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Stock vs. Mutual Insurers: Who Does and Who Should Charge More? Alexander Braun Przemys law Rymaszewski Hato Schmeiser Institute of Insurance Economics University of St.Gallen, Switzerland Madrid, June, 2011 A. Braun, P. Rymaszewski, and

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Stock vs. Mutual Insurers: Who Does and Who Should Charge More?

Alexander Braun Przemys law Rymaszewski Hato Schmeiser

Institute of Insurance Economics University of St.Gallen, Switzerland Madrid, June, 2011

  • A. Braun, P. Rymaszewski, and H. Schmeiser, Stock vs. Mutual Insurance Premiums, June 2011

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Table of contents

1

Motivation and Contribution

2

Relevant literature

3

Empirical analysis

4

Normative theory

5

Summary and Conclusion

  • A. Braun, P. Rymaszewski, and H. Schmeiser, Stock vs. Mutual Insurance Premiums, June 2011

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Motivation and Contribution

Different rights and obligations associated with the legal form should affect the marginal insurance premium

Motivation:

  • Private insurance companies are organized either as stock or mutual firms
  • There is no secondary market for mutual equity stakes
  • Distressed mutual insurers can call in additional premiums (recovery option)
  • Due to these aspects, marginal premiums of stock and mutual firms should differ

Contribution:

  • Empirical and theoretical analysis of the premiums charged by stocks and mutuals
  • Panel data analysis for the German motor liability insurance sector
  • Contingent claims model framework for the pricing of stock and mutual insurance
  • Comparison of stock and mutual insurers (premium size, safety level, and capital)
  • A. Braun, P. Rymaszewski, and H. Schmeiser, Stock vs. Mutual Insurance Premiums, June 2011

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Relevant literature

The large body of existing literature does not cover legal-form dependent premium difference

  • Agency issues

(see, e.g., Mayers and Smith, 1981, 1986, 1988, 2005) ◮ Owner-policyholder conflict (more intense in stock insurance firms) versus... ◮ Owner-manager conflict (more intense in mutual insurance firms)

  • Information asymmetries

(see, e.g., Smith and Stutzer, 1990, 1995) ◮ Parallel existence of both legal forms ◮ Size of mutual companies (see Ligon and Thistle, 2005)

  • Further differences between stock and mutuals

◮ Reasons for (de)mutualization (see, e.g., McNamara and Rhee, 1992; Viswanathan and Cummins, 2003; Zanjani, 2007) ◮ Differences in efficiency (see, e.g., Spiller, 1972; Cummins et al., 1999; Jeng et al., 2007) ◮ Differences in capital structure (see, e.g., Harrington and Niehaus, 2002)

  • A. Braun, P. Rymaszewski, and H. Schmeiser, Stock vs. Mutual Insurance Premiums, June 2011

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Empirical analysis

Mutuals do not seem to charge significantly higher premiums than stocks

Hausman-Taylor FEVD Procedure Fixed Effects Model (Intercept)

  • 213.4151***
  • 237.3012***

— (-2.6692) (-12.1466) AvLoss 0.3420*** 0.3469*** 0.3420*** (15.4295) (9.9042) (10.9533) AvCosts 0.6053*** 0.5994*** 0.6053*** (7.3825) (6.1891) (3.9955) EqR 20.0231 15.7489* 20.0231 (1.0095) (1.9075) (0.5184) LTP 19.2463*** 18.7959*** 19.2463*** (7.0319) (17.3699) (7.3742) Stock

  • 3.9429

33.7803*** — (-0.0470) (14.7292)

Coefficients and t-statistics (in parentheses) for Hausman-Taylor estimator, the FEVD proce- dure, and the standard FE model. The average annual premium (AvPrem) is regressed on the following set of explanatory variables: average annual losses (AvLoss), average annual costs (AvCosts), equity ratio (EqR), and logged total premium (LTP). Hausman-Taylor and FEVD additionally include the time-invariant variable legal form (Stock). ***, **, and * denote sta- tistical significance on the 1, 5, and 10 percent confidence level. Tha analysis is based on the accounting data (2000-2006, source: Hoppenstedt) for German insurance companies offering motor vehicle liability insurance. A panel data set contains 99 stock and 14 mutual insurers covering 532 and 87 firm years for stock and mutual insurance companies, respectively.

Table: Estimation results

  • A. Braun, P. Rymaszewski, and H. Schmeiser, Stock vs. Mutual Insurance Premiums, June 2011

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Normative theory Model framework

The employed contingent claims model framework is based

  • n the work of Doherty and Garven (1986)
  • Stock insurer claims structure

ECS

0 = e−r EQ 0 (A1 − L1)+DPOS

PS

0 = πS 0 = e−r EQ 0 (L1)−DPOS

  • Mutual insurer claims structure

◮ Full participation in equity payoff ECMf = e−r EQ

0 (A1 − L1)+RO0+DPOM

PM = e−r EQ

0 (L1)−RO0−DPOM

◮ Partial participation in equity payoff ECM = γe−r EQ

0 (A1 − L1) − (pL − γ) DPOS 0 + pL

  • RO0 + DPOM
  • ECMn

= (1 − γ) e−r EQ

0 (A1 − L1) + (pL − γ) DPOS 0 + (1 − pL)

  • RO0 + DPOM
  • PM

= e−r EQ

0 (L1) − RO0 − DPOM

  • A. Braun, P. Rymaszewski, and H. Schmeiser, Stock vs. Mutual Insurance Premiums, June 2011

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Normative theory Stock insurance company

ECS 1 ECS 1 A1

Figure: Payoff to the equityholders EC S

1 and policyholders PS 1 of a stock

insurance company in t = 1

  • A. Braun, P. Rymaszewski, and H. Schmeiser, Stock vs. Mutual Insurance Premiums, June 2011

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Normative theory Stock insurance company

ECS 1 ECS 1 A1 − L1 L1 A1 45◦ DPOS 1 DPOS 1

Figure: Payoff to the equityholders EC S

1 and policyholders PS 1 of a stock

insurance company in t = 1

  • A. Braun, P. Rymaszewski, and H. Schmeiser, Stock vs. Mutual Insurance Premiums, June 2011

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Normative theory Stock insurance company

ECS 1 ECS 1 PS 1 PS 1 A1 − L1 L1 A1 45◦ DPOS 1 DPOS 1

Figure: Payoff to the equityholders EC S

1 and policyholders PS 1 of a stock

insurance company in t = 1

  • A. Braun, P. Rymaszewski, and H. Schmeiser, Stock vs. Mutual Insurance Premiums, June 2011

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Normative theory Mutual insurance company

L1 A1 45◦ DPOS 1 DPOS 1

Figure: Mutual insurer default put option payoff in t = 1 (DPOM

1 )

  • A. Braun, P. Rymaszewski, and H. Schmeiser, Stock vs. Mutual Insurance Premiums, June 2011

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Normative theory Mutual insurance company

L1 A1 45◦ DPOS 1 DPOM 1 DPOM 1 Cmax X DPOS 1 Cmax

Figure: Mutual insurer default put option payoff in t = 1 (DPOM

1 )

  • A. Braun, P. Rymaszewski, and H. Schmeiser, Stock vs. Mutual Insurance Premiums, June 2011

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Normative theory Mutual insurance company

L1 A1 45◦ DPOS 1 DPOM 1 DPOM 1 POX 1 Cmax X BPO1 BPO1 DPOS 1 POX 1 Cmax

Figure: Mutual insurer default put option payoff in t = 1 (DPOM

1 )

  • A. Braun, P. Rymaszewski, and H. Schmeiser, Stock vs. Mutual Insurance Premiums, June 2011

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Normative theory Mutual insurance company

L1 A1 45◦ RO1 RO1 Cmax X Cmax

Figure: Mutual insurer recovery option payoff in t = 1 (RO1)

  • A. Braun, P. Rymaszewski, and H. Schmeiser, Stock vs. Mutual Insurance Premiums, June 2011

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Normative theory Mutual insurance company

L1 A1 45◦ RO1 RO1 DPOS 1 POX 1 Cmax −Cmax X BPO1 −BPO1 DPOS 1 −POX 1 Cmax

Figure: Mutual insurer recovery option payoff in t = 1 (RO1)

  • A. Braun, P. Rymaszewski, and H. Schmeiser, Stock vs. Mutual Insurance Premiums, June 2011

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Normative theory Premium comparison stock insurer mutual insurer

PS πS ECS ΠM case equity participation excess of loss recovery

  • ption

PM ECMf I full γ = 1 no λ = 1

Figure: Comparison of premia

  • A. Braun, P. Rymaszewski, and H. Schmeiser, Stock vs. Mutual Insurance Premiums, June 2011

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Normative theory Premium comparison stock insurer mutual insurer

PS πS ECS ΠM πM case equity participation excess of loss recovery

  • ption

PM ECMf I full γ = 1 no λ = 1 PM ECMn ECM II partial γ < 1 no λ = 1

Figure: Comparison of premia

  • A. Braun, P. Rymaszewski, and H. Schmeiser, Stock vs. Mutual Insurance Premiums, June 2011

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Normative theory Premium comparison stock insurer mutual insurer

PS πS ECS ΠM πM πM RO0 + DPOM −DPOS case equity participation excess of loss recovery

  • ption

PM ECMf I full γ = 1 no λ = 1 PM ECMn ECM II partial γ < 1 no λ = 1 PM ECMf III full γ = 1 yes λ > 1 PM ECMn ECM IV partial γ < 1 yes λ > 1

Figure: Comparison of premia

  • A. Braun, P. Rymaszewski, and H. Schmeiser, Stock vs. Mutual Insurance Premiums, June 2011

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Normative theory Premium comparison

The mutual insurer can offer the same or a lower premium as the stock insurer if it holds less capital

5 10 15 20 25 60 65 70 75 80 85 EC0

S, EC0 Mf

P0

S = π0 S, P0 M, Π0 M Curves: Π0

M (mutual premiums in PV terms)

L0 (PV of claims costs) L0 − DPO0

M (safety levels of mutuals with RO)

P0

M = P0 S = π0 S (PV of policyholder stakes)

Points: Π0

M = L0 − DPO0 M

Π0

M = L0

Figure: Equity-premium combinations for full equity participation/recovery option

  • A. Braun, P. Rymaszewski, and H. Schmeiser, Stock vs. Mutual Insurance Premiums, June 2011

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Summary and Conclusion

Arbitrage opportunities suggest wealth transfers

Summary:

  • No empirical evidence that mutuals charge significantly higher premiums
  • According to the normative results, however, mutuals should usually charge more
  • Equality of premiums would require the mutual to hold less equity capital
  • The inconsistency between empirical and theoretical results indicates a mispricing

Conclusion:

  • Potential violation of the no-arbitrage principle due to asymmetric information
  • There are likely to be wealth transfers between different stakeholder groups
  • Could identify the size and direction of these wealth transfers in future research
  • Our normative results also raise questions as to why these forms actually coexist
  • A. Braun, P. Rymaszewski, and H. Schmeiser, Stock vs. Mutual Insurance Premiums, June 2011

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Thank you

Thank you for your attention

  • A. Braun, P. Rymaszewski, and H. Schmeiser, Stock vs. Mutual Insurance Premiums, June 2011

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Further information

Further information

  • References
  • A. Braun, P. Rymaszewski, and H. Schmeiser. Stock vs. Mutual Insurers: Who

Does and Who Should Charge More?, Working Papers on Risk Management and Insurance, 2010.

  • Contact information

◮ Alexander Braun

alexander.braun@unisg.ch

◮ Przemys

law Rymaszewski przemyslaw.rymaszewski@unisg.ch

◮ Hato Schmeiser

hato.schmeiser@unisg.ch

Institute of Insurance Economics University of St. Gallen Tannenstrasse 19 CH–9010 St. Gallen Phone: +41 71 243 40 43 www.ivw.unisg.ch

  • A. Braun, P. Rymaszewski, and H. Schmeiser, Stock vs. Mutual Insurance Premiums, June 2011

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References

References I

Cummins, J. D., Weiss, M. A., and Zi, H. (1999). Organizational Form and Efficiency: The Coexistence of Stock and Mutual Property-Liability Insurers. Management Science, 45(9):1254–1269. Doherty, N. A. and Garven, J. R. (1986). Price Regulation in Property-Liability Insurance: A Contingent-Claims Approach. Journal of Finance, 41(5):1031–1050. Harrington, S. E. and Niehaus, G. (2002). Capital Structure Decisions in the Insurance Industry: Stocks versus Mutuals. Journal of Financial Services Research, 21(1):145–163. Jeng, V., Lai, G. C., and McNamara, M. J. (2007). Efficiency and Demutualization: Evidence From the U.S. Life Insurance Industry in the 1980s and 1990s. Journal of Risk & Insurance, 74(3):683–711. Ligon, J. A. and Thistle, P. D. (2005). The Formation of Mutual Insurers in Markets with Adverse Selection. Journal of Business, 78(2):529–555. Mayers, D. and Smith, C. W. (1981). Contractual Provisions, Organizational Structure, and Conflict Control in Insurance Markets. Journal of Business, 54(3):407–434. Mayers, D. and Smith, C. W. (1986). Ownership Structure and Control: The Mutualization of Stock Life Insurance Companies. Journal of Financial Economics, 16(1):73–98. Mayers, D. and Smith, C. W. (1988). Ownership Structure across Lines of Property-Casualty

  • Insurance. Journal of Law and Economics, 31(2):351–378.

Mayers, D. and Smith, C. W. (2005). Agency Problems and the Corporate Charter. Journal of Law, Economics, and Organization, 21(2):417–440.

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References

References II

McNamara, M. J. and Rhee, S. G. (1992). Ownership Structure and Performance: The Demutualization of Life Insurers. Journal of Risk and Insurance, 59(2):221–238. Smith, B. D. and Stutzer, M. J. (1990). Adverse Selection, Aggregate Uncertainty, and the Role for Mutual Insurance Contracts. Journal of Business, 63(4):493–510. Smith, B. D. and Stutzer, M. J. (1995). A Theory of Mutual Formation and Moral Hazard with Evidence from the History of the Insurance Industry. Review of Financial Studies, 8(2):545–577. Spiller, R. (1972). Ownership and Performance: Stock and Mutual Life Insurance Companies. Journal of Risk and Insurance, 39(1):17–25. Viswanathan, K. S. and Cummins, J. D. (2003). Ownership Structure Changes in the Insurance Industry: An Analysis of Demutualization. Journal of Risk and Insurance, 70(3):401–437. Zanjani, G. (2007). Regulation, Capital, and the Evolution of Organizational Form in US Life

  • Insurance. American Economic Review, 97(3):973–983.
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