Open-Market Stock Repurchases by Insurance Companies and Signaling

ABSTRACTThe signaling hypothesis of share repurchases implies that management uses repurchases to signal either that their firm's future operating performance will improve or that shares of their stock are simply underpriced by the market. This study examines which of the two interpretations can better explain open-market share repurchase programs announced by insurance companies. We find no evidence that future-operating performance of insurers improves following the repurchase announcement. In addition, changes in future operating performance cannot explain the announcement-period abnormal return. Instead, the stock undervaluation prior to the repurchase announcement can significantly explain the announcement-period abnormal return, particularly for life insurers. Overall, our results suggest that the positive market reaction to insurers' open-market share repurchase announcements is due to the stock undervaluation by the market, but not due to positive information content about future operating performance conveyed in the repurchase announcement.The finance literature has documented significantly positive market reactions around announcements of open-market stock repurchase programs. The most prominent explanation for this finding is the signaling hypothesis (Vermaelen, 198 1).1 However, there are two interpretations for the positive market reaction under the signaling hypothesis.The first interpretation is that the stock is fairly priced based on publicly available information, but is undervalued if private information is considered. Under this hypothesis, share repurchases are associated with positive announcement excess returns because managers use share repurchases to convey favorable private information about their firm's future prospects - the performance-signaling explanation (Vermaelen, 1981). The second interpretation is that the market is inefficient and managers use share repurchases to signal that their stock is undervalued based on publicly available information - the undervaluation-signaling explanation (Oded, 2005). The undervaluation-signaling hypothesis suggests that repurchases do not signal improvements in future operating performance. Instead, repurchases signal management's disagreement with the market in interpreting publicly available information.While both the performance signaling and the undervaluation interpretations can explain the positive market reaction to share repurchase announcements, prior studies (e.g., Born et al., 2004; Miller and Shankar, 2005; Polonchek and Miller, 2005) that analyze share repurchases by insurance companies do not make a distinction between undervaluation signaling and the performance signaling in explaining the market reaction. A significant contribution of our article is to address this shortcoming by examining which of the two interpretations of the signaling hypothesis can better explain the market reaction to open-market share repurchase announcements by insurance companies.Our article also contributes to the literature by focusing on repurchase programs announced by insurance companies. Insurance firms provide an opportunity to learn more about the information conveyed in repurchase announcements. Unlike industrial companies, insurance companies are regulated and closely monitored by several agencies such as state and rating agencies. Insurance regulation encompasses several activities to protect consumers and to ensure that insurance companies are financially viable.2 Accordingly, insurance companies have less asymmetric information when compared to industrial companies. Thus, the stock market may react less to corporate policies (e.g., dividend policy and share repurchase) announced by insurance companies. For instance, Akhigbe et al. (1993) find that the market reaction to dividend-increase announcements by insurers is smaller than that of industrial firms, suggesting that insurers' dividend policy contains less informational signal. …