Stock Options and the Corporate Demand for Insurance

Authors: Han, Li-Ming¹; MacMinn, Richard²

Source: Journal of Risk & Insurance, Volume 73, Number 2, June 2006 , pp. 231-260(30)

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Abstract:

This article shows that a corporate manager compensated in stock options makes corporate decisions to maximize stock option value. Overinvestment is a consequence if risk increases with investment. Facing the choice of hedging corporate risk with forward contracts on a stock market index fund and insuring pure risks the manager will choose the latter. Hedging with forwards reduces weight in both tails of corporate payoff distribution and thus reduces option value. Insuring pure risks reduces the weight in the left tail where the options are out-of-the-money and increases the weight in the right tail where the options are in-the-money; the effect is an increase in the option value. Insurance reduces the overinvestment problem but no level of insurance coverage can reduce investment to that which maximizes the shareholder value.

Document Type: Research article

DOI: http://dx.doi.org/10.1111/j.1539-6975.2006.00172.x

Affiliations: 1: Li-Ming Han is a professor, Department of Finance, Chinese University of Hong Kong, Shatin, Hong Kong; , Email: han@baf.msmail.cuhk.edu.hk 2: Richard MacMinn is a professor and Edmondson-Miller Chair in Insurance and Financial Services, Katie School, Illinois State University, Normal, IL, USA; , Email: richard.macminn@ilstu.edu.

Publication date: 2006-06-01