Recent visitor to the Department, John Turner (QUB), and his co-authors David A. Bogle, Gareth Campbell, and Christopher Coyle explore when and why shareholder liability disappeared from the insurance industry.
Limited liability is now a standard feature in modern economies, but historically, financial institutions operated under stricter frameworks. In Australia, Canada, and the United States many banks were subject to double liability, meaning shareholders could face additional calls beyond their initial investment if the bank became insolvent.
In the United Kingdom, following liberalizing legislation in 1862, most banks and insurance firms voluntarily chose to have extended liability, where shareholders could potentially be exposed to calls which were much greater than the amount that they had invested. A dramatic example of this occurred with the failure of the City of Glasgow Bank in 1878. This institution operated under unlimited liability, bankrupting most of its 1,800 shareholders upon collapse, though depositors did not lose a penny. Similarly, shareholders of the Albert Life Insurance Company were called upon to cover losses when it failed in 1869.
Trial of the directors of the City of Glasgow Bank
When did shareholder liability disappear?
The disappearance of extended liability among British insurance firms occurred gradually. Before the 1862 Companies Act, only companies incorporated by Royal Charter or an Act of Parliament, such as the London Assurance and Royal Exchange Assurance, could limit liability. Other insurance companies operated as unincorporated entities. These insurance companies contracted in their corporate constitutions to a framework of limited liability, but under the common law, these companies remained liable to external creditors like policyholders.
The 1862 Act changed this landscape, allowing companies to limit liability by simply registering under the new law. Even so, insurance firms generally maintained large reserves of uncalled capital – funds that could be demanded from shareholders at any time to meet obligations. By 1880, 97% of insurance firms retained uncalled capital. However, this practice steadily declined, and by 1930, it had fallen to 74%. By 1965 only 15% of firms held uncalled capital. By 1975, no British insurance company retained shareholder liability.
While the formal end of shareholder liability occurred in 1975, the shift began much earlier, with a marked decline after World War I and rapid acceleration after 1930. By the 1960s, extended liability was a relic of the past.
In 1880, the average insurance shareholder was exposed to more than quintuple liability. For every £1 invested, shareholders could be called upon for £5.67. By 1930, this exposure had reduced to near double liability. In terms of uncalled capital, 56.7% of firms’ total assets in 1880 were backed by such reserves, but by 1930, this figure had fallen to just 4.4%, and it was nearly zero by 1965.
Why did shareholder liability disappear?
We examine three possible explanations for the disappearance of shareholder liability. One possibility is that regulation and government-provided policyholder protection meant that shareholder liability was no longer needed. However, we find that nearly all companies removed their shareholder liability many decades before the passage of the Policyholders Protection Act in 1975. Furthermore, there were no regulatory changes during or immediately after the period when shareholder liability disappeared.
Another possibility is that shareholder liability had become effectively limited in practice, even if not formally abolished. Since insurance shares were freely transferable, individuals without the means to meet additional calls could still purchase them, rendering liability unenforceable in many cases. Despite this, our analysis of detailed archival data from an insurance company with quadruple liability shows that shareholders were generally wealthy enough to meet potential obligations, indicating that enforceability was not necessarily the primary issue.
The final possibility we explore is that the risks associated with extended liability led to a higher cost of capital, which incentivized companies to remove uncalled capital. We analyzed a century of monthly share prices and found that firms with shareholder liability faced higher financing costs. Although companies were initially reluctant to abandon this system, since it reassured customers that their policies would be honoured, the buffer provided by shareholder liability became less crucial as firms grew larger. Organic expansion and mergers allowed companies to rely on their size and stability instead. The study’s analysis of hand-collected financial statement data confirms that a company’s size was an important determinant of the level of shareholder liability. As companies grew, they became more likely to cut shareholder liability.
The findings of our study ultimately suggest that shareholder liability disappeared in British insurance because of the increasing size of insurance firms. We speculate that the same was true for British banks, which finally expunged their shareholder liability in the mid-1950s.
The full paper is available here: David A. Bogle, Gareth Campbell, Christopher Coyle, John D Turner, Why did shareholder liability disappear?, Journal of Financial Economics, volume 152, February 2024.