Optimal Managerial Incentive Contracts and the Value of Corporate Insurance

This paper investigates the impact of managerial hedging on shareholder wealth when managers are able to choose the level of effort they expend in managing firms' investments. We demonstrate that shareholders will prefer managers to hedge observable unsystematic risks because they expect that this will induce managers to be more productive. We begin with the case where the risk being hedged is independent of managerial effort. In this case, we show that if shareholders are able to adjust incentive contracts either in anticipation of hedging or after observing hedging, but before managers expend effort, then they will benefit from that hedging. When the insurable risk is also dependent on managerial effort, then we have what we term an “embedded moral hazard” problem. In this case, the optimal contract may entail either over or under insurance by the manager, relative to that preferred by shareholders.