MANAGERIAL AND DECISION ECONOMICS

Manage. Decis. Econ. 31: 249–261 (2010)

Published online 14 June 2009 in Wiley InterScience
(www.interscience.wiley.com) DOI: 10.1002/mde.1473

Principal–Principal–Agency Relationships
and the Role of External Governance
Damian Warda, and Igor Filatotchevb
a
Bradford University School of Management, Bradford, UK
b
CASS Business School, London, UK

This paper explores agency problems associated with mutual and joint stock organizational forms.
It examines whether the independent mode of distribution acts as a governance factor that reduces
principal–agent and principal–principal costs. By analyzing a 1990–1997 panel of life insurance
companies this paper provides evidence that mutuals have higher principal–agent costs, but lower
principal–principal costs, compared with stocks. Independent distribution mitigates both agency
problems by reducing managerial expenses while safeguarding interests of policyholders. These
relationships are positively moderated by product complexity and free cash flow. This is consistent
with the assumption that companies that use independent agents exhibit lower levels of manager
and shareholder opportunism. Copyright r 2009 John Wiley & Sons, Ltd.

INTRODUCTION optimal solutions to agency problems between

There is a considerable debate around the efficiency
of corporate governance mechanisms associated
with the joint stock and mutual forms of organi-
zation (Galai and Masulis, 1976; Rasmussen, 1988;
Mester, 1989, 1991; Ingham and Thompson, 1995;
Cummins, 1999). It has been acknowledged that
‘these two forms have long coexisted and competed
in the financial services industry, in many different
countries’ (Baker and Thompson, 2000, p. 46).
Among financial services firms, insurance com-
panies face two important agency relationships. On
the one hand, their shareholders have to control
managerial opportunism, on the other hand policy-
holders have to prevent exploitation by share-
holders (Krishnaswami and Pottier, 2002; Ward,
2003). According to Mayers and Smith (1981) stock
companies are optimal solutions to shareholder–
manager type agency costs, while mutuals, in
combining policyholders and shareholders, are
*Correspondence to: Bradford University School of Management,
Emm Lane, Bradford BD9 4JL, UK.
E-mail: d.r.ward@bradford.ac.uk
shareholders and policyholders. However, these
are local, and not global solutions, and corporate
governance mechanisms used by insurance com-
panies cannot effectively deal with two types of
agency relationship simultaneously. This paper
explores how life insurance companies can use an
external channel of governance through indepen-
dent distribution in conjunction with corporate
modes of governance to achieve a global agency
cost solution.
In this paper we view conflicts between and
among sets of agents and principals as local
conflicts, but investigate the extent to which
governance systems can help to control global, or
all of the organization’s agency type conflicts. For
example, managers as agents of shareholders
(principals) can engage in self-serving behavior,
which may destroy shareholder wealth. Share-
holders can control these agency costs by the use
of corporate governance. This includes monitoring
by boards of directors (e.g., Fama and Jensen,
1983); and monitoring by large outside shareholders
(e.g., Demsetz and Lehn, 1985; Holderness and
Sheehan, 1988). Various equity-based managerial

Copyright r 2009 John Wiley & Sons, Ltd.

250 D. WARD AND I. FILATOTCHEV
incentives can align interest of agents and principals
(Murphy, 1985; Jensen and Murphy, 1990). Finally,
the threat of takeover (e.g., Grossman and Hart,
1988; Shleifer and Vishny, 1997), and competition
on the product (Hart, 1983; Jensen, 1993) and
managerial labor markets (Fama, 1980) may con-
strain managerial opportunism. However, these
governance arrangements address conflict between
(agents) managers and (principals) owners. They do
not recognize, deal with or include conflicts between
principles; and so may not reduce the global agency-
based costs of an organization.
Conflict between principals is well recognized.
Corporate finance theorists distinguish between
debt- and equity-holders as two types of principals
with potentially conflicting interest (Williamson,
1988; Dewatripont and Tirole, 1994; Hart and
Moore, 1995). Furthermore, dominant share-
holders may abuse their power at the expense of
minority shareholders. As a result, the primary
agency problem is the expropriation of minority
shareholders by the controlling shareholders
(La Porta et al., 2000).
These differences in principals’ preferences and
objectives may lead to a principal–principal agency
relationship with associated agency costs (Walsh and
Seward, 1990). Traditional governance mechanisms
developed to deal with principal–agent conflicts
may be less effective against principal–principal
conflicts. Previous research within the agency
perspective discusses possible governance responses
to principal–agent and principal–principal agency
problems separately (see Arthurs et al., 2008, for a
comprehensive survey), but there is very little
research on global governance solutions to a
combination of these problems.
This paper extends previous research and makes a
number of contributions. It develops an integrated
theoretical framework where the firm may suffer
from a combination of principal–agent and principal–
principal problems, with the extent of the associated
agency costs depending on the adopted organi-
zational form. By focusing on the life insurance
industry, the paper highlights that stocks mitigate
shareholder–manager problems but do not reduce
agency costs between shareholders and policyholders.
Similarly, mutuals solve shareholder–policyholder
problems but do not reduce agency costs between
shareholders and managers. Therefore, the life
insurance sector represents a unique setting where
two different organizational forms and principal–
agent and principal–principal problems co-exist
Copyright r 2009 John Wiley & Sons, Ltd.
within a single industry. In recognizing these points
this study examines these agency relationships by
utilizing a variety of agency cost measures based on
financial flows between shareholders, managers, and
policyholders.
This paper, in line with the ideas of Hart (1983)
and Jensen (1993), also emphasizes how the product
market, rather than the market for corporate
control, can be used to manage agency costs.
Independent distribution bonds the insurance
company to behave in the interests of its policy-
holders. If not, then by moving new business from
‘bad’ to ‘good’ companies, independent distribution
starves bad companies of new cash flows.1 An
independent distribution strategy may offer a
powerful channel of control over agency costs that
complement traditional ‘voice’- and ‘exit’-based
mechanisms of traditional corporate governance.
Finally, the paper also considers a number of
important contingency factors that can moderate
the relationship between the external governance
and agency costs, such as product complexity and
the presence of free cash flow. Using panel data on
UK life insurance firms, it provides empirical
analysis of these inter-relationships, while taking
account of possible endogeneity problems.
THEORETICAL BACKGROUND AND
HYPOTHESES
Previous studies recognize that the mutual and stock
organizational forms in financial services have their
own specific sets of agency problems (Fields, 1988;
Rasmussen, 1988; Mester, 1989, 1991; Cummins,
1999). Figure 1 presents a simplistic representation
of the agency relationships within the insurance
sector. In mutual companies, policyholders are
shareholders; and managers (the agents) answer to
their policyholders (the principal). With mutuals
generally operating a one-member one-vote policy,
and with no active market for ownership rights, it is
difficult for policyholders to organize themselves and
discipline poorly performing management teams
(Mayers and Smith, 1981; Ingham and Thompson,
1995). Mutuals have, therefore, been seen to
generate particularly acute ‘vertical’ principal–agent
problem, where managers may enjoy considerable
discretion (Baker and Thompson, 2000).
In stock companies, shareholders as principals
employ managers to act as their agents in the
Manage. Decis. Econ. 31: 249–261 (2010)
DOI: 10.1002/mde
 PRINCIPAL–PRINCIPAL–AGENCY RELATIONSHIPS
Stocks
“Vertical” Agency
Relationship
Agent Managers
Principal Policyholders
Principal
“Horizontal” Agency
Relationship
Figure 1. Principal–principal–agent relationships in UK life insurance.
running of the company. However, policyholders in
stock companies also employ companies to act as
their agents in the management of risk and the
provision of financial intermediary services. Both
relationships are associated with ‘vertical’ principal–
agent problems in Figure 1. However, if share-
holders, particularly large shareholders, can exert
more pressure over managers than small disparate
policyholders, then a ‘horizontal’ agency problem
can also exist between the two principals, e.g.,
shareholders and policyholders (Mayers and
Smith, 1981; Rasmussen, 1988; Krishnaswami and
Pottier, 2002). This ‘principal–principal’ agency
relationship has been identified by previous studies
(Walsh and Seward, 1990; Dharwadkar et al., 2000),
and, in the context of insurance companies,
manifests itself in shareholders directing financial
flows within the company away from policyholders
and toward themselves (Ward, 2003).
As traditional, ‘exit’- and ‘voice’-based channels of
corporate governance may fail to mitigate ‘vertical’
and ‘horizontal’ agency problems simultaneously, we
suggest that insurance companies can strategically
use independent distribution as the external, product
market-related governance channel, which, in
conjunction with corporate modes of governance,
may help to achieve a global agency cost solution
(Hart, 1983). The following sections develop these
arguments further and generate a number of testable
hypotheses.
Agency Costs and Corporate Governance in Life
Insurance
Mayers and Smith (1981) define life insurance
companies as a union of conflicting parties. For
mutuals, previous research identifies a number of
potential sources of principal–agency problems.
First, insurance contracts are complex, mixing
various types of life and critical illness cover as
Copyright r 2009 John Wiley & Sons, Ltd.
251
Mutuals “Vertical” Agency
Relationship
Managers Agent
Shareholders Policyholders Principal
Principal
well as providing tax shields for investors. Funds
can be linked or non-linked and premiums can be
regular or single. The ordinary individual has little
interest or willingness to understand the full
complexity of these products and often employs
a financial adviser. Therefore, policyholders buy
on trust and rarely undertake active monitoring of
their policies. Second, with restricted ownership
rights, it is difficult for policyholders to organize
themselves and discipline management teams
(Ward, 2003). Finally, life insurance policies are
often front-loaded with the life-time expenses of
the policy. This has the effect of reducing
investment returns, particularly in the early
years. This makes exit costly for policyholders.
In contrast, stocks may mitigate the extent of
principal–agency problems and achieve benefits
from monitoring both by boards of directors and
other managers (Fama and Jensen, 1983; Rediker
and Seth, 1995). In addition, monitoring by large
outside shareholders that are prepared to trade
portfolio diversification for greater control may
have ‘spill over’ affects for other shareholders (e.g.,
Demsetz and Lehn, 1985; Holderness and Sheehan,
1988). In addition, internal governance mechanisms
may include various equity-based managerial
incentives that align interest of agents and
principals (Murphy, 1985; Jensen and Murphy,
1990). Externally, factors, such as the threat of
takeover (e.g., Grossman and Hart, 1988; Shleifer
and Vishny, 1997) and competition on the
managerial labor market (Fama, 1980) may
constrain managerial opportunism. Therefore, a
combination (or bundle) of internal and external
governance mechanisms may reduce principal–
agency costs and improve corporate performance
(Rediker and Seth, 1995).
Previous studies (e.g., Mayers and Smith, 1981;
Cummins, 1999; Baker and Thompson, 2000)
suggest that within mutuals these bundles of
Manage. Decis. Econ. 31: 249–261 (2010)
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252 D. WARD AND I. FILATOTCHEV
corporate governance are largely ineffective. An
extremely diffused nature of the principals
(claimholders) may accentuate a free rider
problem and discourage claimholders to exercise
their voice. Baker and Thompson (2000, p. 40)
conclude that the mutual form ‘would be subject
to severe agency problems, with managers
eschewing profit-maximization and opting for the
pursuit of preferred goals’. Building on this
research, we suggest
Hypothesis 1:
The extent of principal–agent problem and
associated agency costs will be higher in mutuals
than in stocks.
A number of studies suggest that, in different
national and industry context environments, firms
may have heterogeneous groups of principals
whose interests and objectives do not coincide
(Walsh and Seward, 1990). For example, research
on optimal financial structure and claims sub-
ordination literature (e.g., Williamson, 1988;
Dewatripont and Tirole, 1994; Hart and Moore,
1995) emphasizes information asymmetries and
divergent interests among bondholders, share-
holders and managers. Banks, for example, may
have intimate knowledge of the firm’s affairs, and
in the case of impending failure they may continue
to press the firm to liquidate receivables to cover
fixed claims, even if this action harms the firm’s
equity holders. This research suggests that there
may be unique agency problems that result from
misalignment of interests between the principals.
Therefore, a conflict between principals in the firm
is due to the fact that some transactions can
benefit one claimant group at the expense of
the others (Walsh and Seward, 1990). These
differences in principals’ goals and objectives
leads to a ‘horizontal’, or ‘principal–principal’
agency relationship and associated agency costs
(Dharwadkar et al., 2000).
In insurance companies, there are a number of
possible sources of the ‘principal–principal’ agency
costs. Cash flows into an insurance company
come in the form of capital from shareholders,
premiums from policyholders, retained under-
writing profit and positive investment returns.
The outflows are claims paid, managerial expenses,
dividends to shareholders and investment returns
to policyholders. Diverting investment returns
from policyholders’ funds to shareholders’ divi-
dends or into managerial expense accounts is
possible. Moreover, as diversified investors,
Copyright r 2009 John Wiley & Sons, Ltd.
shareholders can take bigger risks with the
insurance company’s funds, perhaps taking
higher risks in equities than less diversified
policyholders would find desirable. This problem
is known as the risk-shifting problem, or the asset
substitution problem in the agency literature
(Galai and Masulis, 1976; Jensen and Meckling,
1976). Because policyholders anticipate this
problem, the agency costs of risk shifting will be
fully reflected in the price of the insurance policy at
the time of issuance.
Another type of policyholder–shareholder
agency conflict is associated with the under-
investment problem. Because shareholder claims
are junior to fixed liability claims, the shareholders
accept only projects in which the cash flows exceed
the liabilities. As a result, managers will forgo
some positive NPV projects. Again, the costs of
under-investment will be imposed on shareholders
by rational policyholders (Krishnaswami and
Pottier, 2002).
Therefore, stock insurance companies have to
bear the burden of ‘principal–principal’ costs, in
addition to principal–agent costs (Jensen and
Meckling, 1976). As a result, traditional gover-
nance mechanisms, developed to deal with
principal–agent conflicts, may be less effective
against principal–principal conflicts. In contrast,
mutuals are effective at reducing the agency
problems between policyholders and share-
holders, since the interests of shareholders and
policyholders are fully aligned. Hence,
Hypothesis 2:
The extent of principal–principal problem and
associated agency costs will be lower in mutuals
than in stocks.
Corporate Governance Through Independent
Distribution
The above arguments suggest that insurance
companies face a combination of principal–agent
and principal–principal agency relationships. A
global solution would reduce total agency costs by
trading increases in shareholder–manager agency
costs, for greater decreases in shareholder–
policyholder agency costs, or vice versa.
In order to solve this problem it is necessary to
examine the complementary nature of alternative
governance systems (Walsh and Seward, 1990;
Rediker and Seth, 1995; Hoskisson et al., 2002).
Life insurers may introduce complementary
Manage. Decis. Econ. 31: 249–261 (2010)
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 PRINCIPAL–PRINCIPAL–AGENCY RELATIONSHIPS
governance systems if there is a net reduction in
overall agency costs. For example, a stock
company will benefit from additional comple-
mentary governance if the reduction in agency
costs associated with shareholders and policy-
holders outweighs the increase in agency costs
between shareholders and managers. As an
example Krishnaswami and Pottier (2002) exa-
mine the governance effects of issuing ‘parti-
cipating’ or ‘with profit’ policies. These provide
policyholders with a claim on the company’s
profits. This entails a partial mutualization of the
stock company and therefore a partial solution to
the remaining principal–principal agency problem.
Unfortunately, this approach will diminish the
beneficial aspects of the stock mode of governance,
as any positive returns to a potential bidder for the
company will be shared with the participating
policyholders. Moreover, Krishnaswami and
Pottier (2002) argue that the power of any
incentive or stock option contract to align share-
holders’ and managers’ interest will be diminished
when participating policies are issued, because a
share of any additional profits will be placed with
the policyholders.
Some authors suggest that a global solution to
principal–agent and principal–principal agency
problems lies outside the organization, and they
forcibly pointed out that external governance
through the product market competition may be
an important complement to the traditional
governance channels (Hart, 1983; Jensen, 1993).
In the context of the insurance industry, the firms
may strategically use independent distribution
as a complementary mode of corporate gover-
nance. By monitoring managers and shareholders
independent distribution reduces ‘vertical’ and
‘horizontal’ agency costs of policyholders dealing
with managers and shareholders. Independent
distribution can add value to the company by
facilitating transactions with policyholders that
in the presence of direct sales forces would not
take place.
From the policyholders’ perspective, the services
offered by independent agents can help to reduce
the agency costs associated with purchasing
insurance. Pre-contractual opportunism by the
insurance company can be reduced through
searches for price and cover. Furthermore, by
negotiating claims and monitoring investment
performance, independent agents can limit post-
contractual opportunism by threatening to move
Copyright r 2009 John Wiley & Sons, Ltd.
253
new business to alternative suppliers of insurance
(Kim et al., 1996). Based on these arguments we
suggest the following hypotheses:
Hypothesis 3:
The use of independent distribution is negatively
associated with principal–agency costs.
Hypothesis 4:
The use of independent distribution is negatively
associated with principal–principal agency costs.
Fama and Jensen (1983) and Mayers and Smith
(1981) relate the extent of potential agency conflicts
to organizational and product complexity. There-
fore, the potential agency costs between policy-
holders, shareholders and managers will be greater
when the market environment is complex (Dess and
Beard, 1984). Child (1972, p. 3) conceptualizes
environmental complexity as ‘the heterogeneity of
and range of an organization’s activities’. In
complex environments managerial discretion will
need to be high in order to monitor, control and
exploit profitable opportunities as they arise (Li and
Simerly, 1998). In the context of the insurance
industry, complexity can exist in a number of forms.
Death is very predictable. This simple liability can
be matched with a simple asset such as a long-term
bond. Pensions and investment aspects of life
insurance are less predictable and rely on good
portfolio management. Discretion is needed in
researching and selecting investment options. Fre-
quent changes in government policy on taxation or
pensions create opportunities for product innova-
tion. Successful exploitation of these opportunities is
assisted by managerial discretion.
However, if the interests of managers and
shareholders are not aligned, then management
can take advantage of information asymmetries
and use discretion to facilitate expense preference
behavior (Fields, 1988; Mester, 1989, 1991), or
the pursuit of growth as opposed to profita-
bility objectives (Zajac and Westphal, 1994).
Berger et al. (1997) suggest that the product mix
of a company is likely to drive the complexity
associated with managing and distributing various
products. Krishnaswami and Pottier (2002)
associate product diversity with an increase of
both manager and shareholder opportunism.
At the same time, the feasibility and degree to
which owners can effectively monitor the beha-
vior of managers may be reduced by product
complexity (Li and Simerly, 1998). Zajac and
Westphal (1994) also emphasize that an increase
in complexity makes it costlier for boards and
Manage. Decis. Econ. 31: 249–261 (2010)
DOI: 10.1002/mde
254 D. WARD AND I. FILATOTCHEV
shareholders to monitor managerial decisions.
Hence,
Hypothesis 5a:
The relationship between the use of independent
distribution and principal–agent costs is positively
moderated by product complexity. This relationship
will be stronger for firms with greater product
complexity.
Hypothesis 5b:
The relationship between the use of independent
distribution and principal–principal agency costs is
positively moderated by product complexity. This
relationship will be stronger for firms with greater
product complexity.
Agency theorists link the extent of agency
problems with the presence of free cash flow, or
‘cash flow in excess of that required to fund all
projects that have positive net present values when
discounted at the relevant cost of capital’ (Jensen,
1986, p. 323). Jensen (1986, 1993) emphasizes that
agency conflicts are especially severe when the
organization generates substantial cash flow. The
free cash flow hypothesis predicts that managers with
unused borrowing power and large cash reserves are
more likely to undertake low-benefit or even value-
destroying mergers or unrelated diversification
programs (Lang and Litzenberger, 1989; Lehn and
Poulsen, 1989; Chatterjee and Wernerfelt, 1991).
Jensen (1993) suggests that fixed-claim holders,
such as banks, LBO firms, etc., may impose an
effective restraint on managerial opportunism by
reducing the extent of free cash flow. Strategic
management research (e.g., Bethel and Liebeskind,
1993; Gibbs, 1993) argues that the amount of cash
available to managers can be reduced by financial
restructuring strategies, such as share buy-backs,
increasing dividend payments, etc. Wells et al.
(1995) examine whether stock or mutual modes of
governance are better at reducing free cash flow
within life insurance companies.
In our theoretical framework we suggest that
independent distributors may be an effective
external governance factor. If free cash flow
reduces the effectiveness of ‘traditional’ gover-
nance mechanisms, then the importance of inde-
pendent distribution as a mode of governance
should be even higher in the presence of free cash
flow. Hence, we suggest
Hypothesis 6a:
The relationship between the use of independent
distribution and principal–agent costs is positi-
vely moderated by the free cash flow. This
Copyright r 2009 John Wiley & Sons, Ltd.
relationship will be stronger for firms with greater
free cash flow.
Hypothesis 6b:
The relationship between the use of independent
distribution and principal–principal agency costs is
positively moderated by the free cash flow. This
relationship will be stronger for firms with greater
free cash flow.
METHODS
The Data
The UK has approximately 100 operating life
insurance companies, and independent agents are a
significant feature of the insurance industry, with the
Association of British Insurers (ABI, 2002), reporting
33% of new life business and 66% of new pension
business was sourced by independent agents in the
year 2001. Under UK investor protection legislation
direct and independent agents are required to
document the reasons why they have advised the
purchase of a particular product. Independent agents
also have to provide reasons for selecting one
product provider over another. Direct and inde-
pendent agents are audited by the regulator and non-
compliance results in the imposition of fines.
Table 1 provides data on the percentage of new
business, by product groupings, sourced in the inde-
pendent channel. It is clear that independent agents
source more regular premium business in the pen-
sions sector, but more significantly independents are a
big source of business in the single premium market,
regardless of the split between life and pensions.
Similarly, independent agents are strong in non-linked
business where life insurance companies operate
discretion over the allocation of investment returns.
Table 1. Percentage of New Business Sourced by
Independent Agents
Percentage of new business
New regular premiums
Non-linked life 34.0
Linked life 24.9
Non-linked personal pensions 41.9
Linked personal pensions 53.3
New single premiums
Non-linked life 69.2
Linked life 57.9
Non-linked personal pensions 74.7
Linked personal pensions 84.8
Source: ABI (2002).
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 PRINCIPAL–PRINCIPAL–AGENCY RELATIONSHIPS
The authors used multiple sources of data when
constructing a sample of insurance companies.
Firm level financial data over the period
1990–1997 was taken from the THESYS
database, which publishes financial regulatory
returns made by all UK insurance companies.
The information on distribution method is
obtained from the annual New Business Survey in
the industry journal Money Management. The
survey reports the percentage of new business sold
by a company through independent, or direct
distribution channels. Firms that use company
representatives, but who are independent agents of
the insurance company were excluded from the
sample. Thus, the sample provides a straight
comparison of those companies using inde-
pendent financial advisers and direct, in-house,
agents. As a result of this selection procedure,
this study utilizes a panel data set consisting of
42 UK life insurance companies over the period
1990–1997 that generate a dataset of 294 firm-year
observations. A comparison between our sample
and the remaining companies does not identify any
significant differences in terms of size, leverage,
mode of corporate governance and product
distribution.
Measures
Dependent variables
A direct measure of agency costs is difficult.
If independent agents do constrain managerial
discretion, then one should expect to see the use of
independent agents associated with lower
managerial expense ratios, where managerial
expenses are the costs of managing the business
(Fields, 1988; Mester, 1989, 1991). One should
expect independent agents to discriminate between
high expense ratios, which relate to improved
levels of service for policyholders, from high
expense ratios that relate to the consumption of
perquisites by managers. Evidence by Berger et al.
(1997) suggests that service level costs do vary by
product and distribution channel, particularly as
products become more complex. Given that
independent agents are at the forefront of
managing these transactions, then one can argue
that they will be aware of service differentials and
therefore capable of separating service level costs
from excessive managerial expenses levied by the
insurance companies. Therefore, as a proxy for
principal–agency costs, PA, we used MGTEXP
Copyright r 2009 John Wiley & Sons, Ltd.
255
calculated using the THESYS database. MGTEXP
is the ratio of managerial expenses to total expenses.
There is very little empirical research related to
principal–principal agency problem and associated
costs, PP. We use a cash-based measure of claims
to approximate these principal–principal costs.
CLAIMS is measured as the total claims paid by
a life insurance company, less claims paid on
death, where a life company has no discretion on
death payments. CLAIMS focuses upon payments
made to policyholders, which are investment based
or the result of policy lapses and surrenders.
Therefore, CLAIMS is a measure of the payments
made to policyholders, which are under the
discretionary control of the company. CLAIMS
has a number of benefits as a measure of
principal–principal costs. First, CLAIMS as cash
payments are recorded with a high degree of
accuracy. Second, payments to policyholders
directly reduce the resources against which
residual rights owners can draw on. Therefore,
CLAIMS arguably lies at the heart of the tension
between the two types of principals in the example
of life insurance.
Independent variables
A binary ð1; 0Þ variable MUTUAL was used for
firms with the mutual type of organization. The
measurement of distribution method, INDP, is
taken from the annual New Business Survey in the
industry journal Money Management. The
percentage proportion of sales in the independent
channel was used to measure the type of
distribution channel used.
The measurement of free cash flow (FCF)
follows that of Gibbs (1993), Lehn and Poulsen,
(1989), Wells et al. (1995) and uses undistributed
cash flow as a proxy for free cash flow. This figure
represents the differences between all cash receipts
and all mandatory cash payments. Undistributed
cash flow is equal to net premium income plus
investment income and additional capital changes
paid in, less underwriting expenses, investment
expenses, gross interest charges, income taxes,
policyholder bonuses and stockholder dividends.
Therefore, this variable measures the amount of
cash over which management retains discretion in
terms of its disbursement.
Following Regan (1997) complexity can be
proxied by the type of products sold with a reason-
able assumption that the transactional characteristics
of life, pension and permanent health insurance
Manage. Decis. Econ. 31: 249–261 (2010)
DOI: 10.1002/mde
256 D. WARD AND I. FILATOTCHEV

Table 2. Descriptive Statistics and Correlations

Variable Description
INDP Percentage of new business sold by independent agents
MUTUAL Mutual 5 1, stock 5 0
PRODMIX Ratio of new pension to new life insurance premiums
FCF Free cash flow 5 net premium income plus investment income and additional capital changes paid in, less
underwriting expenses, investment expenses, gross interest charges, income taxes, policyholder bonuses and
stockholder dividends
CLAIMS Natural log of all non-death claims
MGTEXP Ratio of managerial expenses to all expenses
Variable Mean Std.Dev. Minimum Maximum
INDP 46.0127 40.8563 0.0000 100.0000
MUTUAL 0.4254 0.4952 0.0000 1.0000
PRODMIX 2.8730 10.2001 0.0505 162.8789
FCF 298.0822 445.8286 0.0000 2912.6955
CLAIMS 5.3065 1.3450 0.0216 7.9503
MGTEXP 37.0737 22.8282 0.0000 125.2100
Correlations
INDP MUTUAL PRODMIX FCF CLAIMS

INDP
MUTUAL 0.2872
PRODMIX 0.1327 0.1279
FCF 0.0000 0.0893 0.1066
CLAIMS 0.1161 0.0833 0.0664 0.0302
MGTEXP 0.0686 0.0657 0.0056 0.0435 0.0194
Correlation is significant at the 0.01 level. Correlation is significant at the 0.05 level.

products are all different. Therefore, in order to
model this relationship PRODMIX as the ratio of
pension to life business is used to measure the weight
of complex pension products within the companies
overall portfolio of business.
All nominal values were deflated to 1995 prices
by the use of the GDP deflator. Descriptives and
correlations are provided in Table 2. As this table
shows, 42% of firms in our sample are mutuals.
On average, firms in our sample sell 46% of their
products via independent distributors.
Model Specification
Modeling the relationship between corporate
governance factors and organizational outcomes
has generally been approached through standard
econometric techniques, such as regression analysis.
The real problem revolves around the issue of
endogeneity of governance and other organizational
parameters (see, for example, Demsetz and Lehn,
1985; Bethel and Liebeskind, 1993; Gibbs, 1993, for
an extensive discussion). Recent research on
insurance companies emphasizes the importance of
recognizing the endogenous nature of insurance
companies’ modes of governance, distribution
decisions and product portfolios (Regan and
Tzeng, 1999; Marx et al., 2001; Ward, 2003).
As empirical applications, Regan and Tzeng (1999)
and Ward (2003) argue that if the mode of
governance and distribution are strategic comple-
ments then decisions over their use will be taken
simultaneously by the company. That is a decision
to use the stock mode of governance will involve a
simultaneous decision to use a particular mode of
distribution. A possible empirical approach, which
recognizes this apparent interconnectedness, is a
two-stage least-squares estimator. However, two-
stage least squares require the identification of
instruments that are correlated with the endo-
genous variables and uncorrelated with the error
term of the model. Researchers sometimes struggle
to identify possible instruments, or find that their
chosen instruments lack empirical validity.
An alternative approach is to forego the
assumption of strict exogeneity of the regressors
and to instead consider the endogenous variables as
predetermined. Under such assumptions the error
terms of the model are uncorrelated with current
and lagged (but not the future) values of the
predetermined variables. This sequential exogeneity
can then be utilized within a dynamic panel data
routine to estimate unbiased coefficients, see Baltagi
(2008) and Roodman (2006).

Copyright r 2009 John Wiley & Sons, Ltd. Manage. Decis. Econ. 31: 249–261 (2010)
DOI: 10.1002/mde
 PRINCIPAL–PRINCIPAL–AGENCY RELATIONSHIPS 257

The benefits of using a dynamic panel data Our main hypotheses can be tested in models 1
estimator are the construction (through lags) of and 2. Within model 1, principal–agent costs are
instruments from within the existing data set, while regressed on the first lag of agency costs, (PAit1),
also enabling a consideration of persistence in the independent distribution (INDP) and the dummy
dependent variable. For example, agency costs can variable for the mutuals (MUTUAL). In addition,
persist over several time periods because managers we included product complexity (PRODMIX) and
are likely to operate established systems and free cash flow (FCF) proxies together with their
procedures, which enable the extraction of rents interactions with INDP variable (see Bethel and
from the firm. As such, agency costs in period t are Liebeskind, 1993; Gibbs, 1993, for a discussion of
potentially related to agency costs in period t1. this methodology). Model 2 has the same structure
Dynamic panel data estimators are capable of as model 1, and it uses principal–principal costs
modeling such relationships by enabling lags of the proxies as the dependent variables.
dependent variable to enter the list of independent
variables, without the subsequent violation of the
assumption that the error term and the independent
variables are uncorrelated. Dynamic panel data RESULTS
estimators therefore appear to offer an improved
alternative on the two-stage least-squares approach Descriptive statistics and correlation coefficients
used by Regan and Tzeng (1999). However, it are presented in Table 2. The correlation coeffi-
should be noted that like the two-stage least- cients do not suggest any multicollinearity pro-
squares approach, the use of instruments requires blem. The results for models 1 and 2 are presented
that the estimated model is tested for over in Table 3.
identifying restrictions using statistical tests such For models 1 and 2, the null hypothesis of no
as those proposed by Sargan (1958). over identifying restrictions is not rejected by the
There are two main types of dynamic panel data Sargan test. As such we are reasonably assured
estimator, the Arellano and Bond (1991) difference that the instruments are uncorrelated with the
estimator and the Blundell and Bond (1998) error term of the models and therefore do not
system estimator. The system estimator brings
improved efficiency to the estimation process.
However, for the system estimator it is assumed Table 3. Dynamic Panel Data Regression
that changes in the instrument variables are Analysis of the Effects of Independent Distributors
uncorrelated with the fixed effects. In this study, on Principal–Principal–Agency Costs
the instruments will be lags of the predetermined MGTEXP CLAIMS
measures of independent distribution and the Coef. Coef.
mode of corporate governance. These are key
characteristics of life insurance companies and any Constant 0.4415 321.1003
(0.000) (0.0251)
changes in these variables may be linked to the Yt-1 0.0268 0.0337
firm-level unobservable heterogeneity captured by (0.0082) (0.000)
the fixed effects. Therefore, the Arellano and Bond INDP 0.0012 0.2951
(0.0070) (0.0130)
(1991) difference estimator is employed. MUTUAL 0.1298 14.0526
The models to be estimated are as follows: (0.0006) (0.9842)
Model 1: Principal–Agent Costs PRODMIX 0.0031 10.5788
(0.2010) (0.000)
PAit ¼fðPAit1 ; INDPit ; MUTUALit ; FCF 0.0005 0.0499
(0.0690) (0.000)
PRODMIXit ; FCFit ; INDP INDPPRODMIX 0.0005 0.0997
(0.4950) (0.000)
 PRODMIXit ; INDP  FCFit Þ INDPFCF 0.0010 0.0007
(0.0390) (0.000)
Model 2: Principal–Principal Costs Wald w2 (7) 17.71 18.28
(0.0000) (0.000)
PPit ¼fðPPit1 ; INDPit ; MUTUALit ; Sargan Test w2 66.58 46.18
MGTEXP df (58), CLAIMS df (44) (0.2056) (0.3821)
PRODMIXit ; FCFit ; INDP n 268 268
 PRODMIXit ; INDP  FCFit Þ p values are in parentheses.

Copyright r 2009 John Wiley & Sons, Ltd. Manage. Decis. Econ. 31: 249–261 (2010)
DOI: 10.1002/mde
258 D. WARD AND I. FILATOTCHEV
introduce any additional bias into the estimation
procedure.
Models 1 and 2 provide good statistical support
for our main hypotheses. In model 1 (principal agent
costs), H1 is supported with mutuals displaying
higher costs than stocks. H3 is also supported with
the use of independent agents exhibiting a negative
impact on the level of principal agent costs. In
addition, the regression coefficient for the inter-
action of FCF with independent distribution is
negative and significant. This findings support the
proposition that independent distribution becomes a
more powerful moderator of principal agent costs in
environments where the potential for principal agent
conflict is greater, in line with Hypotheses 6a.
In model 2, we have support for Hypothesis 4,
indicating that the use of independent distribution
lowers principal–principal conflict by increasing the
level of claims paid to policyholders. The positive
coefficient on MUTUAL is in accord with our
Hypothesis 2, where we would expect mutuals to
payout higher claims than stocks, but the coefficient
is statistically insignificant. However, if lower PP
conflicts in mutuals leads to lower policy surrender
rates, then it is possible that cash payments to
policyholders will be little different between mutuals
and stocks. Further research on the links between
principal–principal conflict and the structure of
financial claims of policyholders is needed.
The regression coefficients for the interactions
between product complexity and free cash flow
with independent distributors are positive, as
predicted by Hypotheses 5b and 6b and both are
significant. This suggests that the governance role
of independent distribution is enhanced when the
insurance company is in possession of higher levels
of free cash flow.
In summary, our results provide strong
evidence for the beneficial role of independent
distribution in controlling both principal–principal
costs and principal–agent cost. We now discuss
more fully the significance of these results.
DISCUSSION
Research Findings
There is a growing recognition that principal–agent
problems are not the only contractual conflicts
faced by an organization. Many, if not all, organi-
zations also face principal–principal conflicts, with
Copyright r 2009 John Wiley & Sons, Ltd.
competing claims among heterogeneous groups of
residual claimants (Walsh and Seward, 1990;
Hoskisson et al., 2002; Dalton et al., 2003). This
study makes a contribution to this research and
highlights how organizations can use external
product market monitoring by independent agents
to supplement corporate modes of governance. In
doing so, it also emphasizes the importance of
bridging the traditions of financial economics and
organization theory (Walsh and Seward, 1990).
In the particular case of the insurance industry,
stock modes of governance have been seen as
effective means of controlling principal–agent
problems, while mutuals have been effective at
reducing principal–principal conflicts. However,
such systems are unbalanced, in that they do not
deal jointly with principal–agent and principal–
principal conflicts. The use of independent distri-
bution has now been shown to be capable of
moderating principal–agent and principal–principal
conflict. Therefore, the qualities of the particular
mode of corporate governance in dealing with
vertical and horizontal agency problems can be
supplemented and complemented by the use of
external product market monitoring.
Previous research has recognized that gover-
nance mechanisms operate interdependently with
the overall effectiveness depending on a simul-
taneous operation of several mechanisms in
limiting managerial opportunism (Walsh and
Seward, 1990; Rediker and Seth, 1995). Different
governance mechanisms can substitute or
complement each other, (Hoskisson et al., 2002;
Dalton et al., 2003), and the cost-benefit trade-
offs among a variety of governance mechanisms
would determine their use (Rediker and Seth,
1995, p. 88). We extend this research further
and make two contributions. First, we suggest
that substitution/complementarity hypothesis
(e.g., Dalton et al., 2003) has relevance not only
within the context of conventional, principal–
agent problems, but it plays a very important
role in terms of mitigating principal–principal
conflicts that are largely overlooked by agency
research. Second, we analyze governance roles of
product market competition within an integrated,
principal–principal–agency framework. Previous
agency and strategy studies are somewhat
skeptical with regard to the effectiveness of this
mode of governance emphasizing its slow response
to internal agency conflicts compared with the
market for corporate control (Jensen, 1986;
Manage. Decis. Econ. 31: 249–261 (2010)
DOI: 10.1002/mde
 PRINCIPAL–PRINCIPAL–AGENCY RELATIONSHIPS
Bethel and Liebeskind, 1993). Jensen (1993)
suggests that the presence of the free cash flow is
a sign that the firm is able to extract various rents
and quasi-rents, and, therefore, it is shielded from
the competitive pressures by its market domi-
nance. Our analysis unambiguously suggests that
independent distributors are a potent external
governance factor that deals effectively with both
agents’ and principals’ opportunism.
In line with previous strategy research (e.g.,
Gibbs, 1993; Zajac and Westphal, 1994; Li and
Simerly, 1998) our analysis also identifies impor-
tant contingency factors that moderate gover-
nance effects on principal–principal–agency costs.
The empirical findings confirm that the gover-
nance effect of independent distributors on
principal–agent costs will be greater for firms
with more complex product portfolio and higher
level of free cash flow.
Limitations and Future Research
Our study has limitations that suggest possible
avenues for future research. Because of our focus
on insurance industry we were able to better
control for potential effects of regulatory,
accounting and ownership structure differences
(see Mayers and Smith, 1981; Krishnaswami and
Pottier, 2002, for a discussion). This inevitably
limits the extent of generalization of our results.
However, the extensions of this work outside of
the insurance sector are numerous and simply
require recognition of where PP and PA costs are
likely to be greater. Similar vertical and horizontal
agency problems exist within other sectors of the
financial services industry, most obviously within
the mutual funds industry, where conflicts between
providers, owners, managers and investors can be
mitigated by marketing and sales activities
through independent agents (see Mester, 1989,
1991 for a discussion). Also with growing syndi-
cation of private equity groups and venture capital
trusts within the UK and elsewhere, there is an
increasing need for investors to be informed,
guided and protected by experienced independent
financial agents from the opportunistic behavior of
lead members of the syndicate (see, for example,
Sahlman, 1990).
Finally, because of the dearth of previous
empirical studies on the principal–principal agency
conflicts our measurements of PP costs are rather
crude, and they need further development, perhaps,
Copyright r 2009 John Wiley & Sons, Ltd.
259
outside the context of insurance industry. However,
our analysis suggests that principal–principal agency
conflicts may be widespread, and the present
corporate governance initiatives that are focused on
principal–agent governance aspects may be ineffec-
tive in addressing PP conflicts that proliferate in
various industries. Future research should look for
new governance solutions that may lie beyond the
traditional principal–agent framework.
NOTES
1. Good and bad companies are defined from the
policyholders’ perspective. The policyholder’s value
of a contract policy with a good company will be
higher than a contract from a bad company.
Acknowledgements
The authors would like to thank Steve Diacon, Mike Wright
and Chris O’Brien for helpful suggestions.
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