Free Cash Flow in the Life Insurance Industry

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Introduction

Jensen (1986) defines free cash flow as cash in excess of that required to fund all positive net present value projects. Free cash flow tempts managers to expand the scope of operations and the size of the firm, thus increasing managers' control and personal remuneration, by investing free resources in projects that have zero or negative net present values. These unprofitable investments are an aspect of the basic conflict of interest between owners and managers. Jensen argues that some industries are particularly susceptible to the generation of free cash flow, and we posit that life insurers constitute a low-growth industry that is likely to generate such excessive cash flow.

We argue that, in the life insurance industry, wasteful uses of free cash flow occur to the detriment of the firm's owners and policyholders. Managerial abuses of free cash flow are inconsistent with the goal of owner wealth maximization. Expenditures wasted by management instead could have been distributed to the owners of stock insurers as cash dividends or to the policyholders of mutual or stock firms in the form of lower premiums, higher policy dividends, or higher investment returns.(1) While regulators primarily focus on insurer solvency, they also are concerned with maintaining premium rates that are not excessive. To the extent that regulators monitor life and health insurance rates, dividends, and surrender values, free cash flow should be of concern to them.

Mayers and Smith (1981) predict more severe owner-manager conflicts in mutual insurers than in stock insurers, and we test their prediction using data from the life insurance industry. Specifically, we test for differences in free cash flow between stock and mutual insurers in the U.S. life insurance industry.(2) Focusing on the life insurance industry allows us to isolate firms having similar investment opportunity sets and differing organizational forms, reduce measurement error in our proxy for free cash flow because of the limited variation in accounting techniques used across the industry, and control for the confounding effects between the investment opportunity set and free cash flow that arise in cross-industry studies.

The majority of existing evidence on the free cash flow hypothesis focuses on intertemporal changes in financial structure. Jensen posits that leveraged buyout activities are one way of controlling free cash flow because the debt incurred in such transactions forces managers to disgorge excess cash. Evidence supporting the free cash flow motivation for financial restructuring has been provided by many authors, including Loh (1992), Gupta and Rosenthal (1991), Lehn and Poulsen (1989), Gibbs (1993), Griffin (1988), and Moore, Christensen, and Roenfeldt (1989).

Byrd (1988) examines the cross-sectional relation between free cash flow and ownership structure and finds some evidence that organizational forms specific to the oil industry (corporations, master limited partnerships, and royalty trusts) have different agency costs of free cash flow. Specifically, the agency costs of free cash flow are lower in royalty trusts and master limited partnerships than in corporations.

Although previous empirical work is generally consistent with the free cash flow hypothesis, the financial industry has been ignored in most studies beo cause of its unique regulatory environment. The insurance industry, in particular, has distinctly different organizational forms not found in other industries, thus providing a natural laboratory for examining cross-sectional differences in organizational form (Mayers and Smith, 1990).(3)

In this study, we test for differences in free cash flow between stock and mutual insurers in the U.S. life insurance industry. Our purpose is to examine whether organizational form affects managerial behavior with respect to the holding of free cash flow. Our results also offer insight into whether contractual limitations of managerial discretion fully compensate for the losses of debt market bonding and the market for corporate control. …