Stock Option Compensation and Managerial Discretion in the Insurance Industry: Are Reserves Manipulated to Enhance Profitability?
27 Pages Posted: 11 Dec 2004
Date Written: December 3, 2004
Stock options create an incentive for managers of companies to maximize the value of their company's stock. Prior research has hypothesized that managers of insurers manipulate reserve levels to achieve organization goals, including minimization of taxes and income smoothing. The current study tests whether the awarding of stock options to insurance company executives is associated with the accuracy of reserve estimates. We test two competing hypotheses. The first hypothesis is that the granting of options to executives encourages under reserving. This would be the case if inflated earnings resulting from under reserving result in higher insurer stock valuations. The second hypothesis is that grants of options to executives result in more accurate reserving. Empirical support for this hypothesis would suggest the market valuations of insurers' stock take into consideration the perceived accuracy of financial disclosures and that valuations are higher for firms that report more accurate reserve estimates. Consequently, executives holding options will attempt to report reserve estimates as accurately as possible. Our empirical analyses support the hypothesis that insurers that award stock options estimate reserves more accurately than other insurers, other things equal.
Keywords: Stock options, executive compensation, reserves, insurance
JEL Classification: G22, G34, J33, M41
Suggested Citation: Suggested Citation