INCENTIVES TO MANAGE EXPENSES IN MUTUAL LIFE INSURANCE FIRMS: TAX MINIMIZATION AND INCREASED PERQUISITE CONSUMPTION

Managers of stock life insurance firms claim that managers of mutual life insurance firms avoid income taxes by manipulating accounting numbers. One method available to managers of mutual life insurance firms to decrease income taxes is to increase discretionary expenses. Another managerial motivation for increased discretionary expenses by mutual firms is increased perquisite consumption. This study attempts to determine if managers of mutual life insurance firms incur higher discretionary expenses to minimize the firm's taxes or to increase the manager's perquisite consumption. A better understanding of this issue will provide guidance for legislators who write tax laws and for regulators who monitor insurance firms.; The tax hypothesis proposes that managers increase discretionary expenses in order to decrease federal income taxes. Mutual life insurance firms receive a tax deduction for policyholder dividends, a portion of which may be a distribution of the company earnings. Conversely, stock firms are not allowed a tax deduction for distributions of company earnings to stockholders. To eliminate this inequity, Internal Revenue Code Section 809 disallows part of the deduction for mutual firms based upon an industry-wide differential return on equity between the stock and mutual segments and the specific mutual firm's equity. By increasing expenses, the mutual firm can reduce its equity and the related deduction disallowance. Comparing mutual firm discretionary expenses before and after the enactment of Section 809 provides an empirical test of the tax hypothesis. The results indicate that discretionary expenses of mutual life insurance firms significantly increased after the passage of Section 809. The same result is not obtained for stock life insurance firms, ruling out alternative economic or regulatory explanations for the structural change in the level of mutual firm expenses.; Prior research in the banking industry posits that managers have self-serving incentives to increase discretionary expenses through increased perquisite consumption. When external monitoring is minimal, these incentives likely lead to expense manipulation. Since mutual firms have no shareholders and are shielded from takeover threats, they face reduced monitoring relative to stock firms. Prior research yields mixed evidence of increased perquisite consumption. This study tests for this self-serving behavior on the part of mutual managers by comparing the level of discretionary expenses between stock and mutual life insurance firms. The results indicate that mutual firms do have higher discretionary expenses than stock firms, indicating that the agency costs associated with the mutual form of ownership are higher than those associated with the stock form of ownership. Thus, increased regulation of mutual firms may be necessary to mitigate the higher agency costs.