Corporate Governance and Cash Holdings: Evidence From the U.S. Property–Liability Insurance Industry

• Author: Gene Lai,Yenyu (Rebecca) Huang,Wen‐Yen Hsu
• Published date: 01 September 2015
• Date: 01 September 2015
• DOI: http://doi.org/10.1111/jori.12049

CORPORATE GOVERNANCE AND CASH HOLDINGS:

EVIDENCE FROM THE U.S. PROPERTY–LIABILITY

INSURANCE INDUSTRY

Wen-Yen Hsu

Yenyu (Rebecca) Huang

Gene Lai

ABSTRACT

This article examines the impact of board and finance committee character-

istics on insurers’ cash holdings using a sample of 1,454 U.S. stock property–

liability insurer-year observations. We focus on the roles of independent

board members and independent finance committee members. Our results

suggest that independent board members allow managers to hold excess

cash holdings to avoid underinvestment and play a monitoring role in

managers’ cash spending behavior in a regulated industry. The overall

findings are consistent with the independent director responsibility

hypothesis, which suggests that independent directors play a monitoring

role in managers’ cash spending behavior and avoiding underinvestment

problems.

INTRODUCTION

This article examines the impact of corporate governance on cash holdings in the U.S.

property–liability insurance industry. The literature suggests that firm managers

need enough cash to fund all investment opportunities and to ensure a firm’s overall

liquidity at the same time. If they hold unjustified excess cash, however, managers can

Wen-Yen Hsu is an Associate Professor in the Department of Risk Management and Insurance,

Feng Chia University, Taiwan. Hsu can be contacted via e-mail: wyhsu@fcu.edu.tw. Yenyu

(Rebecca) Huang is an Associate Professor in the Department of Tourism and Leisure

Management, St. John’s University Taiwan. Huang can be contacted via e-mail: vision@mail.

sju.edu.tw. Gene Lai (corresponding author) is a Safeco Distinguished Professor of Insurance

in the Department of Finance and Management Science, Washington State University. Lai can

be contacted via e-mail: genelai@wsu.edu. Both Gene Lai and Wen-Yen Hsu are research

fellows in Risk and Insurance Research Center, College of Commerce, National Chengchi

University, Taiwan. The authors would like to thank the two anonymous referees for their

helpful suggestions and comments on earlier drafts of the manuscript.

© 2014 The Journal of Risk and Insurance. 82, No. 3, 715–748 (2015).

DOI: 10.1111/jori.12049

715

build their own empires, consume perquisites that benefit only themselves, and be

less careful about efficient operation at the expense of shareholders.

1

Effective internal and external corporate control mechanisms to mitigate agency

conflicts over excess cash holdings have been of academic interest since Jensen’s

(1986) work on the agency theory of free cash flow. Studies on the association between

cash holdings and shareholder rights for industrial firms provide mixed evidence.

Dittmar, Mahrt-Smith, and Servaes (2003), Pinkowitz, Stulz, and Williamson (2004),

and Kalcheva and Lins (2007) show that firms with greater shareholder rights have

lower levels of cash holdings, suggesting that shareholders who have enough power

will force managers to pay out cash to the shareholders and prevent managers from

accumulating excess cash to serve their own interests.

Harford, Mansi, and Maxwell (2008), however, find that firms with weaker

shareholder rights and low insider ownership have less in cash reserves than firms

with stronger shareholder rights (low Governance Index [G-Index]) and high insider

ownership. They present evidence that low cash reserves in poorly governed firms

occur because managers spend cash on capital expenditures and acquisitions that

reduce firm value. Similar results are found in Dittmar and Mahrt-Smith (2007).

Dittmar and Mahrt-Smith also find that the negative impact of excess cash on

operating performance will dissipate in a firm with stronger governance structures. It

should be noted that these prior studies generally exclude financial firms and do not

control for the impact of external control by regulators.

The purpose of this article is to examine the impact of corporate governance on cash

holdings in property–liability insurers. This industry provides an exceptionally good

setting for analyzing the effectiveness of insurers’ internal corporate governance

mechanisms in mitigating agency conflicts. First, property–liability insurers usually

generate and hold substantial amounts of cash; virtually all their business

transactions are completed in cash.

2

Second, huge losses (e.g., the recent earthquake

and tsunami in Japan) may result in illiquidity or insolvency in the insurance

companies. Previous studies (e.g., Grace, Klein, and Phillips, 2005) provide evidence

that insurer insolvencies are, on average, three to five times more expensive than

other financial institutions, and the cost of insolvency is inversely related to insurer

liquidity.

Third, the insolvency of insurance companies may be worse than that of manu-

facturing firms because policyholders buy insurance policies and pay premiums for

necessity (e.g., auto and homeowner insurance policies), while stockholders or

creditors invest in manufacturing firms for profits (e.g., capital gains, dividends, and

interests). Although policyholders are protected by guaranty funds, it takes time for

policyholders to get reimbursed for the premiums paid and they may not be fully

1

Detailed reviews of the relevant literature are provided throughout the article.

2

We compare cash to net premium written ratio for insurance companies with cash to sales ratio

for noninsurance companies. Our results show that cash to net premium ratio is about 50

percent for insurance companies while cash to sales ratio for noninsurance companies is only

about 18 percent (Harford, Mansi, and Maxwell, 2008).

716 THE JOURNAL OF RISK AND INSURANCE

compensated. Finally, Demsetz and Lehn (1985) suggest that regulation “provides

some subsidized monitoring and disciplining of the management of regulated firms”

(p. 1161). The insurance industry is subject to regulations, which could represent a

source of external corporate control. The insurance industry setting allows us to

examine the efficacy of firms’ internal control systems while controlling for the

possible substitution effect of external corporate control mechanisms. In addition, our

results can shed new light on whether corporate governance in a regulated industry

such as the insurance industry is needed.

This article focuses on the effect of independence of boards and finance committees,

among other corporate governance variables. The literature suggests independent

directors do not have economic or psychological ties to management and thus should

have more incentive to monitor managers. More important, the literature generally

suggests that board of director independence is the most effective monitoring

characteristic (Anderson, Mansi, and Reeb, 2004). Also, financial committees are

responsible for financial affairs and investment activities. Based on the above

arguments, we propose the independent director responsibility hypothesis that

suggests that independent directors play a monitoring role in managers’ cash

spending behavior and avoiding underinvestment and insolvency problems.

We investigate the impact of boards and finance committees on insurers’ cash

holdings using a sample of 1,454 U.S. stock property–liability insurer-year

observations over 1997–2002.

3

The empirical results are summarized below. We

find insurers with a higher proportion of outsiders on their boards and finance

committees hold larger cash holdings. Additional results show that the independence

of boards and finance committees is positively related to the growth of an insurer

when it has excess cash holdings. These two results imply that independent board

and finance committee members allow managers to hold excess cash holdings

to avoid underinvestment. We further find that excess cash spent on salary

insignificantly declines with a higher proportion of outside directors on a board or a

finance committee. These results suggest that independent board and finance

committee members play a monitoring role in managers’ cash spending behavior

even in a regulated industry. The evidence overall is consistent with the independent

director responsibility hypothesis that suggests independent board members and

independent finance committee members not only aim to avoid underinvestment

problems but also play monitoring roles.

Other important findings are summarized below. We find that large board size and

duality are associated with more cash holdings. Further examination shows that these

two variables are positively related to growth opportunities as proxied by Tobin’s Q

and negatively related to expenses, when insurers have positive cash holdings in the

prior period. The evidence also shows that insurers with more diligent board and

more financial expert on financial committee are positively related to growth

opportunities when insurers have positive excess cash. Equally important, we also

find excess cash spent on salary expenses does not increase with more financial expert

3

The actual sample period used in this study is from 1992 to 2006 because we need to calculate

standard deviation of cash flows and future actual growth rate of direct premium written.

CORPORATE GOVERNANCE AND CASH HOLDINGS 717