Organizational Structure, Board Composition, and Risk Taking in the U.S. Property Casualty Insurance Industry

Article excerpt

Abstract

This study examines the impact of organizational structure and board composition on risk taking in the U.S. property casualty insurance industry, addressing different risk-taking behaviors from different perspectives. The risk-taking measures include total risk, underwriting risk, investment risk, and leverage risk. The evidence shows that mutual insurers have lower total risk, underwriting risk, and investment risk than stock insurers. In terms of board composition variables, we find that some board composition variables not only have impact on risk-taking behaviors but also affect different risk measures differently. Thus, using different risk measures is better than using one risk measure to assess risk-taking behavior. Finally, we conclude that an insurer can control its total risk through management of underwriting, investment, and leverage risks that determine an insurer's risk profile.

INTRODUCTION

The purpose of this article is to examine property casualty insurer risk-taking behaviors in relation to companies' organizational structure and a number of board composition variables. Risk taking, and its impact on investors and stakeholders, has become a concern for the financial sector, especially for financial institutions such as banks and insurers. Risk-taking behavior in the property casualty insurance industry is an important issue because of considerable loss variability. Huge losses may result from catastrophes such as major hurricanes or weather disasters.

Galai and Masulis (1976) point out shareholders with limited liability have some incentive to take excessive risk in order to maximize corporate value at the expense of bondholders. Shareholders can enjoy 100 percent of upside potential after paying fixed obligations (e.g., interest payments), but their liabilities are limited because of limited liability rules. The argument is applicable to insurance companies.

The property casualty insurance industry is particularly interesting because insurers take different organizational forms and there are agency conflicts particular to the different organizational structures. The two most important organizational structures in the insurance industry are mutual and stock forms. (1) Those organized as stock insurers may be motivated to take excess risk, thereby increasing shareholder wealth at the expense of policyholders. Shareholders with their limited liability have more incentive to take risk because financial difficulties will be shared with policyholders but positive earnings accrue only to shareholders. Policyholders also bear the consequences of insolvency and thus prefer a low level of risk taking in mutual insurers (Cummins and Nini, 2002). According to Cummins, Phillips, and Smith (2000), insurance exists because policyholders are risk averse and relatively undiversified. Mutual insurers are owned by policyholders and do not have shareholders. Thus, the conflicts between shareholders and policyholders do not exist. It is less likely mutual insurers would take excessive risks.

Mayers and Smith (1981, 1986, 1988, 1990, 1992, 1994), Lamm-Tennant and Starks (1993), and Lee, Mayers, and Smith (1997) examine the impact of organizational structure on various issues including risk behaviors. Most studies examining risk-taking behavior focus only on one proxy for risk-taking behavior. Lamm-Tennant and Starks, for example, use the variance of loss ratio as a proxy for risk-taking behavior; this measure represents only underwriting risk. (2) We use four risk-taking measures: total risk, underwriting risk, investment risk, and leverage risk variables in a comprehensive examination of the risk-taking issue. (3) Total risk, which reflects a combination of underwriting risk, investment risk, and leverage risk, is the most important overall risk for shareholders or policyholders. Underwriting risk is associated with the uncertainty of insurance contract losses. …