Open‐Market Stock Repurchases by Insurance Companies and Signaling

• Author: Herman Manakyan,Ming‐Shiun Pan,Kartono Liano,Gow‐Cheng Huang
• Date: 01 March 2013
• Published date: 01 March 2013
• DOI: http://doi.org/10.1111/rmir.12003

Risk Management and Insurance Review

C

Risk Management and Insurance Review, 2013, Vol.16, No. 1, 47-69

DOI: 10.1111/rmir.12003

FEATURE ARTICLE

OPEN-MARKET STOCK REPURCHASES BY INSURANCE

COMPANIES AND SIGNALING

Gow-Cheng Huang

Kartono Liano

Herman Manakyan

Ming-Shiun Pan

ABSTRACT

The signaling hypothesis of share repurchases implies that management uses

repurchases to signal either that their firm’s future operating performance will

improve or that shares of their stock are simply underpriced by the market.

This study examines which of the two interpretations can better explain open-

market share repurchaseprograms announced by insurance companies. We find

no evidence that future-operating performance of insurers improves following

the repurchase announcement. In addition, changes in future operating perfor-

mance cannot explain the announcement-period abnormal return. Instead, the

stock undervaluation prior to the repurchase announcement can significantly

explain the announcement-period abnormal return, particularly for life insur-

ers. Overall, our results suggest that the positive market reaction to insurers’

open-market share repurchase announcements is due to the stock undervalu-

ation by the market, but not due to positive information content about future

operating performance conveyed in the repurchase announcement.

The finance literature has documented significantly positive market reactions around

announcements of open-market stock repurchase programs. The most prominent expla-

nation for this finding is the signaling hypothesis (Vermaelen, 1981).1However, there

are two interpretations for the positive market reaction under the signaling hypothesis.

Gow-Cheng Huang is at the Department of Accounting and Finance, Alabama State University,

Montgomery,AL 36101; phone: 334-229-6920; e-mail: ghuang@alasu.edu. Kartono Liano is at the

Department of Finance and Economics, Mississippi State University,Mississippi State, MS 39762;

phone: 662-325-1981; e-mail: kliano@cobilan.msstate.edu. Herman Manakyan is at the Depart-

ment of Economics and Finance, Salisbury University,Salisbury, MD 21801; phone: 410-677-5024;

e-mail: hxmanakyan@salisbury.edu. Ming-Shiun Pan is at the Department of Finance and Sup-

ply Chain Management, Shippensburg University,Shippensburg, PA17257; phone: 717-477-1683;

e-mail: mspan@ship.edu. This article was subject to double-blind peer review.

1In addition to signaling, sharerepurchases could be used to distribute excess cash to shareholders

(i.e., the free cash flow hypothesis), to support both management and employee stock option

exercises, or to increase financial leverage ratio.

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48 RISK MANAGEMENT AND INSURANCE REVIEW

The first interpretation is that the stock is fairly priced based on publicly available infor-

mation, but is undervalued if private information is considered. Under this hypothesis,

share repurchases are associated with positive announcement excess returns because

managers use share repurchases to convey favorable private information about their

firm’s future prospects—the performance-signaling explanation (Vermaelen, 1981). The

second interpretation is that the market is inefficient and managers use sharerepurchases

to signal that their stock is undervalued based on publicly available information—the

undervaluation-signaling explanation (Oded, 2005). The undervaluation-signaling hy-

pothesis suggests that repurchases do not signal improvements in future operating

performance. Instead, repurchases signal management’s disagreement with the market

in interpreting publicly available information.

While both the performance signaling and the undervaluation interpretations can ex-

plain the positive market reaction to sharerepurchase announcements, prior studies (e.g.,

Born et al., 2004; Miller and Shankar,2005; Polonchek and Miller, 2005) that analyze share

repurchases by insurance companies do not make a distinction between undervaluation

signaling and the performance signaling in explaining the market reaction. A significant

contribution of our article is to address this shortcoming by examining which of the

two interpretations of the signaling hypothesis can better explain the market reaction to

open-market share repurchase announcements by insurance companies.

Our article also contributes to the literature by focusing on repurchase programs an-

nounced by insurance companies. Insurance firms provide an opportunity to learn more

about the information conveyed in repurchase announcements. Unlike industrial com-

panies, insurance companies are regulated and closely monitored by several agencies

such as state and rating agencies. Insurance regulation encompasses several activities

to protect consumers and to ensure that insurance companies are financially viable.2

Accordingly, insurance companies have less asymmetric information when compared

to industrial companies. Thus, the stock market may react less to corporate policies (e.g.,

dividend policy and share repurchase)announced by insurance companies. For instance,

Akhigbe et al. (1993) find that the market reaction to dividend-increase announcements

by insurers is smaller than that of industrial firms, suggesting that insurers’ dividend

policy contains less informational signal. Similarly,the announcement of an open-market

share repurchase program by an insurance company may not contain as much favorable

information about the insurer’s future operating performance. Furthermore, the infor-

mation conveyed in insurers’ repurchase announcements may differ across different

insurance lines of business. For instance, Zhong (1999) finds that dividend signaling

by property–liability insurers yields larger stock price response. He suggests that this

larger response is related to limited information regarding property–liability insurers’

performance induced by price regulation. Our research provides valuable insights into

whether insurers’ open-market share repurchases contain an information signal and

whether the information signal differs across different insurance line of business.

We examine 148 insurers that announced an open-market share repurchase program

over the period 1993–2005. Consistent with the finance literature, these insurance com-

panies display an average positive excess return over a 3-day repurchase announcement

2These regulation activities include capital requirements, price regulation, product approval,

investment restrictions, disclosure of information, and licensing, among others.