Academic journal article Journal of Risk and Insurance

Dividend Policy and Signaling by Insurance Companies

Academic journal article Journal of Risk and Insurance

Dividend Policy and Signaling by Insurance Companies

Article excerpt


Insurers exhibit some operating and financial characteristics resembling industrial firms, other characteristics resembling depository institutions, and unique characteristics of their own. Like industrial firms and depository institutions, insurers may have inside information about their future cash flows that is not known by investors. However, since their financial characteristics vary from those of industrial firms and depository institutions, they may have a different level of asymmetric information. Our objective is to measure their level of asymmetric information contained within announcements of increased dividends.

Because of the nature of their product, insurers tend to accumulate relatively large amounts of cash, cash equivalents, and investments in order to pay future claims and avoid financial ruin. A portion of these reserves ultimately becomes the property of policyholders. In the case of stockholder-owned firms, a large portion of these assets implicitly belongs to policyholders. In the case of mutually owned firms, virtually all of these assets are the property of the policyholders. In this respect, insurers may be considered pseudo-depository institutions that hold and invest funds belonging to others.

Insurers are subject to different regulations than commercial banks or savings and loan associations. In fact, regulations even vary among insurers, depending on their line of business and their location. Property-liability insurers are subject to price regulations, while life insurers and commercial banks are not. Some states impose more stringent solvency regulations than others. As custodians of a portion of society's wealth, insurers are under a tacit obligation to protect the safety of this wealth. Such an unspoken mandate may cause society to be particularly sensitive to the financial soundness and viability of insurers. Failures of large insurers can affect healthy companies and can endanger guaranty fund protection (see Randall and Kopcke, 1992). Any hint or signal of impending financial trouble may elicit a particularly strong reaction from financial markets.

While insurers report the market values of their bonds in their 10-K reports, they typically do not report unrealized capital gains and losses on their bond portfolios. Innovations such as securitization and financial reinsurance, along with the flexibility of booking underwriting profits and setting loss reserves, can reduce the reliability of financial statements (see Randall and Kopcke, 1992). This implies that the public is somewhat insulated from the true economic condition of an insurer at any particular point in time, which allows for the possibility of asymmetric information. Furthermore, accounting procedures frequently hide major changes in the market values of real estate holdings. This lack of complete information may add to uncertainty and, consequently, lead to increases in stock price volatility. To counteract this information asymmetry argument, Foster (1977) contends that the market imputes unrealized capital gains and losses into non-life insurer share prices.

Since financial statements of insurers do not disclose complete information about the market value of some assets, investors may rely heavily on other signals of changes in financial condition. One such signal is a change in dividend policy. In general, many firms try to avoid unnecessary changes in dividend policy, perhaps because of signaling consequences. Consequently, dividend policy changes may be perceived by the financial markets as important signals and thus may invoke strong reactions.

Because of their unique structure and role in society, publicly traded stock of insurers may behave differently from industrial firms or conventional depository institutions such as banks or savings and loan associations. Thus, a unique response may be triggered by insurer dividend policy changes. Furthermore, the degree of response would likely depend on the structure and financial condition of individual firms. …

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