Derivatives Hedging, Risk Appetite, and Managerial Compensation Incentives in U.S. Property-Liability Insurance Companies

We examine the relationship between derivatives hedging, risk-taking, and managerial compensation incentives from an enterprise risk management perspective in U.S. publicly traded property-liability insurance companies. We find that derivatives usage is negatively related to various risks, supporting the stabilizing effect of derivatives use for hedging purposes. Our evidence also shows that derivatives hedging is negatively associated with CEOs’ compensation and their equity portfolio incentives. These results suggest that board of directors may utilize derivatives as part of an overall risk management strategy to manage both underwriting and investment risks, and in turn, respond to changes in their risk appetite by structuring CEOs’ incentive-compensation contracts accordingly. We provide evidence that reinsurance strengthens the risk reduction effect of derivatives usage on risk-taking, managerial compensation, and equity incentives, consistent with the “complementarity” hypothesis. Further, we show that the riskreduction effects of derivatives hedging are weakened during the financial crisis in 2008-2009 than non-crisis period.