Executive Compensation and the Economics of Insurance
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.