A Costly Contracting Analysis of the Insurance Firm

Abstract

The financial economics’ literature predicts that corporate decisions are influenced by internal contracting and incentive structures emanating from organizational form. The insurance industry is dominated by two main forms of organization—the mutual and stock company—which differ in terms of their contracting structure and systems of monitoring. As such, it offers an interesting environment within which to examine diversity in economic decision-making between firms of different ownership structure. Mutuals are considered to have economic advantages over stock companies because there are fewer constituents among whom costly contracting has to take place. On the other hand, mutuals have a more diffuse ownership-control structure than stock companies which means that policyholders are less able to closely monitor and control the contractual obligations of managers. Because managers in mutual companies are less closely monitored, they can impose higher contracting costs on policyholders as owners of the insurance firm. To mitigate costly contracting, policyholders will seek to protect their interests by limiting managerial discretion in economic activities, such as production, investment and reinsurance. To stimulate further empirical research, four propositions derived from a costly contracting analysis of the insurance firm are put forward. The paper concludes that costly contracting analysis can provide researchers with rich insights into the economic behaviour of insurance companies.