Earlier version published in the 1999 Proceedings of the Academy of Economics and Finance
THE CAPITAL STRUCTURE OF A STOCKHOLDER-OWNED INSURANCE
COMPANY
January, 1999
J. Edward Graham
Department of Economics and Finance
Cameron School of Business
University of North Carolina at Wilmington
Wilmington, NC 28403-3297
(910) 962-3516
(910) 962-3815 (fax)
[email protected]
THE CAPITAL STRUCTURE OF A STOCKHOLDER-OWNED INSURANCE
COMPANY
Abstract
The Prudential Insurance Company of America (Prudential) is a mutually-owned
insurance company answering not to a group of shareholders, but to its policyholders. Recent
events in the financial services sector have encouraged the officers and management of
Prudential to consider the re-organization of the company (Wall Street Journal, August 14,
1998) as a stockholder-owned firm. Similar changes are being considered by Metlife and John
Hancock. Policyholders have had little say in the compensation of executives or in the capital
structure of the existing companies. Opponents of existing management point to excessive
compensation amidst poor firm performance and suggest that policyholder and management
incentives are not aligned. It is unclear whether the new firms’ capital structures might
redress this misalignment and serve new shareholders in a fashion better than existing
policyholders. This issue is addressed in this study with a theoretical development of a
stockholder-owned insurance company's capital structure.
Given perfect markets without tax, transaction or bankruptcy costs, capital structure is
shown to be irrelevant. Relaxing the no taxes assumption and providing for the government
subsidy of claims payments supports a capital structure financed entirely by policyholders; an
additional allowance for personal taxes, however, supports capital structure irrelevance. An
allowance for uncertain insurance claims, absent bankruptcy costs, again supports capital
structure irrelevance. A provision for bankruptcy costs supports the traditional view: that a
firm's value is a concave function of its financial leverage and that a capital structure optimum
exists that maximizes shareholder wealth. A provision for policyholder incentives and agency
costs (given concave policyholder utility functions) also encourages an optimal capital
structure; this implies that a capital structure can be selected that limits the costs to the new
shareholders of the misalignment of management and shareholder incentives. This limitation
is provided, in part, by regular payouts to the “debtholders” (policyholders) of the new firm.
THE CAPITAL STRUCTURE OF A STOCKHOLDER-OWNED INSURANCE
COMPANY
Introduction
Recent remarks by the managements of several of the largest mutually owned insurance
companies in the United States - Prudential, Metlife and John Hancock - portend changes in
the ownership structures of all three firms. Each company is investigating the suitability of
shifting from a policyholder-owned or mutual insurance company to one that is owned by
shareholders. The implications for policyholder/shareholder wealth is not clear. Building
upon traditional and contemporary capital structure theory, we propose a framework for
evaluating and developing the capital structure of a stockholder-owned insurance company.
In Section 1, the nature of an insurance company's capital structure is examined.
Similarities between the rights and obligations of a corporate debtholder and an insurance
policyholder are discussed. A capital structure modeling is proposed in Section 2 under the
restrictive assumptions of a “perfect” market with no taxes or bankruptcy costs, no transaction
costs and uncertain liabilities. The evolution of the capital structure of an insurance company
is furthered in Section 3 with an allowance for corporate taxes, interest deductibility, and
personal taxes. A model in the fourth section allows for uncertainty and bankruptcy costs.
The final modeling is provided in Section 5. It allows for agency costs and policyholder
incentives. Implications for management, stockholder and policyholder are examined. The
paper closes with a summary and encouragement for subsequent research.
Section 1
The financial structure of a firm is the mix of all the items that appear on the righthand side of the firm's balance sheet. The capital structure is the mix of the long-term
components of that financial structure. The conventional corporate capital structure consists
of various elements of liabilities and owner's equity. The insurance company capital structure
in the following pages likewise possesses a capital structure consisting of liabilities and owners
equity. The similarities between the conventional and insurance capital structures can be
appreciated intuitively and with references to Cheung (1983) and Coase (1937).
The debtholder and policyholder of the conventional and insurance corporation trade
away similar rights and obligations (investments of current resources in debt instruments and
insurance policies) in exchange for a commitment from the firm to a future promise to pay
(interest and debt repayment, on the one hand, versus claims payments on the other). Instead
of meeting debt requirements, the insurance company is obligated by the tenets of their
customer’s insurance policies. The similarities between the contractual obligations and
expectations of debtholders and policyholders allow an examination of an insurance company
using contemporary financial theory on capital structure.
There are, of course, important differences between the capital structures of the
conventional and insurance corporation. Whereas the contractual nature of these firms'
liabilities are similar, the stochastic nature of the uncertain future claims against the policies of
an insurance corporation contrast sharply with the “certain” future debt payments of the
conventional firm.
In the examinations that follow, the stockholder-owned insurance company attempts to
select a capital structure that maximizes firm value; this value is composed of the market value
of equity and policyholder financing. Unless otherwise indicated, these examinations ignore
the impact of dividend policy, preferred stock, and strict debt financing on the firm's capital
structure.1 Returns and expected returns are assumed to be normally distributed. The assets
of the insurer are assumed to be fixed.
Section 2
Until the seminal work by Modigliani and Miller (1958), the prevailing view was that
firm value was a concave function of its use of financial leverage; that an optimal mix of debt
and equity existed (a global maximum) that maximized firm value.
Modigliani and Miller (M&M) first propose that firm value is independent of its capital
structure. M&M's arguments are extended to this examination to show that the mix of equity
and policyholder financing do not affect the value of the insurance company.
Given the following assumptions:
1.
Perfect markets,
2.
no taxes, bankruptcy costs, or transaction costs
3.
policyholder financing (borrowing) at the risk-free rate,
1 “Strict” debt financing is simply a certain amount due at some future date vs. the uncertain nature of future insurance
claims.
3
Where:
E
=
Value of equity at time t,
V
=
Value of the firm at time t,
V1
=
Expected value of the firm at time t + 1,
B
=
The market price of risk,
rf
=
Risk-free rate,
rm
=
Market rate, and
~
V1
=
Uncertain firm value at time t + 1.
The firm is initially entirely equity financed (the insurance company is, in effect, a
mutual fund) and the present value of the firm is (discounting at the risk-free rate), using a
certainty equivalent valuation form of the CAPM,
~
V  BCov (V1 , ~
rm )
E V  1
1  rf
(1)
where V1 includes all income or asset appreciation between period t and period t + 1.
Assume the firm then collects P in insurance premiums and immediately distributes
these proceeds to the stockholders. The stockholders receive P now, but an actuarially certain
liquidating insurance claim of (1 + rf)P needs to be paid in one period. The present value of
the equity becomes (with V1 reduced by this obligation)
E
~
V1  (1  rf ) P  BCov[V1  (1  rf ) P, ~
rm ]
1  rf
(2)
and since (1 + rf)P is a constant, this becomes
E
~
V1  (1  rf ) P  BCov (V1 , ~
rm )
1  rf
4
(3)

~
V1  BCov (V1 , ~
rm )
P
1  rf
(4)
adding back the present value of the policies to determine firm value,
V 
~
V1  BCov (V1 , ~
rm )
1  rf
(5)
showing that the value of the levered firm is identical to the value of the unlevered firm. This
illustrates that, given the assumptions above, the choice of capital structure by the insurance
company does not affect its value.2
In this simple example, the insurance policy liability was financed at the risk-free rate.
As M&M show in their Proposition 2, with increases in the relative level of a firm's liabilities
comes an increase in that firm's expected return. Or, with an increase in insurance exposure,
insurance company stockholders are paid a higher rate of return. This relationship also
supports the irrelevance of capital structures. There is simply a change in the risk-aversion of
shareholders.
M&M’s 3rd proposition supports the independence of investment and financing
decisions, given the assumptions above. This proposition can't be easily extended to a
consideration of the stockholder-owned insurance company’s capital structure.
If
“investment” decisions are restricted to a consideration of the assets purchased with
policyholder or equity funding, proposition 3 holds.3 If, on the other hand, “investment”
2 An allowance for uncertain future liabilities (claims payments) is made in Section 4.
3 This is countered in work by Peterson and Benesh, 1983.
5
decisions are allowed to include positive NPV investments in the provision of insurance, then a
dependence between investment and financing decisions may be implied.
Using Fama's (1978) intuition, the irrelevance of a firm’s capital structure does not
mean that its financing decisions are of no consequence to investors or policyholders. The firm
may be able to shift wealth from policyholders to equityholders and vice versa. But, the
provision of "riskier" insurance (with a lower price or higher payout but a higher probability
of non-payment), will merely change the mix of its investors/policyholders. Costlessly enforced
"me-first" rules ensure that "the characteristics of the payoffs on the firm's outstanding
(policies) are unaffected by changes in its capital structure.” Given the provision by the capital
markets of whatever equity or insurance instruments that are demanded, the firm's value is
"always the value implied by the aggregate optimal capital structure and is independent of the
capital structure chosen by the firm.” Thus, "at least with respect to its effects on the firm's
market value, any choice of capital structure is as good as any other."
Section 3
Relaxing the no taxes assumption above and allowing for the deductibility of interest by
the corporation, a capital structure consisting entirely of policyholder financing is suggested.
Recalling equation (3) above:
E
~
V1  (1  rf ) P  BCov (V1 , ~
rm )
1  rf
We allow for the deductibility of policyholder claims and assume a tax rate > 0.
Our function becomes:
6
(6)
E
~
V1  BCov (V1 , ~
rm ) 1  rfAT

P
1  rf
1  rf
where
1  r fAT
1  rf
(7)
1
with rfAT = the after-tax risk-free rate.
Thus, the present value of the levered firm after taxes (and adding back P, the distributed
policy sale proceeds) is:
V 
~
V1  BCov (V1 , ~
rm ) (1  rfAT )

PP
1  rf
1  rf
(8)
And, since

(1  rfAT )
1  rf
PP0
(9)
the value of the levered firm is greater than the value of the unlevered firm. This implies that
the greatest value is achieved for the firm that uses all policyholder financing. Similar
conclusions are reached by Modigliani and Miller in their 1963 reprise of their 1958 paper.
Allowing for corporate taxes and the deductibility of interest, the government subsidy of
policyholder financing suggests its greatest possible use. The value of the firm becomes an
increasing function of policyholder financing. The implication is that an optimal capital
structure exists. If corporate taxes are the only imperfection in the capital markets, then firms
use all policyholder financing. Other frictions, mentioned in later sections, imply an interior
optimal capital structure.
Miller (1977) considers personal taxes and argues that an equilibrium is achieved in the
capital markets where the marginal tax rates of individuals and corporations are equilibrated.
Implying the subsidy of lower bracket investors, he shows that the value of the firm, even
7
given taxes, is independent of capital structure. Acknowledging an optimal capital structure
for the economy as a whole, he proposes that no optimal capital structure exists for the
individual firm. This is similar to the intuition of Fama (1978).
Allowing for personal taxation, the inequality in equation (9), according to Miller, is
equilibrated by the functioning of the capital markets. Similar to the taxation of dividends, the
policyholder distribution "P" is taxed at a rate which, at the margin, equates it with (1 +
rfAT)P/(1 + rf). This extends Miller’s examination of dividends to the consideration of
policyholder distributions. Just as Miller shows, to preclude an arbitrage opportunity, the
market prices of debt will be driven to this equilibrium. Allowing for the deductibility of
interest (insurance claims) by the corporation and includability of these claims by an
individual provides no optimal capital structure for the firm. There is an aggregate optimal
level of policyholder financing for all stockholder-owned insurance companies, but not for the
individual firm.4, 5
Miller claims investors must be compensated for the tax disadvantages of debt,
offsetting the corporate tax advantage of debt. This argument runs counter to the non-taxable
status of many insurance claims. Recalling the tax deductibility of many uninsured losses,
buying insurance has tax disadvantages. Given personal taxes, the government effectively
4 Miller’s arguments are challenged by DeAngelo and Masulis, 1980, “Optimal Capital Structure Under Personal and
Corporate Taxation,” Journal of Financial Economics, 8, 3-29. They argue that a firm’s access to non-debt tax shields (such as
special tax credits and depreciation) provides for the existence of an optimal capital structure.
5 Litzenberger and Ramaswamy (1979) counter some of the spirit of Miller’s reasoning with a modified CAPM treatment
of dividends and personal taxation. Addressing earlier work by Modigliani and Miller, the authors find “a strong positive relationship
between dividend yield and expected return.” Applying their reasoning to policyholder distributions and personal taxes, an optimal
capital structure is implied for the stockholder-owned insurance company. Miller and Scholes (1982), however, faulty the measures
used by Litzenberger and Ramaswamy, and others in examining the differential tax burden on dividends.
8
subsidizes insurance. Thus, a "Miller-type" equilibrium is achieved in the insurance markets
relative to the aggregate risk preferences of those markets.
Section 4
The discounting of liabilities in Sections 2 and 3 implicitly assumes that the policyholder
financing has zero systematic risk. Insurance is, by definition, the assumption of risk by a firm
or individual in exchange for some valuable consideration. Insurance does not exist in a riskfree world. Relaxing the assumptions of Section 3 to allow for uncertainty provides several
insights.
Although insurance does not exist in a "pure" CAPM world, the certainty equivalent
form used previously can be extended to allow for uncertain policy payments.
Recall equation (5):
V 
~
V1  BCov (V1 , ~
rm )
1  rf
showing that the value of the levered firm, given the assumptions of Section 2, equals the value
of the unlevered firm. We introduce the variables:
L
=
expected future obligation to policyholders and
~
L
=
uncertain future obligation to policyholders.
~
(L and L are assumed to be net of taxes.)
Allowing for policyholder financing of a certain present value against an uncertain future
obligation provides:
9
E
~ ~
V1  L  BCov (V1  L , ~
rm )
1  rf
(10)
and since the covariance is a linear operator,
~
~
V1  L  BCov (V1 , ~
rm )  BCov ( L , ~
rm )
E
1  rf
(11)
~
rm )  0
given the presence of systematic risk with Cov( L , ~
~
~
V1 BCov (V1 , ~
rm ) BCov ( L , ~
rm )
L



1  rf
1  rf
1  rf
adding back P, the insurance premium,
~
~
V BCov (V1 , ~
rm ) BCov ( L , ~
rm )
L
 1


+P
1  rf
1  rf
1  rf
(12)
(13)
In the risk-free world with a certain future obligation to policyholders of (1 + rf)P, the
present value of the insurance premium P is:

L
(1  rf )
(14)
In the uncertain world of Equation (13), the present value of the insurance claim and
the expectation for the policy becomes:
~
BCov ( L , ~
rm )
L
Pc 

,
1  rf
1  rf
(15)
where the expected value of the claim has been reduced by the amount of the second element
on the right-hand side of Equation (15). Since B is the market price of risk, the reduction in
expected value is a function of the market price of risk and the covariance of the liability with
the market portfolio, assuming a diversified investor.
The implications of equations 10-15 are fairly straightforward. As the stockholderowned insurance company adds risky policyholder financing to its capital structure,
10
stockholders and policyholders price this increased exposure at a higher expected rate of
return.
If we then allow for the implications of uncertainty, taxes, and bankruptcy costs, we
provide support for the traditional view; that a firm's value is a concave function of its
debt financing and that an interior optimum exists where the slope of this function equals
zero. Extending Kim (1978):
VL  Vu 
TL( R f  1)
Rf
~
~
 T (VO  L)V (b )  (1  T )V ( B )
(16)
where:
VO
=
initial firm value,
V1
=
end-of-period expected firm value,
T
=
the tax rate,
Rf
=
1 + rf,
VL
=
value of the levered firm, with policyholder financing,
Vu
=
value of the unlevered firm, without policyholder financing,
L
=
expected future obligation to policyholders,
~
V( b )
=
risk-adjusted present value of one dollar associated with the
occurrence of bankruptcy, and
~
V( B )
=
risk-adjusted present value of bankruptcy costs where b = 1 if V1 <
rL and the firm is bankrupt and 0 otherwise.
Or the value of the levered firm is equal to the value of the unlevered firm plus the present
value of the tax-shield provided by policyholder financing less tax credits lost and costs
incurred in bankruptcy. Given the non-linear nature of the function, first partials can be
11
taken with respect to policyholder financing and an interior optimal mix of policyholder and
equity financing determined.
Given firm valuation as a function of policyholder
financing, taxes and bankruptcy costs, the firm manages its capital structure such that
(differentiating Equation (16) with respect to rL):
~
~
dVL  T ( R f  1)  dL
~ dL
dV (b )
dV ( B )

 TV (b )
 T (VO  L)
 (1  T )

drL  R f
drL
drL
drL
 drL
(17)
Setting (17) equal to zero provides:
~
~
 Rf 1
~  dL
dV (b ) 1  T  dV ( B ) 
(18)

 V (b )
 (VO  L)

drL
T  drL 
 R f
 drL
~
~
In this model, if bankruptcy is uncertain, V( b ) and V( B ) increase as the amount of
policyholder financing (represented by rL) increases. If the firm is bankrupt, then
~
1
1
V (b ) 

,
R f 1  rf
(19)

~
K (V1 )  BCov K (V1 ), ~
rm
~
V (B) 
1  rf

(20)
where K = bankruptcy costs, which are a function of a fixed amount and V1.
Kim’s model is adapted to the capital structure of a stockholder-owned insurance
company. A firm maximizing equityholder's wealth will not maximize its policyholder
financing. If bankruptcy is certain, both sides of Equation (18) equal zero. The optimal
capital structure is implied by the rL that provides a non-trivial solution to Equation (18).
Policyholder financing below the firm' s capacity is indicated. Rather than maximize
borrowing, the firm equates tax savings from expected (but uncertain) future policyholder
obligations with the present value of bankruptcy costs. The probability of these costs being
~
incurred increases with policyholder financing; V( B ) increases with financial leverage. Thus,
12
given the assumptions of a perfect market and allowing for bankruptcy costs, taxes, and
uncertain insurance claims, an optimal capital structure is characterized by Equation (18).
A ratio of policyholder and equity financing exists where equity value is maximized. The
possibility of bankruptcy costs provides a rationale for the existence of a finite capital
structure. A trade-off exists between the present value of the bankruptcy costs and the tax
savings associated with the government subsidy of policyholder payments. Equity value,
therefore, is first an increasing and then a decreasing function of policyholder financing. The
market value of the equity becomes a strictly concave function of total end-of-period
policyholder obligations with a unique global maximum. The capital markets, in this
framework, view equity as a surplus to guard against unfulfilled expectations.
Haugen and Senbet (1978) suggest certain features of this model may be deficient. The
models examined here consider one period and none address the role played by liquidation or
reorganization. Haugen and Senbet propose that an allowance for these discounts the role
played by a firm's capital structure. Titman (1984) posits that firm valuation must also allow
for values accruing to and costs borne by the customers and suppliers of a firm facing
liquidation. Revisiting their earlier paper, Haugen and Senbet (1988) support an irrelevance
argument concerning bankruptcy costs through simple provisions in corporate charters and
bond indentures. They counter Titman's claims relative to liquidation costs with reference to
implied arbitrage opportunities in Titman's modeling. They acknowledge "impediments to
pure market solutions to agency problems;" these are considered in the following section.
Section 5
13
In their seminal examination, Berle and Means (1932) propose that the separation of
ownership and control leads to inefficient decision making; individual shareholders rarely
have an incentive to monitor management and the interests of management and shareholders
often diverge. Given that management pursues objectives running counter to ownership,
agency costs develop.
Jensen (1986) proposes that management overinvests when firm cash flows are high and
underinvests when cash flows are low. Using Jensen's intuition, Stulz (1990) develops a
financial policy model that limits these agency costs of free cash flow. Stulz’s work can be
extended to a consideration of the minimization of agency costs to the equityholder of the
stockholder-owned insurance company.
Given a two-period model (t = 0, 1, 2) and ignoring the tax and bankruptcy implications
of policyholder financing:
N
=
new funds being raised (either equity or policyholder financing) at t = 1,
R
=
random unobservable (to outsiders) assets in place at t = 1 with cdf of G(R)
and differentiable density g(R); g(R) > 0 for all R such that  > R > O,
I
=
unobservable (to outsiders) investment at t = l,
I*
=
optimal level of investment,
Z
=
expected payoff on 0 < I < I*, and
Y
=
expected payoff on I* < I < .
(Payoffs occur at t = 2 from investment at t = 1.)
14
Without loss of generality, the rate of interest is assumed to be 0, such that Z > 1and Y
<1. Investors are assumed to be risk-neutral. If N is a negative value, a payout has occurred.
Investment past I* hurts existing shareholders.
If the firm does not have access to new policyholder or equity financing, its value is
given by:

I*
V  I * ( Z  1)  E ( R)   ( R  I *)(1  Y ) g ( R)dR  ( I *  R)( Z  1) g (r )dR
I*
0
(21)
Shareholder wealth maximization is achieved where all investments up to I* are
pursued and funds available beyond I* are paid out to shareholders. In this model, however,
shareholder wealth is not maximized as management pursues its own agenda (or is constrained
by inadequate cash flows) -- this cost reflected in the last two terms of Equation (21).
Shareholder wealth is not maximized where positive NPV projects (investments in profitable
insurance provision, for example) are foregone due to inadequate funds.
Similarly,
shareholder wealth is compromised, but management utility maximized, where free cash flows
available beyond I* are invested by management.
If the firm can access the capital markets,
( R  N  I *)Y  I * Z g( R)dR  0
I * N
V (N )  

I * N
( R  N )Zg( R)dR  N , (22)
r value equals the present value of payoffs at t = 1 less the present value of funds raised for investment.
A necessary and sufficient condition for the outside shareholders to allow management to raise
additional funds is that the first partial of Equation (22) with respect to N must be positive, or6
6 Using Leibniz’s Rule.
15
VN (O)  Y 1  G( I *)  ZG( I *)  1  0
(23)
Given that t = 0 is the only time at which outsiders can be certain of firm value and resources
available to management, N* is certain only at t = 0. "An improvement in the investment
opportunity set or a decrease in the probability that management will be able to exhaust
positive NPV investment opportunities leads to an increase in the funds management can
raise" if Equation (23) holds. Equation (23) characterizes the optimal value of N, the new
outside funding (or dividend paid to existing shareholders if N < 0). Equation (23) can be used
as a comparative static and extended to determine an optimal capital structure for the firm.7
Management can be bonded by the commitment of policyholder financing or a strict dividend
policy to select only positive NPV projects.
Jensen (1986) proposes that debt reduces the agency costs of free cash flow. For the insurance
company, increased policyholder financing serves a similar purpose.
Management is
constrained from pursuing its own agenda by regular payment of claims to policyholders.
Myers (1977) considers the determinants of corporate borrowing and implies a policyholder
financing capacity for the firm.
Recalling Equation (18) from Section 4:
~
~
Rf 1
~  dL
dV (b ) (1  T )  dV ( B ) 

V
(
b
)

(
V

L
)



0
drL
T  drL 
 R f
 drL
(24)
Given a perfect market and allowing for taxes, bankruptcy costs and uncertain future
policyholder obligations (L in Equation (24) is the expected value for these uncertain
7 See Stulz (1990).
16
obligations), a rational policyholder' s incentives are characterized by Equation (24). The
~
optimal capital structure is achieved where rL satisfies Equation (24). (V( B ) is uncertain.)
Equation (24) characterizes optimal policyholder financing.
The firm in Equation (24) has a capital structure that is a concave function of its
policyholder financing. As an increasing proportion of the firm is financed by policyholders,
risk of default and probability of non-payment of insurance claims increases. Investors in the
policies require lower priced insurance or higher expected payouts as this probability of
default increases. A global maximum occurs where total policy values cannot be increased
with the issuance of additional policies. An optimal capital structure is reached, given the
parameters of Equation (24), at a level of policyholder financing below firm capacity.8
Conclusions
Successively less restrictive assumptions are employed in this study of the capital
structure of a stockholder-owned company. In perfect markets without taxes, transactions
costs or bankruptcy costs, capital structure is irrelevant. In the absence of bankruptcy costs,
but allowing for uncertainty, capital structure is also irrelevant. Uncertain premiums and
8 Although optimal financing is characterized by Equation (24), its use of a liability expectation (L) is suspect. Broader
variances in these expectations of policyholder obligations (claims) are not specifically modeled by Equation (24). Given the other
assumptions of Section 5, an allowance for this variation impacts capital structure. Intuitively, greater variation (riskier policies)
results in an optimal capital structure consisting of a smaller proportion of policyholder financing and a larger proportion of
equityholder financing; ex ante contracting (larger deductibles, greater policyholder participation, etc.) mitigates this uncertainty.
17
uncertain policyholder obligations are priced at an equilibrium in the capital markets that
supports the irrelevance of Proposition 2 (Modigliani and Miller (1958)). Providing for
corporate taxes, and the deductibility of policyholder financing expenses lends support to a Oequity capital structure. Adding a provision for personal taxes supports capital structure
irrelevance. Relaxing the model further with an allowance for bankruptcy costs provides
support for the traditional view: that a firm's value is a concave function of its financial
leverage. Agency costs are mitigated by policyholder financing. An allowance for agency
costs, given the assumptions of Stulz (1990), supports the existence of an optimal capital
structure for the stockholder-owned insurance company. A provision for policyholder
incentives also implies an optimal capital structure.
There are features of these models that beg scrutiny. The one-period modeling and
other concerns of Haugen and Senbet (1978) and the role of preferred stock in Titman (1984)
are not resolved. The implications of uncertainty (in the pricing of policies and in future
policyholder obligations) are also not clear. Although elements of the uncertainty are included
in the study’s models, they are not robust to broad variances in expectations.
The “perfect” markets assumptions, traditional in many economic examinations, are
also suspect. Perfect markets preclude asymmetric information. Examinations by Leland and
Pyle (1977) and by Ross (1977) and others reveal the importance of ownership structure in
signaling value to the markets. The impact of information asymmetry and its role in the
stockholder-owned insurance company’s capital structure will be included in the later work.
These capital structure examinations ask as many questions as they answer. As Myers (1984)
18
notes in his address, “we [still] know very little about capital structure.” Subsequent
examinations will address the issues above in a single comprehensive framework.
19
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21
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