This article shows that a corporate manager compensated in stock options makes corporate decisions to maximize stock option value. Overinvestment is a consequence if risk increases with investment. Facing the choice of hedging corporate risk with forward contracts on a stock market index fund and insuring pure risks the manager will choose the latter. Hedging with forwards reduces weight in both tails of corporate payoff distribution and thus reduces option value. Insuring pure risks reduces the weight in the left tail where the options are out-of-the-money and increases the weight in the right tail where the options are in-the-money; the effect is an increase in the option value. Insurance reduces the overinvestment problem but no level of insurance coverage can reduce investment to that which maximizes the shareholder value.
Most of the existing literature on the corporate demand for insurance rests either implicitly or explicitly on the notion that the decisions on corporate account are made to maximize the current shareholder value. Mayers and Smith (1982) began a discussion of the determinants of the demand for corporate insurance by noting that the "... corporate form provides an effective hedge since stockholders can eliminate insurable risk through diversification." Equivalently, the value of the insured firm is equal to that of the uninsured firm and insurance plays no role in the management of corporate risk. (1) The role insurance plays in managing corporate risk has since been clarified by Main (1983), MacMinn (1987), Mayers and Smith (1987), MacMinn and Han (1990), Garven and MacMinn (1993), and Han (1996). MacMinn (1987) shows that the risk-shifting problem can be solved with an insurance contract and so increase the value of the corporation; (2) similarly Mayers and Smith (1987) and Garven and MacMinn (1993) show that the underinvestment problem can be solved with insurance. (3) These results were derived assuming the maximization of current shareholder value. Stock option grants, however, have become an increasingly important component of executive compensation in the last two decades of the twentieth century (Murphy, 1998; Murphy, 1999). Stock options are supposed to align the incentives of management and shareholder since the options give management the incentive to increase the share price. The deductive foundation for this conventional wisdom has not been provided in the literature. Hence, the objective here is first to provide the link between the executive compensation scheme and corporate decision making, second to examine the impact of the executive compensation on the corporate demand for insurance, and third to examine the role insurance plays in aligning the interest of executives and shareholders.
The literature on the demand for corporate insurance is one thread of the broader literature on risk management. In the risk management literature, Smith and Stulz (1985) consider a managerial motive that provides a linkage between compensation and corporate decision making. They show that the risk-averse manager compensated with stock will use forward contracts to hedge risk; they also show that when the compensation is stock options, the options will ultimately eliminate the incentive to hedge. (4) There is some empirical support for the managerial theory in Tufano (1996). (5) The Smith and Stulz model differs from that here because they do not allow the corporate executive to hold a portfolio on personal account or diversify that portfolio. The managerial analysis is reframed here and the corporate objective function is explicitly derived for the manager paid in stock options; then the analysis shows that the stock options eliminate the incentive to hedge with forward contracts. (6) This might suggest that neither will the manager use insurance to manage risk but this model shows that not all risk management tools are created equal. The forward contract reduces risk by eliminating weight from the tails of the corporate earnings distribution and this reduces the value of the stock options. …