Corporate Governance and Cash Holdings: Evidence from the U. S. Property-Liability Insurance Industry Wen-Yen Hsu Feng Chia University, Taiwan Yenyu Huang St. John’s University, Taiwan Gene Lai Safeco Distinguished Professor of Insurance Washington State University Presented at China International Conference on Insurance and Risk Management

Outline Introduction Hypotheses Development Data and Methodology Results Conclusion &Policy Implication 2

Introduction Recent regulatory and listing requirements (NYSE, NASDAQ, SEC and SOX) emphasize the role of board of directors and committee members in mitigating the conflict of interests between shareholders and managers Cash holdings - Inspired from Jensen’s (1986) work on agency theory of free cash flow 3

Why Property – Liability Insurance Industry? An exceptionally good setting to analyze the efficacy of corporate governance because – Virtually all business transactions have to be completed in cash they usually generate and tempt to hold a substantial level of cash (Cash to NPW is 50%) – Huge losses such as Sandy and earth quake and tsunami in Japan may result in illiquidity or insolvency 4

Why Property – Liability Insurance Industry? An exceptionally good setting to analyze the efficacy of corporate governance because – The impact of insolvency has more impact on stakeholders of P-L insurance industry – P-L insurance industry is a highly regulated industry. The regulations are external governance. Do we need to have other external governance such as independence of board or finance committee? 5

Introduction - Purpose To examine the relation between board and finance committee characteristics and cash holdings for property-liability insurers to provide the evidence about the monitoring and advising roles of board of directors and finance committee We focus on the independence of board and finance committee 6

Literature Review Monitoring role: the effectiveness of board of directors is negatively related to the level of cash holding (Costs of holding cash). Reasons: – Cash generates lower returns in comparison with other assets – A high level of cash holdings will decrease managers’ pressure to minimize costs or increase managers’ discretionary expense overspending 7

Literature Review Monitoring role: the effectiveness of board of directors is negatively related to the level of cash holding (Costs of holding cash). Reasons: – A high level of cash holdings is generally preferred to lower the likelihood of having financial distress or becoming a takeover target – Self-interested managers tend to retain cash to facilitate their perquisite consumption 8

Literature Review (cont.) Advising role: the effectiveness of board of directors is positively related to the level of cash holding (benefits). Main reasons: – Insolvency avoidance – Meeting future growth, underinvestment prevention – Relatively higher cost of raising external funds – Liquidity

Main Hypothesis We propose the independent director responsibility hypothesis that suggests responsible directors of boards and finance committees will not only monitor the agency costs related to excess cash holdings but also aim to avoid underinvestment problems. In other words, independent directors would maximize stakeholders’ wealth. 10

Reasons for less cash for Independent Directiors Without economic, social or psychological tie (Berton, 1995) Reputation capital (Fama and Jensen, 1983) 11

Reasons for more cash Shareholder power hypothesis (Harford et al., 2008) – prevent underinvestment problem – They did not find empirical support for the hypothesis, but we do. 12

Hypotheses H1a: There is a positive association between the insurers’ cash holdings and the independence of board of directors. H1b: There is a positive association between of insurers’ cash holdings and the independence of finance committees. 13

Hypotheses (cont.) H2: There is a positive association between the growth of insurers and the independence of board of directors (finance committee) when insurers have excess cash holdings in the previous period. – Independent directors allow for more cash holding to prevent underinvestment problem 14

Hypotheses (cont.) H3: There is a non-positive association between the expenses of insurers and the independence of board of directors (finance committee) when insurers have excess cash holdings in the previous period. – Independent directors allow for more cash holding to prevent underinvestment problem, but do not allow for more expenses 15

Corporate Governance Control Variables: Board Si ze There is a positive association between the board size of insurers and the level of insurers’ cash holdings – Reasons for less cash: more monitoring with a large board (Jensen, 1993) – Reasons for more cash: slow decision and not effective of a large board (Jensen, 1993); More expertise and avoidance of underinvestment problem 16

Corporate Governance Control Variables (Duality) There is a positive association between the level of insurers’ cash holdings and CEO/Chairman Duality. – CEO/Chairman duality can control the information made available to other board members because more power (Hambrick and Finelstein (1987) – less monitoring more cash holdings – CEO/Chairman can consolidate the management decisions and control struggle, thus, accelerate decision process (Harrison et al.). To avoid underinvestment by holding more cash. 17

Corporate Governance Control Variables (Other Directorship) There is an association between the level of insurers’ cash holdings and additional directorships by directors. – More cash: busy board less monitoring – Less cash: accumulating governance expertise better monitoring 18

Corporate Governance Control Variables (Director Ownership) There is an association between the level of insurers’ cash holdings and stock ownership by directors. – Morck, Shleifer and Vishny (1998) – Alignment of interests (convergence-of-interest) vs. self-interests – Ownership is small: Agency costs dominate convergence-of-interest more cash – Ownership is large: Convergence-of-interest dominate agency costs less cash – Non-linear relation 19

Corporate Governance Control Variables (Diligence) There is a negative association between the level of insurers’ cash holdings and board of director diligence. – More meetings Better monitoring less cash holdings 20

Corporate Governance Control Variables (Finance Expertise) There is an association between the level of insurers’ cash holdings and percentage of directors with financial expertise When the % is small, cash holdings increase to prevent underinvestment problem as % of financial experts increase When the % is large, cash holdings decrease as % of financial experts increase. Directors have free rider problem do not wish to deal with underinvestment problem or easy way out 21

Corporate Governance Control Variables (F. Committee Blockholders) There is a non-linear association between the level of insurers’ cash holdings and financial blockholders holdings. 22

Data and Methodology (1) Sample: 1,939 stock property-casualty insurers U.S. firm-years Period : (2006) Database : NAIC, A.M. Best and U.S. SEC EDGAR 23

Variable definitions Independence, Governance Expertise, Incentive, and Diligence are related to the effectiveness of board of directors and finance committee

25 Variable Predicted Sign H #Definitions/Descriptions Cash Holdings Ratio of insurer’s cash plus short-term investments to its total invested assets BD_Outside Director%+/+/-1/2/3% of outside directors (excluding affiliate directors) on the board FC_Outside Director%+/+/-1/2/3% of outside directors on finance committee Board Size+ Number of the board directors BD_Avg. # of Directorships? Average number of directorship positions that board directors hold in other firms’ boards BD_CEO/Chair Duality? One if the CEO is also the chair of the board, 0 otherwise Board Director Ownership? % of shares held by directors Log(BD_# of Meetings)- Natural log of number of board meetings FC_ % Expert? % of directors with investment and financial matters oversight responsibility on the finance committee, including chief executive officer, chief financial officer, vice president of finance, executives in the investment, investment banking, or commercial banking industry, or financial consultants, all categorized as having corporate financial management experience Table 1 Variable Definitions

26 FC_5% Blockholder? One if the firm has at least one outside blockholder on the finance committee, where block is defined at the 5% ownership level, 0 otherwise Institutional Ownership? % of shares held by institutions G-Index? An index of shareholder rights developed by Gompers, Ishii, and Metrick (2003) Size- Natural log of total assets Financial Strength- Best’s rating (0 = below B-; 1 = B, B-, 2 = B++, B+; 3 =A, A-; 4 = A++, A+) Volatility of Cash Flows+ The standard deviation of net cash flow from operation over the previous five years Duration of Liabilities- Estimated average duration of liabilities for the insurer Leverage? Ratio of the insurer’s total liabilities to total assets M/B ratio+ Ratio of the market value to book value of insurers’ assets Non-Invested Assets+ Ratio of the insurer’s total non-invested assets to its total assets Common Stock- Ratio of the insurer’s common stock holdings to its total invested assets Firm Age+ Natural log of the difference between firms’ ages and 5 Dividend- One if the insurer pays a cash dividend to stockholders in the year, 0 otherwise

Summary Statistics Variable MeanMedianStd DevMinimumMaximum Cash Holdings BD_Outside Director% FC_Outside Director% Board Size BD_Avg. # of Directorships BD_CEO/Chair Duality Board Director Ownership Log(BD_# of Meetings) FC_ % Expert FC_5% Blockholder Institutional Ownership G-Index Size Financial Strength Volatility of Cash Flows Duration of Liabilities Leverage M/B Ratio Non-Invested Assets Common Stock Firm Age Dividend

Results – Major 28

Table 4: Regression analysis of the level of cash holdings and board and finance committee structure Variable Predicted Sign Model 1 w/o Board & FC outsider Model 2 w/o FC outsider Model 3 w/o Board outsider Colquitt, et al. (1999) Intercept (0.90) (0.99) (0.95) Cash Holdings t (0.67) (0.68) (0.61) BD_Outside Director% (2.60) *** (3.63) *** FC_Outside Director% (1.56) (3.15) *** Board Size (1.79) * (2.19) ** (2.02) ** BD_Avg. # of Directorships ? (-2.52) ** (-2.11) ** (-2.44) ** Board Director Ownership (3.43) *** (3.28) *** (3.04) *** Board Director Ownership (-2.76) *** (-2.57) *** (-2.34) ** Log(BD_# of Meeting) (-1.92) * (-1.91) * (-1.75) * FC_ % Expert (1.89) * (1.61) * (2.08) ** FC_ % Expert (-1.89) * (-1.67) * (-2.04) ** FC_5% Blockholder ? (-1.56) (-1.93) * (-1.55)

Variable Predicted Sign Model 1 w/o Board & FC outsider Model 2 w/o FC outsider Model 3 w/o Board outsider Colquitt, et al. (1999) BD_CEO/Chair Duality (2.08) ** (2.10) ** (1.62) * Institutional Ownership ? (-0.41) (-0.76) (-0.10) G-Index ? (-0.73) (-0.69) (-0.63) Size (1.28) (1.25) (1.33) (.0001) *** Financial Strength (-2.08) ** (-2.10) ** (-2.11) ** (.0001) *** Volatility of Cash Flows (-0.15) (-0.16) (0.11) (.0351) *** Duration of Liabilities (-3.35) *** (-3.39) *** (-3.36) *** (.0001) *** Leverage ? (-0..28) (-0.35) (-0.16) (.0888) * M/B Ratio (1.10) (1.16) (0.76) (.5126) Non-Invested Assets (-0.71) (-0.71) (-0.79) (.4459) Common Stock (-4.59) *** (-4.58) *** (-4.56) *** (.0001) *** Firm Age (2.80) *** (2.82) *** (2.79) *** Dividend (-1.22) (-1.32) (-1.23) Regression analysis of the level of cash holdings and board and finance committee structure (cont~)

Regression analysis of the level of cash holdings and board and finance committee structure Variable Predicted Sign Model 1 with Board & FC outsider Model 2 w/o FC outsider Model 3 w/o Board outsider Colquitt, et al. (1999) Intercept (0.90) (0.99) (0.95) Cash Holdings t (0.67) (0.68) (0.61) BD_Outside Director% (2.60) *** (3.63) *** FC_Outside Director% (1.56) (3.15) ***

Other Results Board size – Positively associated with the level of cash holdings. Slow-decision process, or difficult to coordinate. Or prevent underinvestment problem Duality – Positive Self-interests Prevent from underinvestment problem Avg. # of Directorship – Negative More experience and accumulated expertise and better monitoring 32

Other Results Board ownership – Non-linear associated with the level of cash holdings Inverse U shape # of meetings – Negative – Good monitoring 33

Other Results Percentage of directors with finance expertise – Non-linear associated with the level of cash holdings Inverse U shape Financial strength – Negative Duration of liabilility – Negative Common stock – Negative Firm Age – Positive 34

Other Results Finance committee blockholder – Negatively associated with the level of cash holdings Agency costs reduction 35

Table 5 Regression analysis of future growth and governance variables of interest (using Market-to-Book) VariableModel 1Model 2Model 3 Intercept (-2.64) *** (-2.86) *** (-2.65) *** Excess Cash t (-0.97) (-0.91) (0.02) BD_Outside Director% t (5.71) ***1.281 (4.51) *** BD_Outside Director% t-1 x Excess Cash t-1(positive) (0.22) (1.97) ** BD_Outside Director% t-1 x Excess Cash t-1(negative) (1.62) (-0.47) FC_Outside Director% t (-4.11) *** (-1.67) * FC_Outside Director% t-1 x Excess Cash t-1(positive) (0.52) (1.85) * FC_Outside Director% t-1 x Excess Cash t-1(negative) (-1.79) * (-1.06) Board Size t (0.22) (0.43) (0.67) BD_Avg. # of Directorship t (1.50) (0.32) (2.04) ** Board Director Ownership t (5.67) *** (6.32) *** (4.97) *** Board Director Ownership 2 t (-6.09) *** (-6.84) *** (-5.30) *** Log(BD_# of Meeting) (-1.92) * (-1.70) * (-0.86) FC_ % Expert t (1.66) * (2.85) *** (1.84) * FC_5% Blockholder t (-1.65) * (-1.02) (-1.84) * BD_CEO/Chair Duality t (-2.18) ** (-2.56) *** (-3.29) *** Institutional Ownership t (1.47) (2.18) ** (1.99) ** G-Index t (4.54) ***0.187 (4.31) ***0.197 (4.16) *** Independent System (1.36) (1.38) (1.56) Line_HHI (1.41) (1.35) (1.71) * State_HHI (-1.07) (-1.01) (-0.92) Size (2.22) ** (2.47) ** (2.49) *** Firm Age (2.77) *** (2.65) *** (3.06) ***

Table 5 Regression analysis of future growth and governance variables of interest (using Market-to-Book) VariableModel 1Model 2Model 3 Intercept (-2.64) *** (-2.86) *** (-2.65) *** Excess Cash t (-0.97) (-0.91) (0.02) BD_Outside Director% t (5.71) ***1.281 (4.51) *** BD_Outside Director% t-1 x Excess Cash t-1(positive) (0.22) (1.97) ** BD_Outside Director% t-1 x Excess Cash t-1(negative) (1.62) (-0.47) FC_Outside Director% t (-4.11) *** (-1.67) * FC_Outside Director% t-1 x Excess Cash t-1(positive) (0.52) (1.85) * FC_Outside Director% t-1 x Excess Cash t-1(negative) (-1.79) * (-1.06)

Table 5 Regression analysis of future growth and governance variables of interest (using two years direct premium growth rate) VariableModel 1Model 2Model 3 Intercept (3.56) *** (3.44) *** (3.45) *** Excess Cash t (-1.14) (-0.94) (-0.91) BD_Outside Director% t (0.11) (-1.59) BD_Outside Director% t-1 x Excess Cash t-1(positive) (-0.54) (1.66) * BD_Outside Director% t-1 x Excess Cash t-1(negative) (1.25) (-1.10) FC_Outside Director% t (-2.39) ** (-2.59) *** FC_Outside Director% t-1 x Excess Cash t-1(positive) (1.33) (1.89) * FC_Outside Director% t-1 x Excess Cash t-1(negative) (-1.53) (-1.3) Board Size t (2.04) ** (1.44) (2.14) ** BD_Avg. # of Directorship t (2.25) ** (1.88) * (2.31) ** Board Director Ownership t (-1.20) (-0.95) (-1.09) Board Director Ownership 2 t (0.69) (0.31) (0.57) Log(BD_# of Meeting) (-0.74) (-0.60) (-0.75) FC_ % Expert t (-2.73) *** (-2.15) ** (-2.73) *** FC_5% Blockholder t (1.43) (1.71) * (1.41) BD_CEO/Chair Duality t (-1.52) (-1.75) * (-1.51) Institutional Ownership t (-1.79) ** (-1.49) (-1.85) * G-Index t (0.38) (0.36) (0.34) Independent System (0.81) (0.94) (0.83) Line_HHI (1.75) * (1.72) * (1.75) * State_HHI (-1.33) (-1.31) (-1.34) Size (-3.94) *** (-3.80) *** (-3.85) *** Firm Age (-0.19) (-0.22) (-0.25)

Table 5 Regression analysis of future growth and governance variables of interest (using two years direct premium growth rate) VariableModel 1Model 2Model 3 Intercept (3.56) *** (3.44) *** (3.45) *** Excess Cash t (-1.14) (-0.94) (-0.91) BD_Outside Director% t (0.11) (-1.59) BD_Outside Director% t-1 x Excess Cash t-1(positive) (-0.54) (1.66) * BD_Outside Director% t-1 x Excess Cash t-1(negative) (1.25) (-1.10) FC_Outside Director% t (-2.39) ** (-2.59) *** FC_Outside Director% t-1 x Excess Cash t-1(positive) (1.33) (1.89) * FC_Outside Director% t-1 x Excess Cash t-1(negative) (-1.53) (-1.3)

Table 6 Regression analysis of the impact of main governance variables of interest on the association between the excess cash holdings and salary expense divided by net premium written VariableModel 1Model 2Model 3 Intercept (1.89) * (2.10) ** (2.15) ** Excess Cash t (1.70) * (1.48) 0.62 (1.45) * BD_Outside Director% t (1.00) (0.29) BD_Outside Director% t-1 x Excess Cash t-1(positive) (1.46) (-1.12) BD_Outside Director% t-1 x Excess Cash t-1(negative) (-1.68) * (-2.17) ** FC_Outside Director% t (-2.95) *** (-3.11) *** FC_Outside Director% t-1 x Excess Cash t-1(positive) (-1.87) * (-1.19) FC_Outside Director% t-1 x Excess Cash t-1(negative) (1.34) (-2.09) ** Board Size t (2.02) ** (0.66) (1.86) * BD_Avg. # of Directorship t (0.08) (-1.01 ) (0.06) Board Director Ownership t (-0.54) (-0.18) (-1.20) Board Director Ownership 2 t (1.61) (1.14) (2.26) ** Log(BD_# of Meeting) (1.28) (1.18) (1.45) FC_ % Expert t (-0.56) (0.81) (-0.57) FC_5% Blockholder t (-1.35) (-0.76) (-1.44) BD_CEO/Chair Duality t (-1.04) (-1.23) (-1.43) Institutional Ownership t (-2.18) ** (-1.23) (-1.89) * G-Index t (-1.75) * (-2.00) ** (-1.74) * M/B Ratio (1.29) (1.64) * (1.58) Commercial Line % (-0.01) (0.00) (-0.24) Independent System (-0.17) (-0.05) (-0.06) Line_HHI (0.32) (0.17) (0.32) State_HHI (-2.21) ** (-1.90) * (-2.07) ** Size_DPW (-1.86) * (-1.94) ** (-1.82) * Firm Age (0.70) (0.66) (0.91)

Table 6 Regression analysis of the impact of main governance variables of interest on the association between the excess cash holdings and salary expense divided by net premium written VariableModel 1Model 2Model 3 Intercept (1.89) * (2.10) ** (2.15) ** Excess Cash t (1.70) * (1.48) 0.62 (1.45) * BD_Outside Director% t (1.00) (0.29) BD_Outside Director% t-1 x Excess Cash t-1(positive) (1.46) (-1.12) BD_Outside Director% t-1 x Excess Cash t-1(negative) (-1.68) * (-2.17) ** FC_Outside Director% t (-2.95) *** (-3.11) *** FC_Outside Director% t-1 x Excess Cash t-1(positive) (-1.87) * (-1.19) FC_Outside Director% t-1 x Excess Cash t-1(negative) (1.34) (-2.09) **

Additional test (1) We also examine the relation between other corporate governance variables and growth opportunity and between other corporate governance and variables and expenses. Our analyses of this section are similar to those of Tables 5 and 6.

Conclusions The independence of boards of directors and the independence of finance committees are found to be positively associated with insurers’ level of cash holdings Independence of boards and finance committees is positively related to the actual growth of an insurer when it has excess cash Excess cash spent on advertising and salary expenses does not significantly increase with a higher proportion of outside directors on a board and outside members on a finance committee 43

Policy Implication Our analysis suggests board and finance committee independence provide significant benefits to the insurers, benefits are: – Allowing managers to hold the higher level of cash to meet future growth, yet effectively control managers’ discretionary expense spending These results support regulatory and listing requirements (NYSE, NASDAQ, SEC and SOX): – board and committee independence 44

Thank you! Questions? Comments?