tax Act of 1959 allows life insurers to obtain some tax exemption on their dividend income. If a life insurer and a property-liability insurer are in the same corporate tax bracket, the life insurer is taxed at a lower tax rate on dividend income than the property-liability insurer. This differential tax treatment could cause life insurers to prefer higher dividend yields than property-liability insurers. [1] The after-tax mean and variance model predicts that such tax-induced differences in dividend preference between the two types of insurers can be identified empirically if the risk level is properly controlled. Empirical tests using the actual common stock portfolio data of the largest life and property-liability insurers show that sample life insurers obtain higher portfolio dividend yields than sample property-liability insurers at a given beta level. Moreover, such differences in dividend yields are more pronounced at higher beta levels than those at lower beta levels. To further study whether the observed differences in portfolio dividend yields between the two types of insurers can be explained by non-tax factors, such as safety regulations and liquidity requirements, the basic characteristics of stocks in the sample life insurers' portfolios are compared with those in the sample property-liability insurers' portfolios. Although both types of insurers are found to avoid high-variance or low-liquidity stocks, systematic differences in investment opportunities between the two types of insurers appear to be absent. Specifically, the variance of returns, the average trading volume, and the dividend yields on the individual stocks in the sample life insurers' portfolios are similar to those in the sample property-liability insurers portfolios. …