Corporate Insurance and Managerial Incentives

Abstract

We present an agency model to examine the use of corporate insurance by publicly held firms. We assume that insurance companies serve two functions: providing risk-management consulting services and verifying whether accidents were insured or not. The verification results can be used to produce a pair of managerial performance measures when the manager performs multiple tasks to reduce the expected number of accidents. We show that the optimal pair of performance measures can be obtained when the corporate insurance policy covers all uncontrollable accidents andsome controllable accidents that are "costlier" for the manager to control. This result explains the recent popularity of self-insurance in many large corporations, such as for business risks and workers' compensation. Further, we endogenously derive indemnity contracts, e.g. insurance contracts, as a form of financial contract necessary for insurance companies to serve the above two functions properly.

JEL Classification: G22