On the lack of participating policy usage by stock insurance companies

ABSTRACT Stock insurers can reduce or eliminate agency conflicts between policyholders and stockholders by issuing participating insurance. Despite this benefit, most stock companies don't offer participating contracts. This study explains why. We study an equilibrium with both stock and mutual insurers in which stockholders set premiums to provide a fair expected return on their investment, and with a policyholder who chooses the insurance contract that maximizes her expected utility. We demonstrate that stockholders cannot profitably offer fully participating contracts, but can profitably offer partially participating insurance. However, when the policyholder participation fraction is high, the fair-return premium is so large that the policyholder always prefers fully participating insurance from the mutual company. Policies with lower levels of policyholder participation are optimal for policyholders with relatively high risk aversion, though such policies are usually prohibited by insurance legislation. Thus, the reason stock insurers rarely issue participating contracts isn't because the potential benefits are small or unimportant. Rather, profitability or regulatory constraints simply prevent stock insurers from exercising those benefits in equilibrium. INTRODUCTION The roles of owner and customer are distinctly separate in stock insurance companies, and this separation creates incentive conflicts not present in mutual companies. (1) For example, stockholders have an incentive to expropriate policyholder wealth by increasing the volatility of the firm's assets, creating a conflict similar to Jensen and Meckling's (1976) stockholder-bondholder conflict. Also, managers of a stock insurer may rationally forego certain positive net present value projects, and this underinvestment problem can be particularly severe among insurers with high leverage. Stock insurers can reduce or eliminate these incentive conflicts by issuing participating insurance policies. Participating policies pay dividends based on deviations of actual claims, interest, and expenses from the assumptions built into the premium, thus allowing policyholders to share in the insurer's aggregate profits (Black and Skipper, 2000). Garven and Pottier (1995) develop a formal model of participating insurance and demonstrate that participating policies can eliminate the risk-shifting conflict between a stock company's policyholders and stockholders. Krishnaswami and Pottier (2001) show that although participating business can lead to problems of reduced managerial effort, it effectively eliminates both the underinvestment and risk-shifting conflicts. And yet, it is an empirical fact that stock insurance companies rarely issue participating business. (2) In light of the potential benefits, the general absence of participating policies among stock insurers is not well understood. The primary objective of the current study is to develop a formal model that helps explain the strong positive association between participating contracts and the mutual organization. (3) It should be noted that the general absence of participating contracts among stock insurers is not necessarily evidence against the models of Garven and Pottier (1995) and Krishnaswami and Pottier (2001). Indeed, we would argue that those models are not only valid, but offer important insights into the benefits of participating business for stock insurers. In fact, Krishnaswami and Pottier (2001) offer one potential explanation for stock insurers' use of participating policies. Specifically, their model suggests that participating policy usage is dictated by a trade-off between the benefits of reducing the risk-shifting and underinvestment conflicts and the costs of exacerbating the manager-stockholder conflict. Their model does a good job explaining cross-sectional variation among the subset of stock insurers that issue participating contracts. …