Corporate Governance in the European Insurance Industry

O. Ricci

• Publisher: Palgrave Pivot
• Year: 2014
• Print ISBN: 9781349477562, 9781137376039
• eBook ISBN: 9781137376046
• Topic: Business
• Subtopic: Business General
• Index: Business

Corporate scandals at the beginning of the 2000s and the recent global financial crisis have renewed the attention of academics, regulators and practitioners to agency problems and possible solutions in the financial sector. Since that time, much thought has been given to new regulations and international corporate governance standards, in an attempt to guarantee prudent and sound financial management. While much of this thought has been focussed on the banking sector, Corporate Governance in the European Insurance Industry provides a unique perspective on the subject, focusing on the insurance industry and asking some important theoretical and practical questions. Are insurance companies systemically relevant, and does the existing regulation provide adequate protection for customers and guarantee financial stability? Is regulatory intervention consistent with economic and financial theories? And crucially, is this intervention consistent with empirical evidence of the behaviour and performance of insurance companies? The first part of this book provides the reader with a comprehensive review of current academic studies on the topic; the second part moves on to examine the regulation of corporate governance and its recent evolution after the global financial crisis. Within a context of vivid debate in the financial services industry, the issues explored in this book will be of value to anyone with an interest in insurance corporate governance and regulation. It is also akey source of research for academics in insurance and finance, as well as PhD students and post-graduate students in relevant subjects.

1

The Academic Perspective

Abstract: The first chapter provides a critical review of the academic literature dealing with corporate governance issues in the insurance industry. The objective is to identify the peculiarities of insurance companies with respect to both internal and external corporate governance instruments. Each instrument is analysed in order to emphasize its impact on the performance and the risk-taking of the firm. In the whole chapter, the distinction between stock and mutual companies is always taken into account, since it has always played a pivotal role in the insurance literature. Finally, the main conclusions are discussed providing also a comparison with the banking industry, for which the corporate governance literature is much more developed.

Keywords: Insurance companies; Ownership structure; Corporate Governance; Firm performance; Risk-taking

Ricci, Ornella. Corporate Governance in the European Insurance Industry. Basingstroke: Palgrave Macmillan, 2014. DOI: 10.1057/9781137376046.0006.

Introduction

This chapter proposes a critical review of academic literature dealing with insurance corporate governance. The objective is to identify the specificities of the insurance sector with respect to several mechanisms of corporate governance. We adopt the traditional distinction between internal and external corporate governance instruments. Each instrument is analysed with the objective to emphasize its impact on the performance and the risk-taking behaviour of insurance companies. When relevant, a comparison with the banking industry is provided. The academic literature dealing with corporate governance in the insurance industry has always been characterized by the pivotal role of the distinction between stock and mutual insurers. As a consequence, it is important to outline the roots and the consequences of this distinction before moving on to the analysis of single corporate governance instruments. Consistently with these aims, the remainder of the chapter is organized as follows. Section 1.1 is devoted to highlight what the main differences among several alternative organizational structures of insurance companies are, with a particular focus on stock versus mutual insurers. This is preparatory to the subsequent analysis of different corporate governance instruments since their use and relative importance is significantly different in stock and mutual insurers. Section 1.2 describes the main internal corporate governance instruments while Section 1.3 investigates the external ones. Finally some conclusions are drawn in Section 1.4.

1.1Alternative organizational structures in the insurance industry

As outlined by O’Sullivan (1998), the insurance industry is a relevant example of how alternative organizational structures may coexist and successfully compete with one another. This coexistence is very interesting from a corporate governance perspective and has been at the centre of the academic debate for many years. Even though it is possible to find other organizational structures, such as Lloyds syndicates and reciprocals, the insurance industry has always been dominated by two main alternative models: mutual companies and stock companies. Most studies dealing with the differences among several insurance organizational structures focus on the US; this is especially true for papers published in the 1980s and 1990s. However, mutual companies play a relevant role also in European countries. The most recent data provided by the International Cooperative and Mutual Insurance Federation (ICMIF, 2013) have been published in spring 2013 and refer to the end of 2011. The market share of mutual companies in the European insurance sector was 28.1 per cent in 2011 (25.2 per cent for life insurance and 32.0 per cent for non-life insurance). There are strong differences across Europe: for some countries (e.g., France, Germany, the Netherlands and the UK), mutual insurance accounts for a large portion of the total insurance markets (see Box 1.1 for an example of a successful French mutual insurer) while for others (e.g., Cyprus, Czech Republic, Estonia, Iceland, Liechtenstein, Lithuania, Malta) the weight of mutual companies is close to zero. However, there is no doubt that mutual companies represent a significant component of the European insurance industry. As a consequence, our literature review considers also papers dealing with differences between stock and mutual insurers because even though they are mainly based on the US insurance industry, their results and implications may be interesting also for the European case.

BOX 1.1 Covéa, a flexible group of mutual insurers

Covéa is a mutual insurer with nearly 20 per cent of market share in the French property and liability market. It was created in 2002, with the legal status of Mutual Insurance Group Company (SGAM – Société de groupe d’assurance mutuelle). SGAM is an innovative structure introduced into the French Law on 29 August 2001 and allowing mutual companies, mutual health or pension funds to set up a group. In the current highly competitive context, consolidation and cooperation are crucial also among cooperative companies; the SGAM is a flexible business model, allowing each member to profit from the association while maintaining their own identity and firm values.

Covéa consists of three major brands:

The MAAF group, providing insurance coverage for both individuals and professionals. Considering MAAF ASSURANCES, MAAF SANTÉ and MAAF VIE, it has 3.5 million policyholders and 7,320 FTE employees. It offers coverage for 3.7 million vehicles and 2.5 million homes;

The MMA group, backed by a network of general agents, and applying to individuals, businesses, local authorities and associations. It has 3.3 million policyholders and 6,591 FTE employees. It offers coverage for 2.7 million vehicles and 1.8 million homes;

The GMF group, offering mainly insurance coverage for civil servants. It has 3.3 million policyholders and 5,956 FTE employees. It offers coverage for 3 million vehicles and 2.5 million homes.

MAAF and MMA were the first to sign an agreement, creating the SGAM Covéa in 2003. The SGAM continued to grow by incorporating the AZUR–GMF group, thus becoming France’s largest property and liability insurance group, with one division of insurance companies without brokers (MAAF and GMF) and two insurance companies with agent networks (MMA and AZUR). MMA and AZUR merged in 2006, resulting in a stronger network of agents under the MMA brand name.

The strategy of Covéa is to pool together human and technical resources among several brands in order to realize scale and scope economies, have more bargaining power with partners and providers, share important investments and analyses of market and regulation trends.

As a whole, the Covéa group has 10.9 million policyholders, 26,598 employees (in France and abroad) and 2,800 points of sale. The total amount of gross premiums was 14.7 billion euros in 2012, with an increase of 2.8 per cent with respect to 2011 (29.6 per cent in life insurance and 70.4 per cent in non-life insurance). The net income was 628 million euros in 2011, with an increase of more than 23 per cent with respect to 2011. It is ranked first in France for property insurance, liability insurance and legal protection; third for commercial insurance; and fourth for personal healthcare insurance.

At the international level, the Covéa group has subsidiaries in many other European countries, such as Italy, Spain, Luxembourg and the UK; it also operates in the US and in Canada.

Source: Covéa institutional website (visited in February 2014), Covéa 2012 Annual Report, Covéa The Basics 2012.

1.1.1The ownership structure as a response to agency problems

Mayers and Smith’s study (1981) was the first to propose a foundation for a positive theory of insurance contracting able to simultaneously explain the forms of existing contracts and the structure of the industry. Their theory is based on several assumptions: (1) economic agents interact in an open and competitive market with a rational behaviour, and consistently with the objective to maximize their own utility; (2) the market is unregulated and (3) there are contracting/transaction costs.

While in a zero contracting cost scenario the choice of organizational structure is a matter of indifference, with transaction costs agency problems arise, and the organizational structure becomes a pivotal control mechanism. By applying the agency theory to the insurance industry, potential conflicts of interest may be detected among three different parties: managers, owners/risk bearers and customers/policyholders. Managers are the decision makers, who are responsible for setting quotes and administering claims. Owners/risk bearers provide capital and are the residual claimants. Customers/policyholders pay premiums in return of a promise to receive a stipulated amount if the insured event occurs. The main agency problems derive from the owner-policyholder and the owner-manager conflicts. Mayers and Smith’s basic idea (1981) is that each organizational structure has an advantage in controlling some of these conflicts, but none is able to effectively solve all of them. This explains why several models have coexisted for many decades.

We first examine the conflict between owners/risk bearers and customers/policyholders. The latter are in a similar position to that of lenders in the bond market. After the policy is issued, owners have the incentive to take action in order to increase the value of their stocks at the expense of customers. Hansmann (1985) has analysed in detail what the factors that make market competition an insufficient source of discipline for insurance firms are, with different conclusions for the life and the non-life industries. With reference to life insurance, he identifies three main problems leading to ‘contracting failure’. First of all, life policies are typically long-term contracts, with a duration that often reaches several decades. It is difficult and expensive to design an enforceable contract able to anticipate and deal with all the possible contingencies that may arise in such a long period of time. The main risk for the policyholder is that the insurance firm does not maintain sufficient reserves to be always capable to payoff its policies when the insured events occur. There are two obvious solutions to this problem: the first is to charge the requested premium with a prudential margin determined with the objective to cover even a very pessimistic estimate of the firm’s future liability. However, this makes the cost of insurance too high with respect to its expected value and generates substantial profits for the company’s stockholders. Another solution is that the company promises in its contract that it will raise new equity capital in the event that accumulated reserves decrease under a security level. However, it is not easy to determine this level. In addition, since the downside risk for the company is limited by bankruptcy, the owners have still an incentive to behave opportunistically and invest in high-risk assets. As a result, Hansmann concludes that it is not possible to rely completely upon private contracting to solve the problem of an effective contract over a long time period. The difficulties of long-term contracting under uncertainty are exacerbated by two additional factors: asymmetric information and switching costs. Most policyholders are relatively uninformed and unable to distinguish among several insurance policies: as a consequence, it is unlikely that private contracting results in an optimal choice, from the point of view of both pricing and financial soundness of the provider. Finally, premiums of life insurance policies are designed in order to make it expensive for the client to abandon the policy and switch insurance companies at any point. There are two alternatives for overcoming this market failure: more regulation or the formation of mutual companies in which there is a merge of the ownership/risk bearing and the customer/policyholder functions. The coincidence between owners and customers eliminates the incentive for the company to behave opportunistically at the expense of policyholders. What about non-life insurance? In this case, contracting problems are completely different. Non-life policies are generally short-term, with durations of a single year or less. Therefore, there are no problems of long-term contracting under uncertainty. In addition to this, the condition of asymmetric information seems to be reversed with respect to the life case. Insurance companies are often unable to effectively estimate the level of risk for prospective policyholders so that the insured who perceive themselves as less risky are encouraged to opt out from the traditional insurance market and establish a mutual organization. Furthermore, a mutual form – due to the existence of a long-term relationship and/or a community with similar interests – may also reduce the incidence of moral hazard, increase the effectiveness of inspection programs and stimulate the research for loss-prevention measures. We can conclude that the mutual form is the most effective in controlling the owner-policyholder conflict. However, as noted by O’Sullivan (1998), the elimination of the shareholders category exacerbates the potential for another type of conflict, the one between owners and managers. First of all, voting is generally on the basis of one vote per member, irrespective of the economic interest in the company. In addition, even though there are some legal provisions under which policyholders may elect directors or challenge the existing management, these procedures are rarely invoked (Greene and Johnson, 1980). Basically, irrespective of legal provisions, it is unlikely that single policyholders have a number of policies so significant as to motivate an interest in active monitoring of managers. Second, there is no room for external control by the capital market. In stock companies, the costs imposed by managers to owners are limited by the threat of takeover. If these costs are too high, someone can purchase the company, replace the management and realize the value of the efficiency recover. In a mutual company, an external takeover is not feasible; owners can try to remove the existing management by a proxy fight, which, however, is long, difficult and expensive and may fail to capture any gains. As a consequence, the stock form seems to be the most effective in controlling the owner-manager conflict.

Even though there is large consensus over the respective advantages for mutual and stock companies in controlling the owner-policyholder or the owner-manager conflict, there are also some balancing mechanisms that can be implemented. On the one hand, stockholders are aware of the fact that the pricing of insurance contracts reflects their expected behaviour: as a result, they may decide to limit their opportunity set (i.e., their dividend or investment policies) in a way similar to stockholders including covenants in bond contracts. On the other hand, mutual companies may utilize alternative systems of monitoring to compensate for the absence of external market controls (i.e., a high proportion of outside directors or the institution of several committees assisting the board).

1.1.2The managerial discretion hypothesis

As highlighted by Mayers and Smith (1981), the competition between mutual and stock companies suggests that the main differences between the two models will not be in the contractual conditions or pricing within a certain line of insurance, but in which lines of insurance each structure will dominate. This idea has been further developed by Mayers and Smith in a subsequent study published in 1988. The comparative advantage in a line-of-business, rather than in others, depends on the cost function of each ownership structure. One of the main variables explaining the heterogeneity in costs is the degree of managerial discretion in setting rates for different types of insurance. The more discretion the manager is able to exercise, the larger is the incentive to operate in his own self-interest at the expense of other parties. The managerial discretion hypothesis predicts that the comparative advantage of each ownership structure depends on the mechanisms at its disposal to control the managers’ action. In this paper, the authors consider two specific ownership structures other than stock and mutual companies: Lloyds associations and reciprocals.

In Lloyds associations, insurers are individual underwriters, so that the managerial and the ownership functions are merged. On the one hand, the main advantage is that there are no agency problems deriving from the owner-manager conflict. On the other hand, the main drawback is that the underwriting capacity of Lloyds is given by the single manager’s wealth and willingness to bear risk, with limited diversification opportunities. Since the main benefit of this organizational form is the merger between ownership and management, resulting in no cost of monitoring, Lloyds associations are expected to have a compa...

Table of contents

• Cover
• Title
• Introduction: Aim and Structure of the Book
• 1  The Academic Perspective
• 2  The Regulatory Perspective
• Final Remarks
• Regulation
• References
• Index