can independent distribution function as a mode of corporate governance?: an examination of the uk...

Journal of Management and Governance 7: 361–384, 2003.© 2003 Kluwer Academic Publishers. Printed in the Netherlands.

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Can Independent Distribution Function as a Modeof Corporate Governance?: An Examination of theUK Life Insurance Market

DAMIAN WARDBradford University School of Management, Emm Lane, Bradford BD9 4JL, UK(E-mail: [email protected])

Abstract. This paper examines whether independent modes of distribution can act as effectiveexternal monitors of managerial action. Because independent agents are owners of the client list,control of an essential cash-generating asset is concentrated in the hands of informed purchasers. Aconsequence of this concentration is the ability of independent agents to chastise bad managementby moving customers to alternative management teams. Therefore, insurance companies that useindependent agents should exhibit lower levels of opportunistic behaviour. By studying 42 UK lifeinsurance companies over the period 1990–1997 this study provides evidence that independent agentsdo reduce life companies’ free cash flow, managerial expenses and shareholder dividends, whileincreasing policyholders’ reserves.

Key words: corporate governance, distribution systems, insurance

1. Introduction

Insurance companies face two important agency problems: (A) shareholders haveto control managers and (B) policyholders have to prevent exploitation by share-holders. According to Mayers and Smith (1981) stock companies are optimalsolutions to shareholder-manager type agency costs. While mutuals, in combiningpolicyholders and shareholders, are optimal solutions to agency costs betweenshareholders and policyholders. However, these are local solutions as they dealwith specific agency problems. A global approach would recognise the aggregateagency costs of the organisation. For example, stocks solve shareholder-managerproblems, but do not reduce agency costs between shareholders and policyholders.Similarly, mutuals solve shareholder-policyholder problems, but do not reduceagency costs between shareholders and managers. A global solution would reducetotal agency costs by trading increases in shareholder-manager agency costs, forgreater decreases in shareholder-policyholder agency costs, or vice versa. Indeed,in the absence of market imperfections, firms whether stocks or mutuals, whodo not develop global agency solutions will become cost inefficient and struggleto compete with more efficient rivals. This paper explores how life insurance

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companies can use independent distribution in conjunction with corporate modesof governance to achieve a global agency cost solution.

Ownership of the client list by independent agents has been recognised byMayers and Smith (1981) as an effective mode of governance. Using independentdistribution bonds the insurance company to behave in the interests of it policy-holders. If not, then by moving new business from bad to good companies,independent distribution can starve bad companies of new cash flows.1

These are not entirely new ideas, but previous work on the topic has itslimitations. Kim, Mayers and Smith (1996) argue that because stocks have notdealt with the shareholder-policyholder agency problem, their need for a bond isgreater than mutuals. Therefore, stocks will be more commonly associated withindependent distribution than mutuals. However, within this framework the scaleof the shareholder-policyholder agency problem is proxied by the stock and mutualmodes of governance. This unfortunately does not provide a direct measure of thescale of agency costs within each firm. Assuming instead that agency costs arede facto higher in stocks than in mutuals. Regan and Tzeng (1999) argue thatindependent distribution is used to reduce transaction costs associated with thenature of the insurance policy and not related to reducing agency costs. However,the work of Regan and Tzeng (1999) focused on the non-life US market. Withone year renewable policies the scope for managerial, or shareholder opportunism,is limited by policyholders possessing a timely exit option. It, therefore, seemssensible to test the agency aspects of independent distribution in the long-term lifeinsurance sector where exit options are diminished and the scope for managerial,or shareholder opportunism, should be greater. Finally, if independent agents canmonitor shareholders exploitation in stock companies, then independent agentscan also monitor managers in mutuals. Independent agents have the potential toreduce shareholder-manager and shareholder-policyholder type agency costs andare, therefore, potentially beneficial to both mutual and stock companies in aidinga global solution to agency costs.

In recognising these points this study moves the analysis on by examiningagency relationships within the UK life insurance sector, utilising a variety ofagency cost measures based on financial flows between shareholders, managers,independent agents and policyholders.

For those readers who are unfamiliar with the peculiarities of the insuranceindustry’s corporate governance systems, products and distribution systems, thediscussion continues in the following section by describing in more detail each ofthese areas. This discussion will then provide the foundation for an examinationof complementary governance systems such as independent distribution. This isfollowed by a discussion of the models, data, and results gained by testing thehypothesis that independent agents constrain opportunistic behaviour by managersand shareholders towards policyholders in life insurance companies. A summaryand conclusions then follow.

THE UK LIFE INSURANCE MARKET 363

2. An Overview of the Insurance Industry

There are perhaps three aspects of the industry that need to be understood: (i) themodes of corporate governance, (ii) the nature of the products sold and (iii) themodes of product distribution.

2.1. MODES OF GOVERNANCE

UK life insurance companies, in the main, are either stock or mutual companies.Figure 1 presents a simplistic representation of the agency relationships withinthe two modes of governance. In the case of stock companies, shareholders asprincipals, employ managers to act as their agents in the running of the company.However, policyholders in stock companies employ companies to act as theiragents in the management of risk and the provision of financial intermediaryservices. We can, therefore, see managers as having competing agency relation-ships with shareholders and policyholders. If shareholders, particularly large share-holders, can exert more pressure over managers than small disparate policyholders,then an agency problem can also exist between shareholders and policyholders.With shareholders directing financial flows within the company away from policy-holders and towards themselves. In the case of mutual companies, policyholdersand shareholders are the same. Therefore, rather than having competing agencyrelationships, managers of mutuals simply answer to their policyholders. Withmutuals generally operating a one-member one-vote policy; and with no activemarket for ownership rights, it is difficult for policyholders to organise themselvesand discipline poorly performing management teams.

2.2. PRODUCTS SOLD

Many types of life insurance are a mixture of savings and protection. As a greaterpercentage of the premiums are allocated to the savings/investment function, thelower will be the value of the life insurance component of the policy. Generally lifeinsurance is broken down along three dimensions. Life insurance and pensions,linked or non-linked and regular or single premiums policies. Life insuranceprotects against premature death, pensions protect against living too long. Linkedand non-linked business refers to how the life insurance company generates invest-ment liabilities. With linked business the life insurance company creates investmentfunds with a unit price. As the value of the fund’s underlying assets change thenso does the unit price. Insurance premiums paid into these funds are linked directlyto the value of the underlying assets via the unit price. In the case of non-linkedbusiness the value of the premiums paid into the investment fund are not directlyrelated to the value of the underlying assets. Instead the insurance company seeksto smooth out investment returns. In periods of high financial performance policy-holders’ funds are under-credited with the full investment gains. But in periods

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Figure 1. Agency relationships in UK life insurance.

of low financial performance, the policyholders’ funds are over credited. There-fore, policyholders’ returns on non-linked business should be less volatile thanlinked business. However, the returns on non-linked business are clearly subject tomanagerial discretion, rather than being directly related to the value of the under-lying assets. Finally premiums can be paid to the insurance company on a regularbasis, perhaps once a month, or as single lump sums. Single lump sum paymentscan be associated with the transfer of pensions funds between providers. Addi-tional top ups into pension funds. Or the taking out of insurance based investmentproducts such as bonds or annuities.

2.3. DISTRIBUTION OF PRODUCTS

Ordinarily life insurance is either sold by direct agents working for one insurancecompany, or independent agents representing the policyholder and selling from arange of companies. Independent agents are a significant feature of the industrywith the Association of British Insurers, ABI (2002), reporting 33% of new lifebusiness and 66% of new pension business was sourced by independent agents inthe year 2001. Under UK investor protection legislation direct and independentagents are required to document the reasons why they have advised the purchaseof a particular product. Moreover, in the case of independent agents reasonsfor selecting one product provider over another also have to be documented.Regulators audit agents on a regular basis and none compliance, or breach ofthe regulations, results in the imposition of fines. It is, therefore, difficult (butnot impossible), for independent agents to act as agents of the life insurancecompanies, as opposed to their clients. In an investigation of bias amongst UK


Table I.

Percentage of newbusiness sourced byindependent agents

New regular premiumsNon linked life 34.0Linked life 24.9Non-linked personal pensions 41.9Linked personal pensions 53.3

New single premiumsNon linked life 69.2Linked life 57.9Non-linked personal pensions 74.7Linked personal pensions 84.8

Source: ABI (2002).

independent agents CRA (2002) found that in the case of single premiums, highercommissions only generated product provider bias in 3 out of 13 life insuranceproduct categories. No evidence of bias was found for regular premium business.

Table I provides data on the percentage of new business, by product groupings,sourced in the independent channel. It is clear that independent agents sourcemore regular premium business in the pensions sector, but more significantlyindependents are a big source of business in the single premium market, regardlessof the split between life and pensions. Similarly, independent agents are strongin non-linked business where life insurance companies operate discretion over theallocation of investment returns.

3. Agency Costs and Corporate Governance in Life Insurance

It is now possible to see how the mode of corporate governance, product character-istics and distribution fit together. To begin Mayers and Smith (1981) argue that thecontinued existence of stock and mutual companies reflect differing agency prob-lems. By utilising the market for corporate control, stock companies are effective atcontrolling agency problems between shareholders and managers. In contrast, bymaking policyholders the residual claimant, mutuals are effective at reducing theagency problems between policyholders and shareholders. Theoretically, the stockmode of governance will be employed when the agency costs between shareholdersand managers dominate the agency costs between shareholders and policyholders.But what are the likely sources of these agency costs?

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3.1. SHAREHOLDERS AND MANAGERS

The potential agency costs between shareholders and managers will be greaterwhen the market environment is complex. In these environments managerial discre-tion will need to be high in order to monitor, control and exploit profitableopportunities as they arise. Complexity can exist in a number of forms. Deathis very predictable. This simple liability can be matched with a simple assetsuch as a long-term bond. Pensions and investment aspects of life insurance areless predictable and rely on good portfolio management. Discretion is neededin researching and selecting investment options. Frequent changes in govern-ment policy on taxation, or pensions create opportunities for product innovation.Successful exploitation of these opportunities is assisted by managerial discretionand timely decision making. However, if the interests of managers and shareholdersare not aligned then management can use its discretion to facilitate expense prefer-ence behaviour, or the pursuit of growth as opposed to profitability objectives Forexample, in seeking growth, managers could pursue high-risk investment, or under-writing strategies. In order to discipline and constrain managers there is a strongneed for a stock mode of governance with its over arching market for corporatecontrol. In contrast, when the environment is simple, the need for managerialdiscretion is much reduced. This limits the need for shareholders to monitor thebehaviour of their managers and as a consequence the effectiveness of the mutualmode of governance increases, with policyholders becoming shareholders.

According to Baker and Thompson (2000), there is weak empirical supportfor the proposition that managers of mutuals are more likely to abuse discre-tionary powers. A possible explanation for this empirical contradiction lies inthe importance of prudential financial regulation and solvency requirements. Asregulators impose financial operating conditions on mutuals; and stocks, then theregulator can represent an effective constraint on managerial discretion. However,following financial deregulation throughout the 1980s and 1990s, the stringency ofprudential regulation within the UK has diminished and mutuals have been ableto move into more complex product markets. Baker and Thompson (2000) arguethat the increased number of demutualisations within the UK financial servicessector reflects the increased agency costs of mutuals following product marketdiversifications. In more complex markets, with less prudential regulation, it isarguably more efficient for a mutual to convert into a stock company; and use themarket for corporate control to discipline managers. A contention of this study isthat demutualisation is not inevitable when complementary modes of governance,such as independent distribution, are capable of monitoring managerial discretion.This point will be discussed in more detail, in section 4.1, when the governancecharacteristics of independent distribution are considered.


3.2. SHAREHOLDERS AND POLICYHOLDERS

Insurance companies are a collection of competing interests: shareholders,managers and policyholders. The cash flows into an insurance company comein the form of capital from shareholders, premiums from policyholders, retainedunderwriting profit and positive investment returns. The outflows are claims paid,managerial expenses, dividends to shareholders and investment returns to policy-holders. It is fairly easy to ascertain proof of death or retirement, so there is little,if any, scope for a life insurer to refuse the payment of a claim. However, divertinginvestment returns from policyholders’ funds to shareholders’ dividends, or intomanagerial expense accounts is possible. Moreover, as diversified investors, share-holders can take bigger risks with the insurance company’s funds, perhaps takinghigher risks in equities than less diversified policyholders would find desirable.

This behaviour is possible for a number of reasons. Unlike motor or propertyinsurance, life insurance is a long-term contractual arrangement, often in excessof ten years. If at the end of the contract, policyholders returns have been reducedby managerial, or shareholder opportunism, then the company still has a multitudeof mitigating circumstances available to it, including for example, “the governmenthas failed in its management of the economy”. Furthermore, insurance contracts arecomplex, mixing various types of life and critical illness cover as well as providingtax shields for investors. Funds can be linked, or non-linked and premiums can beregular or single. The ordinary individual has little interest, or willingness to under-stand the full complexity of these products and often employs a financial adviser.Therefore, policyholders buy on trust and rarely undertake active monitoring oftheir policies.

Life and pension policies, because of their long-term nature, are not renewed.You die, retire, or your saving plan comes to an end. If a motor insurer does notfully honour its contracts, then policyholders can cancel their insurance immedi-ately, or at least at renewal. Life insurance companies make exit very costly forthe policyholder. Policies are front-loaded with the life-time expenses of the policycharged in the early years. This has the effect of reducing investment returns andin early years the investment fund can often be less than the premiums paid in.Front-loading, therefore, makes early exit costly. At the present time, due to underperforming stock markets, policyholders face exit penalties, where policyholderfunds are reduced by 10 to 15% to reflect current market values. Therefore, policy-holders’ exit options are restricted by switching costs, finding a new company andpaying the penalty associated with early exit.

The scope for such opportunistic behaviour by managers and shareholders issomewhat bigger with single premiums as the policyholder’s funds are handedover in one payment. With regular premiums the policyholder can at least threatento stop the premiums if opportunistic behaviour becomes apparent. The mutualmode of governance attempts to reduce these agency problems by making policy-holders shareholders. The interests of shareholders and policyholders are then fullyaligned.

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4. Complementary Governance Systems

While it is possible to understand the benefits of stocks and mutuals it is stillinteresting to ask why a policyholder would use a stock company if at risk ofopportunistic behaviour by shareholders? Similarly, why would a policyholder usea mutual if at risk of opportunistic behaviour from managers? Krishnaswami andPottier (2002) argue that in order to understand these questions it is necessary toexamine the complementary nature of alternative governance systems. Life insurerswill introduce complementary governance systems if there is a net reductionin overall agency costs. For example, a stock company will benefit from addi-tional complementary governance if the reduction in agency costs associated withshareholders and policyholders outweighs the increase in agency costs betweenshareholders and managers.

As an example Krishnaswami and Pottier (2002) examine the peculiar activityamongst stock companies of issuing “participating” or “with profit” policies. Theseprovide policyholders with a claim on the company’s profits, or more commonlyresidual claimant rights. This entails a partial mutualisation of the stock companyand, therefore, a partial solution to the remaining shareholder-policyholder agencyproblem. Unfortunately, this approach will diminish the beneficial aspects ofthe stock mode of governance. As any positive returns to a potential bidderfor the company will be shared with the participating policyholders. Moreover,Krishnaswami and Pottier (2002) argue that the power of any incentive, or stockoption contract to align shareholders’ and managers’ interest will be diminishedwhen participating policies are issued because a share of any additional profits willbe placed with the policyholders. But in the case of participating policies increasedagency costs between shareholders and managers are being traded for reducedagency costs between policyholders and shareholders. This reduces overall agencycosts and according to Jensen and Meckling (1976) should increase the value ofthe organisation.

4.1. CORPORATE GOVERNANCE, INDEPENDENT DISTRIBUTION AND

RESEARCH HYPOTHESES

The central issue for this paper is to explore how the use of independent distribu-tion can be used as a complementary governance system to the mode of corporategovernance, and like participating policies offer a more global solution to insurancecompanies’ conflicting agency problems. Independent distribution may reduce thefinancial returns to shareholders or managers. Work by Joskow (1973) and Bergeret al. (1997) have shown that independent distribution is more expensive than directdistribution. However, by monitoring managers and shareholders, independentdistribution also serves to reduce the agency costs of policyholders dealing withmanagers and shareholders. Independent distribution can thereby add value tothe insurance company by facilitating transactions with policyholders that in thepresence of direct sales forces would not take place.


Figure 2. Indepent distribution and agency relationships.

From the policyholders’ perspective life insurance, as discussed above, is acomplex set of products. Furthermore the purchasing decision is non-trivial in thatit relates to long-term investment decisions and costly exit options. The servicesoffered by independent agents can help to reduce the agency costs associated withpurchasing insurance. Pre – contractual opportunism by the insurance companycan be reduced through searches for price and cover. Furthermore, by negoti-ating claims and monitoring investment performance independent agents can limitpost-contractual opportunism by threatening to move new business to alternativesuppliers of insurance. Independent agents are able to achieve this for a numberof reasons. First, unlike many policyholders independent agents are qualifiedfinancial experts. Second, by representing many policyholders the independentis less affected by the free rider problem. Any effort expended in monitoringand disciplining a company, can provide wide benefits for its entire client base.Finally, since life insurance is a long-term product, individual policyholders are notrepeat purchasers. But independent agents are and, therefore, overtime can advisenew clients to purchase products from companies that display less opportunisticbehaviour.

Figure 2 includes independent agents as a complementary mode of governanceand is simply an augmentation of Figure 1. Independent agents sit between policy-holders and the company. As a business proposition, the value of an independentagent depends upon its ability to reduce the agency costs between policyholdersand managers and shareholders. The more effective independents are at controllingmanagers and shareholders, the more valuable will be its business with policy-

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holders. In the case of stocks, independents can help policyholders by seeking tomonitor and control shareholders. While in mutuals, independents can attempt tomonitor managers in the absence of a market for corporate control.

The effectiveness of independents maybe greater for mutuals when marketopportunities presented by financial deregulation lead to a greater need formanagerial discretion. Baker and Thompson (2000) highlight how increasingmanagerial discretion, following product market diversification, has led toincreasing demutualisations. An argument not considered by Baker and Thompson(2000), is that increased use of independent distribution, may aid the shareholdersof mutuals in the monitoring of managerial discretion. The use of independentdistribution enables mutuals to take advantage of new market opportunities withouthaving to change the corporate mode of governance.

Based on these arguments hypothesis one can be stated as:

Hypothesis 1: The use of independent distribution provides a means by whichpolicyholders (and shareholders of mutuals) can reduce the agency costs ofdealing with managers and shareholders of life insurance companies.

A direct measure of agency costs is difficult. But Mayers and Smith (1981)define life insurance companies as a union of conflicting parties. The conflictfor Wells, Cox and Graver (1995) is measured using Jensen’s (1986) conceptof free cash flow. In particular, Wells et al. (1995) examine whether stock ormutual modes of governance are better at reducing free cash flow within US lifeinsurance companies; and thereby reducing the agency costs between shareholdersand managers. Therefore, if independent distribution can also act as a mode ofgovernance then free cash flow within stock and mutual companies should bereduced.

It has to be recognised that a simple analysis of free cash flow levels is unlikelyto be a sufficient test of the corporate governance effects of independent distribu-tion. This is because it is important to recognise where free cash is flowing to. Forexample, if we return to Figure 2 the free cash can be flowing to shareholders,managers, independent agents or policyholders. Only in the latter case of freecash flowing to policyholders would we have support for hypothesis 1. In orderto discount the alternatives we also need to test a number of additional hypotheses.

Hypothesis 2 addresses whether independent agents reduce the flow of financialresource to managers.

Hypothesis 2: For comparable service levels insurance companies usingindependent distribution will have lower managerial expenses than companiesusing direct distribution.

If independent agents do constrain managerial discretion, then one should expectto see the use of independent agents associated with lower managerial expenseratios. Where managerial expenses are the costs of managing the business. It is notclear specifically which managerial expenses will be curbed, but if independentagents can reduce managerial discretion, then one should expect them to attempt


to discriminate between high expense ratios which relate to improved levels ofservice for policyholders, from high expense ratios that relate to the consumptionof perquisites by managers. While this may not be an exact science, evidenceby Berger at al. (1997) suggests that service level costs do vary by product anddistribution channel, particularly as products become more complex. Given thatindependent agents are at the forefront of managing these transactions then onecan argue that they will be aware of service differentials and, therefore, capableof separating service level costs from excessive managerial expenses levied by theinsurance companies.

Hypothesis 3 address whether independent agents divert financial resource tothemselves

Hypothesis 3: For comparable service levels, the costs of distribution will notdiffer across independent and direct agents.

Independent agents can extract free cash flow for themselves; financing theirown expense preference behaviour. If true, then the insurance companies’ salesexpense ratio will be higher for independent agents. However, one still needsto control for a number of other variables. In particular, as shown by Berger etal. (1997) larger companies should be capable of attaining economies of scalein distribution and so one should expect size to be negatively related to salesexpenses. Also, as found by Berger et al. (1997) the product mix of a companyis likely to drive the complexity associated with managing and distributing variousproducts and, so the more a company focuses on simple life products, the lower itssales expenses should be and, therefore, one should expect a negative relationshipbetween product mix and sales expenses.

Hypotheses 4 and 5 relate to the flow of financial resource from shareholders topolicyholders.

Hypothesis 4: Companies using independent distribution will pay lowerdividends to shareholders

Hypothesis 5: Companies using independent distribution will allocate largerreserves for policyholders’ future claims

If the main premise of this study is correct and independent agents arean important mode of corporate governance for insurance companies, then oneshould expect to see dynamic relations over time between life insurance companybehaviour and the degree of future business sourced through independent agents.Therefore, a negative relation between dividend payments to shareholders and theuse of independent distribution should be observed. Through cut backs in dividendpayments, companies can try to signal their willingness to consider policyholderreturns. Adding financial capital to policyholders’ reserves through increasedbonuses can further enhance this. Therefore, as dividends fall and policyholderreserves increase one can expect more business to be supplied by independents inthe future.

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Table II.

Code Variable Hypothesised sign

Where FCF = Free cash flowFCFt−1 = Free cash flow lagged one period +INDP = Use of independent distribution channel −ORG = Organizational form +LEVG = Leverage −/+SIZE = Firm size +PREMS = Total Industry Premiums +CLAIMS = Total Industry Claims −INVINC = Total Industry Investment Income +

5. Models

Hypothesis one is tested using the model (1)

FCFit = b10 + b11FCFit−1 + b12INDPit + b13ORG+it + b14SIZEit+

b15LEVGit + b16PREMSit + b17CLAIMSit = b18INVINCiteit (1)

Model (1) is the model of Wells et al. (1995) augmented with independentdistribution. Size is expected to be positively related to the generation of freecash flow simply because larger firms will underwrite more insurance and mayalso benefit from economies of scale in underwriting and investment. Therefore,larger revenues and lower unit costs will lead to higher free cash flows. Further,Wells et al. (1995) note that smaller firms are likely to suffer less from problemsassociated with separating ownership and control, as ownership is concentrated infewer hands. As a consequence, the problem of free cash flow will also be reduced.Organizational form is seen by Wells et al. (1995) to be instrumental in determiningthe generation of free cash flow simply because stock companies and the marketfor corporate control are more effective at controlling managerial discretion thanmutuals. Leverage is a measure of the debt to equity ratio of a company andas argued by Jensen (1986) debt commits managers to disburse free cash flow.Therefore, the higher the level of leverage, the lower the amount of free cash flow.This view is supported by Lehn and Poulsen (1989) in the US, but Thompson(1999) when examining UK utility companies found that debt was positivelyrelated to greater undertakings of non core activities indicative of managerialdiscretion. Thompson (1999) explains this finding with reference to the work ofCarpenter (1995) who argues that the relationship between leverage and free cashflow is dependent upon the investment opportunity set of the company. Therefore,debt may complement free cash flow and aid a company in the exploitation ofgood investment opportunities. Or alternatively, when investment opportunities arelimited, debt may act as a restraint on the use of free cash flow, making the actualrelation between leverage and free cash flow unclear.


Time varying factors, particularly outside the control of the individual firmmay have an impact on free cash flow. However, a problem exists in accuratelyspecifying what these factors might be. Therefore, in the first instance this studyemploys a simple TIME trend to control for inter-temporal changes in the level offree cash flow across the industry. This is then substituted for industry level totalearned premiums, (PREMS), total claims, (CLAIMS), and investment income,(INVINC). Therefore, if factors, such as rising income, cause total premiums torise, or the financial markets rise leading to increases in investment income, thenthe effect of such changes can be controlled for across companies.

Before (1) can be estimated it is important to recognize the potentialendogeneity of the distribution variable, INDP. While Regan and Tzeng (1999)show that the mode of ownership and the mode of distribution are not jointlydetermined. Their exogenous specification of the distribution decision reinforcesthe finding of Kim et al. (1996) in showing that the mode of ownership is asignificant determinant of the decision to use an independent distribution system.Therefore, in order to recognize this particular problem, a two-step procedure wasemployed, where INDP distribution was modelled and then the predicted valuesfor INDP distribution were used in the model of free cash flow, thus recognizingthe potentially endogenous nature of distribution.

Importantly, within the system estimator it is necessary to overcome the identifi-cation problem. Fortunately, Regan (1997) and Regan and Tzeng (1999) haveshown that the distribution decision is dependent upon transaction costs. Withindependents being used when the transactional costs are higher. Therefore, itshould be possible to identify the two equations by including in the INDP distri-bution model measures that proxy for the levels of complexity and uncertainty.Following Regan (1997), complexity can be proxied by the type of productssold, with a reasonable assumption that the transactional characteristics of life,pension and permanent health insurance products are all different. Indeed, the ABI(2001) show that at an industry level around 60% of pension policies, a complexproduct, were sold via independents. Therefore, in order to model this relationshipPRODMIX, as the ratio of life to pension business, is used to measure the weightof simple life products within the companies overall portfolio of business. Thehigher this ratio, the less likely the firm is to use independent distribution. Interms of uncertainty Regan (1997) suggests that leverage can be used to proxythe uncertainty associated with the insurance company failing to meet its finan-cial obligations and the same will be carried out here. The model for INDP wasspecified as:

INDPit = b21CONSTANT + b21iDUMMY + b22MUTUALit + b23SIZEit

+b24LEVGit + b25PRODMIXit + eit (2)

In testing hypothesis 2, which covers the relationship between overallmanagerial expense ratios and the use of independent distribution. The followingmodel was employed:

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Table III.


DUMMY = Firm specific dummy variableMUTUAL = Organizational form +LEVG = Leverage +SIZE = Firm size −PRODMIX = Ratio of life to pension business +

Table IV.


MGTEXPa = Managerial Expense ratioDUMMY = a firm specific dummy variableINDP = independent distribution −MUTUAL = Organizational form +SIZE = Firm size −PRODMIX = Ratio of life to pension business +

The management expense ratio was measured as managerial expenses divided by totalpremiums, where both variables were again taken from the THESYS data base.

MGTEXPit = b31constant + d31iDUMMYi + b32INDPit + b33MUTUALit

+b34SIZEit + b35PRODMIXit + eit (3)

Following Berger et al. (1997) cost differentials across insurance companieshave been shown to reflect service differentials and it is not unreasonable to expectthat independent agents should be able to distinguish between cost differencesarising from service differentials and managerial expense preference behaviour.Therefore, independent distribution should be associated with companies thatoperate at lower cost levels, while costs will be higher when the product mix ofthe company includes more complex products such as pensions. Furthermore, dueto the limited ex-post managerial control of mutuals by disparate policyholders it iscommonly hypothesised by amongst others Mayers and Smith (1981), Ingham andThompson (1995) and Wells et al. (1995) that mutuals will be more costly to runthan stock companies. While recent evidence by Ward (2002) does not support thisargument, a conservative approach would be to still include the mode of corporategovernance as a control. Finally, Hardwick (1997) has found economies of scaleto be an important determinant of life insurance companies’ costs; therefore, themodel also includes the natural logarithm of assets as a measure of size.

In order to test the competing proposition of hypothesis 3, that independentagents could be extracting free cash flow for themselves the following model ofsales expenses was also developed.


Table V.


SALESEXP = Sales Expense ratioDUMMY = A firm specific dummy variableINDP = independent distribution +MUTUAL = Organizational form +SIZE = Firm size −PRODMIX = Ratio of life to pension business +

SALESEXPit = b41constant + d41iDUMMYi + b42INDPit

+b43MUTUALit + b44SIZEit + b45PRODMIXit + eit (4)

If independent agents are extracting free cash flow for their own benefit, in theform of higher commissions, then we should expect to see a positive relationshipbetween sales expenses and the use of independent agents. However, it is alsorecognised following the work of Berger et al. (1997) that sales expenses mightalso be influenced by economies of scale in distribution. Therefore, size is alsoincluded in the model. Similarly product mix is also included as following Berger etal. (1997) and Regan (1997) increasingly complex products are more expensive todistribute than simpler ones. Finally, if managers within mutuals are less motivatedthan stock managers to control costs, then this should also be reflected in highersales expenses. The model is also estimated using the fixed effects estimator.

Finally, in order to test hypotheses 4 and 5, the premise that independent agentswill move business to companies which transfer benefits from shareholders topolicyholders; the current percentage of sales in the independent channel by aparticular company are modelled as a function of the previous years dividendpayments to shareholders, LAGDIVS and bonus payments to policyholders,LAGADDRES. As Kim et al. (1996), have also shown that the use of independentdistribution is also conditional upon the agency costs associated with the mode ofcorporate governance, then mutual is included in this model. Regan (1997) andRegan and Tzeng (1999) have also shown that increasing product complexity andcompany risk are associated with increased use of independent distribution thenproduct mix is included to capture product complexity and leverage is used as ameasure of financial risk. Therefore, the following model is estimated using thefixed effects estimator.

INDPit = b51CONSTANT + b52MUTUALit + b53SIZEit + b54LEVGit

+b55PRODMIXit + b56LAGDIVSit + b57LAGADDRESit

+eit (5)

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Table VI.


INDP = Distribution by independents

MUTUAL = mode of ownership +SIZE = Firm size −LEVG = Leverage of the company +PRODMIX = Ratio of life to pension business −LAGDIVS = Lagged dividends −LAGADDRES = Lagged additions to policyholders reserves +

Discussed in more detail below, this study employed a panel data set, combiningcross section and time series data. Reflecting this characterisation, panel dataestimators were used. Such estimation procedures control for the cross-sectionaland time series nature of the data. The fixed effects estimator was used for allmodels, except for the Tobin panel estimator used in estimating model (1), whichrequires a random effects estimator, see Greene (2000) for further details.

6. Data

The UK has approximately 100 operating life insurance companies, but data ondistribution is limited, hence this study utilises a panel data set consisting of 42UK life insurance companies over the period 1990–1997. The measurement ofdistribution method, INDP, is taken from the annual New Business Survey in theindustry journal Money Management. The survey reports the percentage of newbusiness sold by a company in independent, or direct distribution channels. Theproportion of sales in the independent channel was used to measure the type ofdistribution channel used.2

Firm level financial data was taken from the THESYS database, whichpublishes financial regulatory returns made by all UK insurance companies. Themeasurement of free cash flow follows that of Wells et al. (1995) and usesundistributed cash flow as a proxy for free cash flow. This figure represents thedifferences between all cash receipts and all mandatory cash payments.3 Therefore,cash that is left is that which management retains discretion over its disbursement.LEVG was measured as the ratio of liabilities to total assets, where liabilities weremeasured as the sum of total mathematical reserves plus short-term creditors.4

SIZE was measured using total assets expressed in natural logarithms to alleviateproblems of heteroscedasticity and the potentially confounding effects of extremevalues. MGTEXP and SALESEXP are ratios created within the THESYS database.MGTEXP is the ratio of managerial expenses of maintaining existing business tototal expenses. SALESEXP is the ratio of sales commissions to total expenditure.


The category of other expenditures reduces the potential for multicollinearitybetween the two measures. LAGDIVS are dividends paid in the previous financialyear and LAGADDRES are additions to policyholders’ reserves paid in theprevious financial year.

The industry level variables PREMS, CLAIMS and INVINC, used to control forpotential time varying factors, were taken from the ABI (2000) Insurance Trends.All nominal values were deflated to 1995 prices by the use of the GDP deflator.

Table VII contains descriptive statistics and correlation coefficients for the firmspecific variables.

Examining the descriptive statistics first, the range of minimum and maximumvalues, plus the relatively wide standard deviations for each of the variables isindicative of good variability within the data set, which should aid the identifica-tion and testing of the hypothesised relationships. In terms of these hypothesisedrelationships, there appears to be no correlation between free cash flow andindependent distribution, or between free cash and mode of governance. However,in contrast to the work of Kim et al. (1996) there is a strong and positive relation-ship between mutuals and the use of independent distribution. This suggests thatwithin the UK life sector, independent distribution is more complementary tothe mutual, rather than stock mode of corporate governance. Given the changingcomplexity of the financial services industry, this result could be indicative ofattempts to control and monitor increased managerial discretion within mutuals.

We need to take these three findings together. Agency costs, or our proxy freecash flow, is not expected to vary with mode of governance, or mode of distribu-tion. Rather, it is the combination of mode of governance and distribution, whichis important. The correlation between our measure for mode of governance andmode of distribution supports the contention of this paper that the two systems needto be examined jointly. For example, if mutuals provide managers with increaseddiscretion, free cash flow maybe higher. However, independent distribution canthen be employed to counteract the increased agency costs. To accommodate thepotentially endogenous relationship between mode of governance and mode ofdistribution, the models for free cash, presented below, are estimated using twostage least squares. In the first stage, the mode of distribution is modelled. Thepredicted values for distribution are then used as instruments for distribution in thesecond stage estimation of the free cash flow models.

Lowering dividends is associated with greater use of independent distributionin the future, supporting hypothesis 4 that independent distribution can act asa restraint on shareholder opportunism. Managerial expenses are also correlatedwith independent distribution supporting hypothesis 2 that independent agentscan restrain managerial opportunism. Finally from a purely statistical standpointthere are no high correlations between the independent variables. Suggesting theindependent variables are orthogonal.

378 DAMIAN WARD

Tabl

eV

II.

Des

crip

tive

stat

isti

cs

Mea

nM

inim

umM

axim

umSt

anda

rd

devi

atio

n

FCF

295.

2781

0.00

0029

12.6

955

444.

6553

IND

P45

.847

10.

0000

100.

0000

40.8

155

MU

TU

AL

0.42

680.

0000

1.00

000.

4954

SIZ

E14

.283

77.

8144

16.9

232

1.64

10

LE

VE

RA

GE

0.86

980.

5825

0.99

040.

0851

PRO

DM

IX2.

6608

0.07

0016

2.87

899.

2558

LA

GD

IVS

209.

0809

0.00

0034

00.0

000

474.

5316

LA

GA

DD

RE

S58

5.36

750.

0000

5203

.842

097

1.29

70

MG

TE

XP

0.16

280.

0349

0.50

750.

0858

SAL

ESE

XP

0.07

000.

0409

0.54

750.

0807

Cor

rela

tions

FCF

IND

PM

UT

UA

LSI

ZE

LE

VE

RA

GE

PRO

DM

IXL

AG

DIV

SL

AG

AD

DR

ES

MG

TE

XP

FCF

IND

P−0

.002

7

MU

TU

AL

0.06

010.

2892

∗∗SI

ZE

0.33

62∗∗

−0.1

935∗

∗−0

.149

5∗∗

LE

VE

RA

GE

0.18

19∗∗

0.30

69∗∗

0.07

89−0

.017

4

PRO

DM

IX−0

.079

0−0

.090

3−0

.091

0−0

.124

3∗∗

0.04

49

LA

GD

IVS

−0.0

475

−0.2

555∗

∗∗−0

.186

9∗∗

0.13

81∗∗

0.12

02∗∗

−0.0

229

LA

GA

DD

RE

S−0

.019

2−0

.046

9−0

.075

7−0

.021

40.

2387

∗∗∗

0.01

140.

3229

∗∗∗

MG

TE

XP

−0.1

197∗

∗−0

.251

1∗∗∗

−0.0

518

−0.0

740

−0.0

605

−0.0

521

0.04

42−0

.176

3∗∗∗

SAL

ESE

XP

0.15

32∗∗

∗0.

0947

0.10

47∗

−0.0

301

0.07

36−0

.066

5−0

.052

6−0

.071

00.

0012

∗∗∗ M

eans

are

sign

ifica

ntly

diff

eren

tatt

he1%

leve

l.∗∗

Mea

nsar

esi

gnifi

cant

lydi

ffer

enta

tthe

5%le

vel.

∗ Mea

nsar

esi

gnifi

cant

lydi

ffer

enta

tthe

10%

leve

l.


7. Results

Equation (2) was estimated using a fixed effects panel data estimator. The fittedvalues from this were then used in the estimation of equation (1) which wasestimated using a Tobit panel data specification as in Wells et al. (1995).5

The results from the two-stage estimation procedure are listed in Table VIII.Stage one is the estimation of the INDP distribution model and these results areshown in the first column. This paper finds that UK life mutuals are more likelythan stocks to use independent modes of distribution. This result is in contrast tothe work of Kim et al. (1996) and Regan and Tzeng (2000), which focused uponthe agency problems within the US non-life sector. This may suggest that withinthe UK life sector, the agency problem between shareholders and managers withinmutuals, is greater than the agency problem between shareholders and policy-holders in US non-life stock companies. Given that independent distribution isalso associated with complex, rather than simple products, then the greater use ofindependent distribution by mutuals may be indicative of increased agency prob-lems stemming from greater managerial discretion. This would suggest thatthrough the use of independent distribution, mutuals can compete against stocksin the same complex product markets. Therefore, in order to monitor managerialdiscretion effectively, it is not necessary to demutualize and utilise the market forcorporate control, the use of independent distribution may be as effective.

Examining the remaining estimated parameters; larger companies are less likelyto use independent distribution given that they are more capable of financing thecreation of an internal, or direct sales force. Companies with higher levels ofleverage, or displaying greater risk are more likely to use independent distribution.This is not surprising as independent agents are then capable of advising potentialpolicyholders of the financial risk associated with dealing with such companies.

In column two the results from the second stage free cash flow model withtime trend are detailed. The results suggest that there is a negative and statisticallysignificant relationship between free cash flow and the use of independent agents.This suggests that independent agents are associated with companies that have alower free cash flow. In order to examine whether this is associated with greatermonitoring and constraint of manager and shareholder discretion, it is necessary totest the remaining hypotheses. However, in terms of the other factors within model(1), one can see that there is no statistically significant difference in free cash flowbetween mutuals and stocks. However, as predicted by the theory larger companiesare associated with higher levels of free cash flow. Highly leveraged companies arealso statistically associated with higher levels of free cash flow. Given the workof Carpenter (1995) and Thompson (1999) on the complementary nature of freecash flow and debt, this result should not be surprising. For the UK life insuranceindustry has undergone a period of expansion and therefore free cash flow anddebt are more likely to be financial complements facilitating growth, rather thansubstitutes as in the case of Jensen (1986). The TIME trend is also significantand negative suggesting industry level changes over time in the amount of free

380 DAMIAN WARD

Table VIII. Results for distribution model and free cash flow models

Distribution model Free cash flow with Free cash flow withtime dummies industry level variables

Constant −31.82463 (29.54694) −1273.4066 (329.7767)∗∗∗ −1398.0517 (476.2382)∗∗∗FCF (t − 1) 0.6948 (0.0511)∗∗∗ 0.7036 (0.05097)∗∗∗INPDHAT −6.5430 (2.7137)∗∗∗ −6.3385 (2.6948)∗∗∗MUTUAL 19.48697 (4.64031)∗∗∗ −35.2014 (61.4161) −31.7108 (60.9896)

SIZE −3.897868 (1.38432)∗∗∗ 60.9202 (14.3635)∗∗∗ 60.4126 (14.2496)∗∗∗LEVERAGE 145.21681 (25.2222)∗∗∗ 715.6887 (294.2574)∗∗∗ 692.9735 (292.8961)∗∗∗PRODMIX −0.556074 (0.2243)∗∗TIME −23.2759 (10.3112)∗∗PREMIUMS 0.0204 (0.0155)

CLAIMS −52.5989 (23.7243)∗∗INVINCME 0.0321 (0.0165)∗∗

Sigma 323.9844 (15.7202)∗∗∗ 321.6415 (15.5923)∗∗∗R2 0.2126

Adj. R2 0.2011

F 18.56∗∗∗

N 280 280 280

∗∗∗Means are significantly different at the 1% level.∗∗Means are significantly different at the 5% level.∗Means are significantly different at the 10% level.Standard errors in parentheses.

cash flow. In an attempt to understand these changes the results in column threecontrol for industry level changes in premiums, claims and investment income.The results for the influence of independents, mode of organization, corporate sizeand leverage remain fairly similar suggesting good parameter stability within themodels. There is no evidence for a statistical relation between total premiums andfree cash flow, but there is a negative and significant relation between claims andfree cash flow and a positive and significant relation between investment incomeand free cash flow. Although these results add little to the insights of the model, theuse of these variables within the model help to control for industry level effects onfree cash flow and as such help to focus the analysis on the specific characteristicsof the individual firms.

The results from estimating models (3), (4) and (5) which focus the analysison the competing hypotheses 2, 3, 4 and 5 are to be found in Table IX. Takingmanagement expenses first one can see that there is a negative and statisticallysignificant relationship between the use of independents and the level of managerialexpense. This is supportive of hypothesis 2 that independent agents have the poten-tial to curb expense preference behaviour within insurance companies. This resultremains fairly constant even after making a rudimentary control for economies ofscale by including SIZE squared in the specification. In terms of sales expense


the overall model is not well estimated, with a low R2 and an insignificantF-test. Therefore, neither independent agents nor any of the controls are seento determine the sales expense. This finding is also evident when economies ofscale are controlled for. Therefore, there is little support for hypothesis 3 thatindependent agents are extracting financial resource from insurance companiesin the form of higher commissions. As a result, we have no evidence to suggestthat independent agents are pursuing expense preference behaviour against theirclients’ interests. Taking these findings on hypothesis 2 and 3 together there isevidence to suggest that lower managerial expenses are associated with the use ofindependent agents and that these savings are not transferred into the sales expensefor the principle benefit of independent agents. Therefore, independents do appearto be capable of influencing managerial behaviour for the benefit of policyholders.

The last set of results in Table IX demonstrate that current distribution has anegative and significant relationship with past dividend payments. Current distri-bution also has a positive and significant relationship with past additions topolicyholders’ reserves. Therefore, there is evidence to support hypotheses 4 and5 that independent agents react to the past behaviour of life insurance companiesand reward positive behaviour with higher levels of future business. This supportsthe idea of a long run co-operative relationship between independent agents andlife insurance companies that signal a willingness to work towards the interests oftheir policyholders.

8. Summary and Conclusion

Mayers and Smith (1981) have highlighted how mutual and stock companies usetheir mode of corporate governance to deal with different agency problems betweenshareholders, managers and policyholders. A significant problem with these solu-tions is that they are likely to require complementary governance systems. Inthe case of stocks the shareholder - manager agency problem is solved, but theissuing of participating policies and the use of independent distribution channelsare likely to assist in solving the remaining agency problems between shareholdersand policyholders.

These are not new ideas, particularly in the area of insurance distributionsystems, but previous work by Kim et al. (1996) on the role of independentdistribution in reducing agency costs has been superseded by Regan and Tzeng(1999) who show that such agency aspects are limited and it is more likely thatindependent distribution stems from transactional problems such as complexity andrisk. However, each of these studies have merely proxied the level of agency costsby the mode of corporate governance. This study moves the analysis on by testingthe impact of independent distribution on a variety of agency related measures.Hence, this study provides a more direct test of the external monitoring capabilitiesof the independent distribution channel.

382 DAMIAN WARD

Tabl

eIX

.F

urth

eran

alys

is:M

odel

sof

man

agem

ente

xpen

ses,

sale

sex

pens

esan

dfu

ture

dist

ribu

tion

patt

erns

Man

ager

ial

Man

ager

ial

Sal

esS

ales

Fut

ure

Con

stan

tex

pens

e(1

)ex

pens

e(2

)ex

pens

e(1

)ex

pens

e(2

)di

stri

buti

on

IND

P−0

.001

49(0

.000

26)∗∗

∗−0

.001

6(0

.000

26)∗∗

∗0.

0002

(0.0

0029

)0.

0002

4(0

.000

30)

MU

TU

AL

0.07

043

(0.0

3078

)∗∗∗

0.06

29(0

.030

8)∗∗

−0.0

094

(0.0

3441

)−0

.009

53(0

.034

8)21

.944

31(7

.882

53)∗∗

∗S

IZE

−0.0

046

(0.0

0197

)∗∗∗

0.00

35(0

.004

74)

0.00

08(0

.002

19)

0.00

091

(0.0

0535

)−0

.001

84(0

.000

51)∗∗

∗S

IZE

SQ

0.00

05(0

.000

2)∗∗

∗−0

.000

1(0

.000

3)

LE

VE

RA

GE

2.37

860

(31.

4826

2)

PR

OD

MIX

−0.0

0027

(0.0

0051

)−0

.000

3(0

.000

51)

−0.0

001

(0.0

0057

)−0

.000

09(0

.000

57)

−0.0

2465

(0.1

4028

)

DIV

S−0

.098

27(0

.048

38)∗∗

∗A

DD

RE

SV

0.00

283

(0.0

0060

)∗∗∗

R2

0.57

790

0.58

540.

1938

0.19

380

0.80

870

R2

Adj

.0.

4927

00.

4992

0.03

100.

0260

00.

7686

0

F6.

78∗∗

∗6.

79∗∗

∗1.

1900

1.16

000

20.2

0∗∗∗

N28

028

028

028

028

0

∗∗∗ M

eans

are

sign

ifica

ntly

diff

eren

tatt

he1%

leve

l.∗∗

Mea

nsar

esi

gnifi

cant

lydi

ffer

enta

tthe

5%le

vel.

∗ Mea

nsar

esi

gnifi

cant

lydi

ffer

enta

tthe

10%

leve

l.St

anda

rder

rors

inpa

rent

hese

s.


The results show that independent distribution is associated with lower levelsof insurance company free cash flow. While it is questionable where this free cashflow might actually be going. Further analysis of the data shows that independentagents appear to be associated with companies that have lower cost ratios and,hence, we might presume lower expense preference behaviour amongst managers.Sales expenses are no higher when independent agents are used, therefore, it isalso unlikely that agents are extracting rents at the expense of their clients. Butperhaps the greatest support for the arguments made in this paper is provided bythe fact that independent agents channel business to companies that lower dividendpayments to shareholders and increase bonus payments to policyholders.

Therefore, using a set of measures which more directly tackle the agencyproblems between policyholders, managers and shareholders, this paper providesrenewed support for the arguments made by Mayers and Smith (1981) and Kim etal. (1996) relating to the agency aspects of independent distribution. This is not tosay that the transactional arguments made by Regan and Tzeng (1999) are withoutmerit. Indeed the results offered in this paper are not without their own limitations.At an elementary level they are specific to the UK and the life industry. The workof Regan and Tzeng (1999) was focused on the non-life US market. and with oneyear renewable policies the scope for managerial or shareholder opportunism islimited, as policyholders have a timely exit option. In the case of long-term lifeinsurance policies the exit option is diminished and hence the agency costs arelikely to be higher. Therefore, there is need to test the method of this paper in othermarkets.

Acknowledgements

Comments on earlier versions of this paper by Mike Adams, Philip Hardwick andtwo anonymous referees are gratefully acknowledged.

Notes1 Good and bad companies are defined from the policyholders’ perspective. The policyholder’svalue of a contract policy with a good company will be higher than a contract from a bad com-pany.2 Firms that use company representatives, but who are independent agents of the insurance companywere excluded from the sample. Thus the survey is a straight comparison of those companies usingindependent financial advisers and direct, in-house, agents.3 Undistributed cash flow is equal to net premium income plus investment income and additionalcapital changes paid in, less underwriting expenses, investment expenses, gross interest charges,income taxes, policyholder bonuses, and stockholder dividends.4 A measure which proxies Wells et al.’s (1995) Total assets minus surplus.5 Wells et al. (1995) note that the distribution for free cash flow is truncated at zero. Whilst theproxy measure for free cash may exhibit negative values, there is no such thing as negative free cashflow and therefore no problem of managerial discretion. In consequence any negative value for theproxy for free cash flow is transformed to equal zero. An appropriate way to estimate such a modelis to use a Tobit.

384 DAMIAN WARD

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