Risk Taking and Performance of Public Insurers: An International Comparison

ABSTRACT We investigate how investor protection, government quality, and contract enforcement affect risk taking and performance of insurance companies from around the world. We find that better investor protection results in less risk taking, as do higher quality government and greater contract enforceability. However, we find only limited evidence that these factors influence firm performance. We conclude that better overall operating environments result in less risk taking by insurers without the concomitant decline in performance. These results imply that better investor protection environments benefit policyholders and outside stockholders by preventing corporate insiders from expropriating wealth from policyholders and outside stockholders. INTRODUCTION The quality of the environment in which a firm operates affects its value by impacting the cash flow rights of and/or the risks endured by the firm's stakeholders (La Porta et al., 2002). Investor protection, government quality, and contract enforcement (i.e., proxies for operating environment quality) may affect the profitability/performance of and risk taking by insurance companies differently than they do industrial firms. Specifically, creditors and stockholders (insiders, i.e., controlling stockholders or managers, and outsiders or minority stockholders) are the primary stakeholders in industrial firms, but insurance companies must also consider the needs of a third stakeholder, policyholders. (1) Given the fundamental relation between risk and performance, we expect that if a better overall environment lowers risk taking and markets are frictionless, then performance will be lower as well. On the other hand, a change in firm risk without a concurrent change in performance indicates that one stakeholder group may be expropriating wealth from another. While all stakeholders may potentially benefit from increases in profitability, changes in risk taking affect the stakeholder groups differently. Increases in risk taking benefit shareholders at the expense of policyholders and creditors, if any. Likewise, reductions in risk benefit policy holders and creditors whose claims are with insurers that are less likely to default. We examine the impact of operating environment quality on risk taking and performance for life and nonlife insurance companies from around the world. Because life and nonlife insurers differ in terms of operations, investments, duration of liabilities, and vulnerabilities, we analyze these two types of insurers separately. The purpose of the article is to ascertain whether a favorable overall environment tends to benefit insurance company shareholders, policyholders, and creditors if any. We find that better investor protection and better government quality decreases risk taking by insurers but do not affect profitability. We also find that better contract enforcement and enhanced competition decreases both risk taking and profitability for life and nonlife insurers. Therefore, the preponderance of our evidence suggests that favorable operating environments benefit policyholders and outside stockholders, and that in environments with better contract enforcement and enhanced competition the benefit to these stakeholders may be driven by lower likelihood of rent extraction by controlling shareholders or managers. Our data source is confined to publicly traded companies and does not cover mutuals. Further, applicability of our findings to mutuals will be tempered by the extent to which policyholders are recognized as shareholders by a nation's laws. The article is organized as follows. First, we provide a brief review of the literature pertaining to investor protection, government quality, and contract enforcement and their impact on insurance firms. Second, we discuss our data selection process, variable definitions, and sample characteristics. Next, we present the empirical method employed and our results for life and nonlife insurers. …