Do U.S. Insurance Firms Offer the 'Wrong' Incentives to Their Executives?

Abstract

We examine the relation between executive compensation and market-implied default risk for listed insurance firms from 1992-2007. Shareholders are expected to encourage managerial risk-sharing through equity-based incentive compensation. We find that long-term incentives and other share-based plans do not affect the default risk faced by firms. However, the extensive use of stock options leads to higher future default risk for insurance firms. We argue that this is because option-based incentives induce managerial risk-taking behavior, which seeks to maximize managerial payoff through equity volatility. This could be detrimental to the interests of shareholders, especially during a financial crisis.

Keywords: Executive Compensation, Default Risk, Risk Management, Insurance

JEL Classification: G22, G24, G32, G34