Do Publicly Traded Property–Casualty Insurers Cater to the Stock Market?

ABSTRACT This article examines the catering theory in the insurance industry. We investigate whether managers of publicly traded insurers pursue a growth strategy catering to the stock market's preference. Two hypotheses are tested in this study: (1) an insurer will devote more efforts to increasing premium growth when the stock market places greater values on growth, and (2) this catering effect will be more pronounced at firms where managers have greater incentives to maximize short-term stock prices. We find evidence supporting both hypotheses. Our study discovers a new channel through which the stock market and executive compensation affect insurance companies' business strategies and the insurance market. The implication of the interplay between insurers and the stock market is significant and deserves future research. INTRODUCTION A healthy and sustained growth strategy is important to the success of an insurance company. Rapid growth, however, may come at a price of reduced profitability and excessive risk taking, especially when high-growth target is achieved by loosened underwriting selectivity. (1) Previous studies find managers who are concerned about short-term stock price may react to stock market signals by adjusting their business strategies (see, e.g., Baker et al., 2003). Whether the growth strategy of an insurance company is affected by the stock price of the company is the question we address in this study. There is a considerable literature investigating the influence of stock valuation on managerial decisions. A thread of literature proposes various catering theories describing that short-run-oriented managers tend to make decisions that cater to investor preference. For example, Baker et al. (2003) develop a catering theory of investment, which describes how managers make investment decisions according to stock price movements. Baker and Wurgler (2004a, 2004b) and Li and Lie (2006) propose a catering theory of dividends, which predicts that managers cater to investors demand for dividends when make decisions on dividend payments. Rajgopal et al. (2007) propose a catering theory of earning management showing that it is driven by the prevailing investor demand for earnings surprises. Aghion and Stein (2008) present a model in which managers cater to the market by focusing on a firm's growth (or profit margins) performance when the stock market rewards strong growth (or profit margins) performance more heavily. Simliarly, Baker and Wurgler (2002) examine the influence of stock valuation on a firm's capital structure, Shleifer and Vishny (2003) investigate how stock valuation drives mergers and acquisitions, and Subrahmanyam and Titman (2001) model the effect of stock prices on a firm's cash flow. As evidence supporting the catering theories has accumulated (e.g., Baker and Wurgler, 2002, 2004, 2004b; Baker et al. 2003; Rhodes-Kropf and Viswanathan, 2004; Dong et al., 2006; Glushkov and Salavei, 2009), little is known about its application to the insurance industry, which serves as the motivation for this study. The rationale for examining the catering theory in insurance industry is due to the unique features of the insurance industry. First, the insurance industry is heavily regulated because of its importance for social steadiness, which leaves limited room for managerial discretion for insurance companies, compared to firms in other industries. For instance, in many states the insurance rate is regulated on a prior approval basis. As a result, insurance companies usually cannot easily boost sales by lowering price, like manufacturing or retail industries. Second, as insurers are buying risks from customers, business expansion brings not only higher income but also greater risks. When making decisions on firm growth strategies, managers of insurance companies need to take into account the risk associated with firm growth. Third, insurance companies are generally considered experts in risk management and follow a philosophy of prudence. …