Agency and Corporate Purchase of Insurance

Abstract

Abstract Consistent with the agency cost rational, this paper documents that managers having large private benefits of control purchase more insurance to reduce their own exposure to the probability of left-tail outcomes and hence the volatility of the firm's cash flows. Private benefits of control are estimated as the difference between the price of the stock, and an equivalent synthetic stock (constructed with options) that provides claims on the same cash flows but gives its owners no voting rights. Consistent with the Jensen (1986) free cash flow hypothesis we also find that firms with larger private benefits of control tend to use more debt. ∗ We would like to thank SwissRe for providing us with the property insurance data and, in particular, Kurt Falk for his invaluable help. We wish to thank an anonymous referee for many helpful and insightful comments and suggestions. We also wish to thank Yakov Amihud, Sudheer Chava, Jim Schallheim, Avi Wohl, participants at the University of Iowa seminar series, participants at the 2010 European Finance Association meetings, and Felix Suntheim (EFA discussant). Paul Ehling acknowledges financial support from The International Center for Financial Asset Management and Engineering (FAME) and SwissRe.