Trust‐Preferred Securities and Insurer Financing Decisions

Published date01 March 2018
AuthorSteven W. Pottier,James I. Hilliard,Jianren Xu
Date01 March 2018
DOIhttp://doi.org/10.1111/jori.12137
© 2016 The Journal of Risk and Insurance. Vol. 85, No. 1, 219–244 (2018).
DOI: 10.1111/jori.12137
219
TRUST-PREFERRED SECURITIES AND INSURER FINANCING
DECISIONS
James I. Hilliard
Steven W. Pottier
Jianren Xu
ABSTRACT
We analyze insurance holding company (IHC) issuance of trust-preferred
securities (TPS) from 1994 to 2013. We find that larger and more financially
levered IHCs issued TPS in 1996 and 1997, as well as those that obtained
financial strength ratings from A.M. Best. Abnormal stock price returns are
positively related to financial distress costs, growth opportunities, and tax
burden, but negatively related to size. Consistent with the pecking order
theory, intent to use TPS proceeds to retire debt is positively related to
abnormal stock returns, whereas intent to use proceeds to retire preferred
equity is negatively related to abnormal stock returns.
INTRODUCTION
In October 1993, Goldman Sachs introduced the first debt–equity hybrid security,
known as monthly income preferred stock (MIPS). Since then, other similar hybrid
securities have been issued under various names, including quarterly income pre-
ferred securities (QUIPS) and trust-preferred securities (TPS).
1
An October 21, 1996
Federal Reserve Board (Fed) ruling that TPS qualified as core (Tier 1) regulatory
capital led to more bank-related issues. Although insurance holding companies
(IHCs) had first issued debt–equity hybrid securities in November 1993, they
increased their hybrid securities issuance activity following the October 1996 Fed’s
ruling. TPS have become an important source of capital for banks and insurers alike.
Indeed, by 2008 banks had issued approximately $149 billion and insurers had issued
approximately $34 billion in TPS. The 1996–1997 period represents the peak 2 years
James I. Hilliard is at the W. A. Franke College of Business, Northern Arizona University, and a
Associate Fellow, Baugh Center for Entrepreneurship and Free Enterprise, Baylor University.
Hilliard can be contacted via e-mail: jim.hilliard@nau.edu. Steven W. Pottier is at the Terry
Collegeof Business, University of Georgia. Pottiercan be contacted via e-mail: spottier@uga.edu.
Jianren Xu is at the Department of Finance, Mihaylo College of Business and Economics,
California State University, Fullerton. Xu can be contacted via e-mail: jrxu@fullerton.edu.
1
The terms “TPS,” “debt–equity hybrid securities,” and “hybrid securities” are used
interchangeably throughout this study.
220 THE JOURNAL OF RISK AND INSURANCE
for TPS issues by IHCs with over $14 billion in issues and is the only 2-year period that
TPS issues by IHCs exceeded common and preferred stock issues (see Table 1).
However, in an effort to strengthen bank balance sheets following the 2008 financial
crisis, TPS has been phased out as Tier 1 regulatory capital for larger bank holding
companies (BHCs) under the Dodd–Frank Financial Reform Act of 2010 (Balla, Cole,
and Robinson, 2011).
Engel, Erickson, and Maydew (1999) study the general impact of hybrid securities
and Benston et al. (2003) study their effect in the banking industry. The present study
is the first to extend the inquiry to the insurance industry. Three key differences
between banks and IHCs that motivate a specific study for IHCs include the nature of
regulation, capital sources, and volatility of cash flows. With respect to regulation,
although banks are regulated by the federal government at the holding company
level, insurance capital regulation is typically enforced by states at the operating
subsidiary (company) level. Furthermore, as state regulators do not explicitly
consider holding company capital structure in their regulatory risk-based capital
models, private credit rating agencies play an important role in evaluating IHCs.
Standard & Poor’s (2002) states that “insurance groups issue hybrid capital securities
to manage economic capital and satisfy constituents other than regulators (including
rating agencies like Standard & Poor’s).” Consequently, rating agency treatment of
TPS as equity may substitute for or intensify regulatory action in practice. In addition,
capital sources are an important difference between banks and insurers. Deposits
are a bank’s major source of capital (rather than debt or equity) and loss reserves
are a major source of capital for insurers. Finally, differences in how insurance
company liabilities arise (stochastically) relative to how BHC liabilities arise
(relatively stable over time) provide the third distinction between the two industries
that makes this study a contribution to our knowledge about TPS and regulatory
spillover in general.
This study examines firm-specific features related to an IHC’s decision to issue debt–
equity hybrid securities and the stock market responses for firms that issued them.
We examine the determinants of TPS issuance with a logistic regression and find that
larger and more financially levered firms are more likely to issue, as are firms that are
rated (as opposed to nonrated firms) by A.M. Best Company. The result with respect
to the rating variable implies that ratings agency treatment of hybrid securities is
important for insurers, even though their issuance does not directly affect regulatory
capital.
Our event study results suggest that the market generally rewards issuers, in contrast
to prior studies on market reactions to conventional equity offerings (see, e.g., Spiess
and Affleck-Graves, 1995; Loughran and Ritter, 1997; Born and McWilliams, 1997).
IHCs that issued TPS in 1996 and 1997, on average, experienced positive abnormal
returns around the date of the Fed’s ruling (October 21, 1996) and on each TPS issuer’s
announcement date. Abnormal returns around the ruling date reflect investor
reaction to the potential change in rating agents’ treatment of TPS capital, and
abnormal returns around each firm’s announcement date reflect investor reaction to
announcements of a planned or actual issue, that is, to expected capital structure
changes.

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