Monday, December 01, 2008

Executive Compensation and the Economics of Insurance

One of the things legal rules do is to allocate risk, so one of the subjects covered in teaching the economic analysis of law is the economics of risk allocation, conventionally put in terms of the economics of insurance. Designing optimal rules in this context is hard, because there are three different objectives and no reason to expect the rule that is best for achieving one to be best for the others.

The first objective is risk spreading—for familiar reasons, many people prefer a certain income of (say) $50,000 a year to a coin flip between $10,000 and $90,000, even though the average outcomes are the same. Insurance provides a way of converting the riskier outcome into the less risky.

The second objective is optimum incentives for controlling risk. Often, although not always, the same person who starts out bearing the risk is the one in the best position to take precautions against it. From this standpoint insurance is the problem, not the solution. Once I have insured my house or factory for its full value, the incentive to me to take costly precautions to make it less likely to burn down is low. In the extreme case, where an insurance company has been so imprudent as to insure something for more than its full value, the chance of a fire may become very large indeed. This is the problem described in the literature as moral hazard, not because taking risks is immoral but because “moral” in this context has an older meaning close to “psychological.” The hazard is due to the incentives of the actors, the moral not the physical characteristics of the situation.

The third objective has to do with the fact that the choices we make signal—imperfectly—information about our private information. That I want to buy lots of life insurance today is evidence that I know something the insurer doesn’t about my chances of living to tomorrow. That is a reason for him not to sell it to me, or only at a high price. The same argument applies, although less strongly, to anyone who wants to buy insurance against any risk that he has better information about than the seller. Wanting to buy is evidence that the risk is higher than average, a fact which the seller will take into account in pricing the insurance.

That is a problem if you face an average or below average risk but still, because of risk aversion, want to insure against it, provided you can do so at a price not much greater than the actuarial value of the insurance, a problem known in the literature as “adverse selection.” The classic example is the market for lemons. Sellers of used cars know more about them than buyers, so the fact that I want to sell my car signals that it is likely to be a lemon, so I get offered a lemon price, which makes it even less likely that I will sell it if it isn’t a lemon.

The same set of problems applies to executive compensation. One obvious way of better aligning the interests of executives with those of stockholders is to require the executives to be stockholders. To align the interests in the long term as well as the short, one could require executives not only to hold a sizable fraction of their personal wealth as stock in the company they work for but also to hold it under rules that prevent them from selling the stock or hedging it for some substantial period of time.

Arguably, this would be a good way of controlling not only moral hazard but adverse selection as well. An executive whose private information implied that hiring him would be bad for the company—perhaps because he planned to keep the job only until a better offer, expected shortly, came through, or because he planned to supplement his income at the expense of the stockholders—would have a good reason not to take the job on those terms, which is a second reason to insist on those terms when offering it.

On the other hand, requiring executives to invest a large fraction of their wealth in the stock of the company they worked for would be a very bad way of spreading risk. If the company did well, both the executive’s salary and his stock portfolio would go up. If it did badly, both would go down. Better, from that standpoint, to spread the risk by owning stock in some company, practically any company, other than the one he works for.

In some contexts, some employees are paid with stock options that can only be exercised after a set period of time; I do not know if there are any precautions to prevent the employee from hedging his bet by selling the stock short before the time has expired. I also do not know to what extent the tactic described above is, or can be, implemented for executive compensation more generally. Clearly there are reasons both for doing it and against.

Comments welcome, especially from anyone who knows more than I do about the actual terms of the usual employment contracts for top executives.

22 Comments:

At 12:00 PM, December 01, 2008, Blogger Arthur B. said...

IANATE but I got stock options in the past and of course was forbidden to hedge them.

 
At 12:03 PM, December 01, 2008, Blogger Jacob said...

Mr. Friedman,

legally requiring companies to pay a part of salaries in stock could probably be done, with difficulty. However, there would be a thousand ways to get around the outcome you desire.


It may surprise you to learn that this type of compensation scheme is often advocated by left-wing socialists in Europe (in the present day). In that case, it applies to executives as well as workers, in order to foster loyalty and solidarity within a corporation. As far as I know, none of these suggestions have been legally successful yet.

 
At 12:24 PM, December 01, 2008, Blogger Arthur B. said...

"It may surprise you to learn that this type of compensation scheme is often advocated by left-wing socialists in Europe (in the present day)."

No.
In the words of Martine Aubry, head of the French Socialist Party, speaking about the financial crisis:

"I suggest to ban stock options for executives, so that no one ever makes a decision in his company based on his own interest."

They do advocate stock options for low level employees, which is stupid has it as all of the disadvantages mentioned and none of the advantage, as a low level employee has little to no influence on the stock price.

Of course this is all about sharing "profits". I never heard the socialists claim the workers should share the losses hey.

It's not too hard to imagine what would happen if workers stock option became worthless. Management would be blame, the state would insure the workers stock option, effectively nationalizing entire businesses.

 
At 1:08 PM, December 01, 2008, OpenID FallenPegasus said...

When I have worked for a public company, I've been forbidden to short it's stock. I'm not sure what the legal basis for enforcing that, whether it's rooted in securities law, or in my employment contract, but the rule is there.

I'm not sure if I'm allowed to collar it, or any of the various other sophisticated derivatives.

Personally, I think that anyone be allowed to short any stock at any time, as long as they can prove they cover it if they guess wrong (no naked shorts), but that employees and executives have to do so publicly.

 
At 1:13 PM, December 01, 2008, Blogger Jacob said...

Arthur,

I'm not advocating this myself, and the socialist movement in Europe is bigger than Martine Aubry. She obviously has misunderstood the issue of stock options completely. If she understood it, she would instead call for limits on selling the stock options.


You say yourself that you never heard of what I mentioned, which is why I said "it may susprise you...". It is not a profit sharing scheme alone that I was talking about, but an equity stake for each employee that includes voting rights (although a lot of European workers already have voting rights in corporations in some form or another). Where the money would come from in order to finance this is unclear. Workers would absolutely be able to incur losses under this scheme, but that means something wholly different in a society that has a social safety net, unlike the United States.


One socialist politician who has frequently advocated this idea is called Johan Lonnroth.


I think it's a dumb idea.

 
At 1:13 PM, December 01, 2008, Blogger dWj said...

> That is a problem if you face an average or below average risk but still, because of risk aversion, want to insure against it.

I have read recently that there is evidence that, in most retail insurance contexts, people looking to buy turn out in aggregate to be better risks than the population in general. The confluence of general averseness to risk and risk-taking seems to be more important than the adverse selection problem.

Back in 1929, the CEO of Chase sold short "against the box" for tax reasons, though he maintained a net long position. Of course, both tax and regulatory treatments of stockholdings changed substantially shortly thereafter. The only publicly traded company I worked for was a broker-dealer, and I was under restrictions against holding short positions on the company, but I had the impression that these were in place because it was a broker-dealer, or in any case were enforceable because it was. I may have been wrong.

 
At 3:25 PM, December 01, 2008, Anonymous Anonymous said...

Boards of directors have a very direct way of controlling CEOs - they can fire them. Giving stock to CEOs is just a sneaky way of increasing pay.

 
At 4:05 AM, December 02, 2008, Anonymous Steve B. said...

Similar proposals have occurred to me, again with the goal of more closely aligning the interests of management, workers, stockholders, etc.

For example, imagine a company in which all or much of the top executives' "pay" is in the form of stock that they don't own but rather "rent" with their labor. As long as they hold their offices, they get the dividends and the votes from those shares, but they can't sell the shares. This would align those executives' interests with those of other stockholders in the short term.

Likewise, giving top executives stock that cannot be sold for a specified number of years would align executives' interests with those of other stockholders in the long term.

But as you point out, this would load a fair amount of risk onto the executives, and they might be reluctant to accept the job, since bad things can happen to the company beyond their control.

 
At 4:11 AM, December 02, 2008, Anonymous Steve B. said...

That I want to buy lots of life insurance today is evidence that I know something the insurer doesn’t about my chances of living to tomorrow. That is a reason for him not to sell it to me, or only at a high price.

The same thing goes on the other side: if an insurance company wants to sell me insurance (knowing perhaps less about me, but more about risk and insurance, than I do), that's a bit of evidence that I probably don't need as much as they want to sell me.

The more work customers do to accurately gauge what insurance they need, and the more work insurance companies do to accurately gauge who needs insurance, the less well insurance works to distribute risk: only high-risk people will want it, and only low-risk people will be able to get it at affordable prices. Ironically, insurance (unlike most parts of a market) works better when the individual players have less choice than more.

 
At 5:38 AM, December 02, 2008, Anonymous Steve B. said...

On the insurance thing, see this post; if you have evidence or logical arguments to the contrary, I'd really like to see them.

 
At 6:47 AM, December 02, 2008, Anonymous Anonymous said...

Here's a concept that may be unobvious: maximizing "shareholder value" is not necessarily in the interest of shareholders!

Example:

Suppose a large, economically important company is teetering on the edge of bankruptcy. The best thing for the economy (and creditors) may be a smooth bankruptcy, but the best thing for the stock price is for management to swing for the fences and postpone bankrupcy as long as possible.

But isn't a high stock price good for shareholders? Not exactly, because most shareholders are diversified. They care about the efficient functioning of the economy as a whole; they don't care about a particular company's stock price.

 
At 11:34 AM, December 02, 2008, Blogger Raphfrk said...

Shareholder value means long term share price. It is not in the interests of the shareholders for the price to stay high, if the end result is that it goes to zero anyway.

Ofc, shareholders do want the company to take more risks than optimal due to limited liability. No matter what debts the company incurs, the share price cannot go negative.

Also, if the economically important company is so important, it should be able to negotiate some forgiveness of its debts or support from other parties. There is no reason for the shareholders to take the hit for the good of the economy as a whole.

 
At 1:07 PM, December 02, 2008, Anonymous Anonymous said...

Raphfrk, let me restate the point. There are not only conflicts of interest between management and shareholders, but also between types of shareholders: concentrated versus diversified. Most shareholders are diversified, but their interests are likely to be ignored when they conflict with concentrated shareholders.

 
At 7:31 PM, December 02, 2008, Blogger Seth said...

If a company I own shares in is close to bankruptcy, it's in my interest for management to "swing for the fences": if they hit a home run, my stock goes from nearly worthless to valuable. If they strike out, it goes from nearly worthless to worthless.

On the other hand, the bond holders (who don't get to vote) feel the opposite: their bonds are pretty valuable now. If the company succeeds, they go up a little; if it fails, they go down a lot.

(You can look at a company as the shareholders owning a call option on the company with a strike equal to the bondholders' interest. If I own a call, and the stock is around the strike, I want volatility.)

 
At 12:20 AM, December 03, 2008, Anonymous Anonymous said...

Seth, that's right. Note that for a company with a lot of debt, the market value of the bonds may be far greater than the equity. So a market-weighted investor would prefer that management consider the interests of bondholders. What is good for the stock may be bad for the (diversified) stockholder.

 
At 5:24 AM, December 03, 2008, Blogger Raphfrk said...

The management have a duty to all the shareholders equally. This is to maximise the value of the shares. They aren't allowed say that the 60% of the shareholders who also have shares in linked companies would benefit by the company taking non-optimal actions and therefore that is what they should do.

More clearly, if those 60% of the shareholders owned 100% of another company, would you consider it acceptable for the company to sell products at a reduced price to the 2nd company? (or maybe just give the 2nd company free money?)

 
At 8:56 AM, December 03, 2008, Blogger Aaron said...

Some people begin their interest in finance or economics when they though that knowledge about such topics can help them to make money. However, things seem to be that, after they master such knowledge, they find that these knowledge informs them that there is no opportunity to make money.

Those who insist their interest become researchers later.

 
At 4:38 AM, December 04, 2008, Blogger Dave said...

This "idea" is interesting, of course. It brings up inevitable problems when control is separated from ownership. The board turns over the reins, and the executive runs the machine, the consequences are visited upon the board. The linkage of this loop is loose, the lag in time between execute action and the board;'s perceived results is lengthened, making for late and exaggerated corrections.

Similarly, separating liabilities from the actions or in-actions that create them, as in insurance, is problematic.

The more abstract the linkage between cause and consequence, the less aware we are, the less control we have, the less effective our decisions.

 
At 6:30 PM, December 05, 2008, Anonymous drederick said...

Steve B, here's a reply to that livejournal post you linked to:

I don't agree that "And the better these people do their job, the worse the insurance system works." Seems that depends on the definition of a "good" insurance system. His definition seems to assume that everyone paying the same amount is good.

Suppose you are very sickly and everyone knows it, therefore no one will offer you cheap health insurance. You might say that this means that the insurance market isn't working, but I disagree. I don't think you have a right to cheap insurance. Insurance in my view should insure against uncertainty, not compensate for bad fortune. You being high risk for health problems is unfortunate like you being born without legs is unfortunate. In both cases I would say: tough luck. Deal with it. Life isn't fair. Expect to pay high insurance premiums. I wish you luck in recieving charity from others to help you cope with that.

The author thinks healthy people are obligated to compensate sick people for their misfortune by subsidizing them, and that assumption seems to be at the root of his argument. He should be more explicit about that because currently when he claims that free market health insurance doesn't work one gets the impression that he's insinuating some sort of market failure type thing, rather than simply pointing out that sickly people are required to pay more.

 
At 3:22 AM, December 07, 2008, Blogger Andrew said...

The management have a duty to all the shareholders equally. This is to maximise the value of the shares

That may be the theory, but in practice the management, along with most employees, do what is in their own personal best interest. This may include making deals that enrich themselves and the company in the short term but bankrupt the company in the long term.

The problems are that companies can get into complex investments with limited transparency that shareholders do not properly evaluate. Limited liability incents companies to take bigger risks.

Let's say i'm an investment banker--I can create some risky derivative that if it succeeds will get me a $1M bonus, and if it fails, the shareholders of the company will lose a huge amount of money...and the worst that will happen to me is that i'll lose my job. Or maybe my derivative will succeed for a year and then i'll get a huge bonus, then the next year it'll crush the company.

As demonstrated by the behavior of the stock market during the last few years, shareholders simply don't have enough knowledge of these risks.

 
At 1:55 PM, December 14, 2008, Blogger Sir Max Higgins said...

This comment has been removed by a blog administrator.

 
At 3:44 PM, December 15, 2008, Blogger Kevin Carson said...

Nice analysis.

The problem with tying executive compensation to stock value, and the rest of Jensen's "entrepreneurial corporation" agenda, is that gaming share value is usually counterproductive for long-term health of the enterprise. The kind of bonus- and stock option-driven behavior we've seen over the past thirty-odd years (what Robert Jackall called "starving" and "milking," stripping assets, gutting human capital, and hollowing out long-term productive capability in order to inflate short-term returns) is precisely what got us "Chainsaw Al" Dunlap, Bob Nardelli and Carly Fiorina.

Once you separate labor from ownership and control, there's simply no magic incentive system you can create that overcomes conflict of interest. The "real" residual claimant of the corporation, behind all the ideological pretenses of shareholder ownership, is senior management. As Martin Hellwig showed, once share ownership is dispersed, management's inside control will always give them a decisive advantage in rigging the rules to fend off genuine shareholder control. And any set of incentives, created for the ostensible purpose of keeping a rein on them, will be gamed by them in a way that works at cross-purposes to the interests the incentives were allegedly created to serve.

What's more, the myth of shareholder ownership serves as a legitimizing ideology to protect management against its internal stakeholders, which has all the perverse incentive effects described by Grossman and Hart and Luigi Zingales. Most of the value of a corporation is created by its human capital, but that value is appropriated by management in the absence of a correctly delineated property rights system that enables the results of effort to be internalized by each actor. So production workers have no rational incentive to invest their human capital in the firm, and elaborate management systems are created to elicit effort (and simulate interest) from those with no rational incentive to be productive.

IMO the producer cooperative, or at least Vogt's "liberal capitalist" firm with high degrees of profit-sharing and self-management, is the only way to overcome this inherent irrationality.

 

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