CEO Inside Debt and Risk Taking: Evidence From Property–Liability Insurance Firms

• Author: Jeungbo Shim,Takeshi Nishikawa,Andreas Milidonis
• DOI: http://doi.org/10.1111/jori.12220
• Published date: 01 June 2019
• Date: 01 June 2019

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CEO INSIDE DEBT AND RISK TAKING:EVIDENCE FROM

PROPERTY–LIABILITY INSURANCE FIRMS

Andreas Milidonis

Takeshi Nishikawa

Jeungbo Shim

ABSTRACT

We examine the incentive effects of CEO inside debt holdings (pensions and

deferred compensation) on risk taking using the sample of U.S. publicly traded

property–liability insurers. To represent managerial risk taking, we employ value

at risk (VaR) and expected shortfall (ES), which capture extreme movements in the

lower tail of insurer stock return distribution. We also estimate firm default risk,

equity volatilities, and insurance-related risk as alternative measures of risk taking.

We document that inside debt represents a significant component of CEOs’

compensation in the insurance industry. We find that there is a significant and

negative relationship between CEO inside debtholdings and risk-taking behavior.

The results suggest that the structure of executive debt-like compensation could be

a potential method of reducing managers’ risk-taking incentives.

INTRODUCTION

The structure of executive compensation has been considered to be a useful

governance mechanism by both academics and regulators since the seminal work of

Jensen and Meckling (1976). The major stream of the literature has focused on the role

of equity-like compensation, which aligns shareholder and managerial interests (e.g.,

Murphy, 1985; Morck, Shleifer, and Vishny, 1988; Coles, Daniel, and Naveen, 2006).

Andreas Milidonis is in the Department of Accounting & Finance, School of Economics and

Management at the University of Cyprus, P.O. Box 20537, CY-1678 Nicosia, Cyprus. Milidonis

can be contacted via e-mail: andreas.milidonis@ucy.ac.cy. Takeshi Nishikawa and Jeungbo

Shim (corresponding author) are in the Business School at the University of Colorado

Denver, 1475 Lawrence Street, Denver, CO 80202. They can be contacted via

e-mail: takeshi.nishikawa@ucdenver.edu and jeungbo.shim@ucdenver.edu, respectively. We

are grateful to two anonymous referees, Keith Crocker (the editor), Gene Lai, Van Son Lai

(discussant), Ajay Subramanian and participants at the 2016 American Risk and Insurance

Association annual meeting for their helpful comments and suggestions, and Andria

Charalambous for excellent research assistance. Additionally, Milidonis would like to thank

the University of Cyprus for research support. Nishikawa and Shim would like to gratefully

acknowledge the financial support from the Business School, University of Colorado Denver.

All errors are our own responsibility.

© 2017 The Journal of Risk and Insurance. Vol. 9999, No. 9999, 1–27 (2017).

DOI: 10.1111/jori.12220

Vol. 86, No. 2, 451–477 (2019).

2THE JOURNAL OF RISK AND INSURANCE

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However, an emerging literature has begun to pay closer attention to the importance

of debt-like instruments, such as pensions and deferred compensation, in executive

compensation packages. The pensions and deferred compensation arrangements

are known as inside debt because a firm undertakes an obligation to pay corporate

insiders (executives) fixed amounts at or after retirement and their payoff structure is

similar to that of corporate debt. For U.S. firms, the vast majority of executive debt-like

compensations are typically unfunded, unsecured, and not guaranteed by the

Pension Benefit Guaranty Corporation (PBGC), making these promised future

payments uncertain and exposing managers to the same default risk as external

creditors (e.g., Sundaram and Yermack, 2007; Wei and Yermack, 2011). Theory

suggests that inside debt contracts closely align managerial interests with those of

debt holders and, thus, induce CEOs to manage their firms more conservatively

(Jensen and Meckling, 1976; Edmans and Liu, 2011). In this article, we empirically test

the incentive effects of CEO inside debt holdings on risk taking using the sample

of U.S. publicly traded property–liability insurance firms.

Recent studies show that banks exhibit lower levels of risk-seeking behavior in a

crisis period if their CEOs hold large inside debt during prefinancial cris is periods

(Bennett, G€

untay, and Unal, 2015; Van Bekkum, 2016). These findings somewhat lend

support to the regulatory view that the use of compensation arrangements may

influence managerial risk-taking behavior in financial institutions. In fact, the Dodd–

Frank Act signed into law in 2010 requires federal bank regulators to issue

regulations that prohibit the use of compensation contracts that migh t lead to

excessive risk taking.

Along with banks, insurers are a key part of the financial services sector and the

insurance industry accounts for a significant portion of the U.S. economy.

1

Although

there is a subtle difference in business models between banking institutions and

insurance companies, the U.S. property–liability insurance industry provides a useful

environment to explore the links between CEO inside debt and risk-taking incentives.

The 2008 near-collapse and subsequent government rescue of American International

Group (AIG) demonstrates not only the importance of investigating the components

of CEO wealth and their effects on risk taking, but also the potential costs of

managerial excessive risk taking faced by policyholders and the public. In the

property–liability insurance industry, underwriting risk, investment risk, and default

risk are essential due to the unique nature of its business that assumes insurance risks

transferred from policyholders and services future financial obligations. Like most

public firms, publicly traded insurers are also exposed to risks arising from internal

governance and separation of ownership and control.

1

According to the annual report of the Federal Insurance Office, total direct premiums written

in the life and health and property and casualty insurance sectors were $1.27 trillion in 2015, or

approximately 7 percent of the U.S. gross domestic product (GDP). About 2.3 million people

are directly employed by insurance firms and insurers rank among the largest purchasers of

corporate, sovereign, state, and local bonds. See the annual report of the Federal Insurance

Office for more information on the vital role of the insurance industry in the U.S. economy

(Federal Insurance Office, 2013–2016).