Corporate Governance and Risk Taking: Evidence From the U.K. and German Insurance Markets

• Date: 01 September 2014
• Author: Martin Eling,Sebastian D. Marek
• DOI: http://doi.org/10.1111/j.1539-6975.2012.01510.x
• Published date: 01 September 2014

© The Journal of Risk and Insurance, 2013, Vol. 81, No. 3, 653–682

DOI: 10.1111/j.1539-6975.2012.01510.x

653

CORPORATE GOVERNANCE AND RISK TAKING:

EVIDENCE FROM THE U.K. AND GERMAN INSURANCE

MARKETS

Martin Eling

Sebastian D. Marek

ABSTRACT

We analyze the impact of factors related to corporate governance (i.e., com-

pensation, monitoring, and ownership structure) on risk taking in the in-

surance industry.We measure asset, product, and financial risk in insurance

companies and employ a structural equation model in which corporate gov-

ernance is modeled as a latent factor. Based on this model, we present em-

pirical evidence on the link between corporate governance and risk taking,

considering insurers from two large European insurance markets. Higher

levels of compensation, increased monitoring (more independent boards

with more meetings), and more blockholders are associated with lower risk

taking. Our empirical results provide justification for including factors re-

lated to corporate governance in insurance regulation.

INTRODUCTION

Corporate agency conflicts have been the subject of extensive research over the past

40 years, with much of it focused on the alignment of interests between shareholders

and corporate management. The primary mechanisms for achieving alignment are

found within the domain of corporate governance, the topic of the research reported

here. Using factors identified as having the potential to mitigate agency conflicts

(Jensen and Meckling, 1976), we investigate the influence of management incentives,

monitoring, and ownership as they relate to U.K. and German insurers. Although

a corporation’s stakeholders include more than just the shareholders, for example,

bondholders, employees, suppliers, buyers, and the general public, our focus here is

on the relationship between shareholders and management.

Mitigation of agency conflicts is relevant to the efficient and effective operation of

any organization. Currently, there is significant interest in the occurrence of such

conflicts within financial services organizations, given the relatively recent examples

of corporate mishandling, some of which had significant implications for the broader

Martin Eling works at the Institute of Insurance Economics, University of St. Gallen,

Switzerland. Sebastian D. Marek works at the Institute of Insurance Science, University of

Ulm, Germany.Martin Eling may be contacted via e-mail: martin.eling@unisg.ch.

654 THE JOURNAL OF RISK AND INSURANCE

economy.Within the insurance arena, AIG’s financial issues area vivid example. Much

of the literature analyzes agency conflicts between shareholders and management by

investigating how certain elements of corporate governance influence risk taking or

firm performance or both. We take a similar perspective, jointly analyzing through

a structural equation model the effect of management incentives, monitoring, and

ownership on insurer risk taking.

We build on recent advances in the capital/risk and agency literature and

proxy risk taking by asset, product, and financial risk measures (see Baranoff,

Papadopoulos, and Sager, 2007). An innovative feature of this article is its use of

a structural equation model to establish the relationship among these three risk

measures and a measure of corporate governance. Structural equation models are

advantageous in this context because they allow describing the insurer’s corporate

governance environment using multiple equations while accommodating unobserv-

able latent factors (see Bollen, 1989). In contrast to the extant literature, our model

allows analysis of the effects of several corporate governance mechanisms simultane-

ously, thereby providing an aggregate perspective on corporate governance instead

of focusing on single mechanisms.

Our main result is that in both the United Kingdom and Germany, corporate gov-

ernance significantly affects insurance company risk taking. All the elements used

in this article to determine the corporate governance environment have a significant

impact on risk taking. Higher compensation, more monitoring, and a larger number

of blockholders are associated with lower risk taking. We conclude that corporate

governance mechanisms need to be looked at closely and taken into consideration

when designing insurance regulation as they affect insurance company risk taking.

Our analysis is important in light of the recent financial scandals and crises, which

have illustrated the link between corporate governance and risk taking (see Fahlen-

brach and Stulz, 2011; Boubakri, 2011). Corporate governance mechanisms can affect

executives’ risk-taking preferences—and, as such, firm risk—which is relevant to

owners and policyholders. The regulatory importance of this analysis becomes obvi-

ous in light of Solvency II, which involves the redefinition of capital adequacy, risk

management, and disclosure requirements for insurance companies in the European

Union. Capital adequacy,risk management, and disclosure requirements are all areas

related to corporate governance.

The remainder of this article is structured as follows. In the “Literature Review and

Hypothesis Development” section, we review the literature and develop our hypothe-

ses. In the “Methodology” section, we explain the modeling approach, and the section

on “Data and Variables” explains the data and variables. The next section gives our

main results. In the “Robustness” section robustness tests are presented. We conclude

in the final section.

LITERATURE REVIEW AND HYPOTHESIS DEVELOPMENT

Much of the extant literature in this field analyzes agency conflicts between share-

holders and management by investigating how certain elements of corporate gover-

nance influence risk taking or firm performance or both. For example, according to

John, Litov,and Yeung (2008), the connection between corporate governance and risk