Executive Compensation and Risk Taking in the Property and Liability Insurance Industry

Agency theory suggests that granting stock‐based compensation to execu‐tives incentivize risk‐taking by aligning managerial interests with those of the share‐holders. This study examines the relationship between executives’ stock‐basedcompensation and managerial risk‐taking behavior in the property liability insuranceindustry. We calculate the sensitivity of the value of executives’ stock holdings andoption holdings to stock price movement and hypothesize that the more sensitiveexecutives’ pay is to share price movement, the greater the incentive it provides toinduce risk‐taking that may result in equity volatility. Using data from 2006 to 2010,we find that firms whose executive compensation is more sensitive to stock pricemovement are associated with greater unsystematic risks. Additionally, consistentwith risk averse theory, our results show that the positive relationship between stock‐based compensation and firm risks is weakened when stock‐based compensationaccounts for a greater percentage of executives’ total compensation. Our main resultsremain consistent and robust when we use different model specifications and riskmeasures. We also find that stock holdings and option holdings create different effectson firm risks when executives receive a significant amount of such compensation. Thefindings suggest that stock granting and option granting should be treated separatelyin designing and evaluating the executive compensation package, and more researchis in call for finding the optimal weight of each in the package.