Managerial compensation and corporate demand for insurance

This article examines the role of insurance in shaping efficient compensation contracts and thereby in determining the value of the firm, assuming rational expectations. With fixed compensation, insurance coverage sufficient to eliminate insolvency is optimal. With compensation based on the firm's liquidating value, full insurance is optimal because it allows for a higher reliance on performance compensation, which then induces higher managerial efforts in both business operation and risk management and therefore a higher value of the firm. With compensation based on stock price, partial coverage or no coverage is optimal due to the cost arising from the imperfect impounding of the effect of insurance in the stock price.