Managerial Discretion and Corporate Governance in Publicly Traded Firms: Evidence From the Property–Liability Insurance Industry

ABSTRACT We study the incremental impact of corporate governance in mitigating managerial discretion, controlling for incentive alignment of managerial ownership. We extend the managerial discretion hypothesis to predict that for firms with the same set of governance tools, those that utilize governance tools more stringently to control agency costs will command greater contracting cost advantages, leading them to specialize in business with greater managerial discretion. Using 72 publicly traded insurers from 1994 to 2006, we find evidence supporting our hypothesis. Our findings complement the finance literature that focuses on the role of financing policies in mitigating agency costs of managerial discretion. INTRODUCTION We study the incremental impact of corporate governance controls in mitigating managerial discretion costs after controlling for the incentive alignment of managerial ownership. To accomplish this, we apply the managerial discretion hypothesis (MDH) of Mayers and Smith (1981, 1988, 1994) to publicly traded, property-liability (PL hence, managerial discretion significantly impacts the success of these functions (Rizzo, 1989; Lamm-Tennant, Starks, and Stokes, 1992; Petroni and Beasley, 1996). In contrast, auto-physical damage insurance, being short-tailed and more static in nature, requires far less managerial discretion to conduct the same business functions. (1) Mayers and Smith recognize that alternative ownership structures have different sets of governance tools to mitigate agency costs. Specifically, stock insurers have governance tools, such as managerial ownership, stock-based compensation, external blockholders, and the takeover market, which are not available to other ownership structures (e.g., mutuals). This leads Mayers and Smith (1981, p. 427) to argue that firms with varying abilities to manage agency costs should experience competitive advantages in different lines of insurance: "... if the cost of controlling management in mutual insurance companies is higher than in stock firms, then mutuals should be more prevalent in lines of insurance where management exercises little discretion .... " Therefore, the MDH predicts line specialization across ownership structures. Our study extends the MDH to explore whether, within the single ownership structure of publicly traded stock insurers, variation in stringency of corporate governance systems generates similar comparative advantages and line specialization. Specifically, Mayers and Smith predict that firms with a more robust set of governance tools will specialize in high managerial discretion business. We extend their theory to predict that within a group of firms having the same set of governance tools, those that utilize these tools more stringently to control agency costs will command greater contracting cost advantages, leading them to specialize in lines of insurance that require higher levels of managerial discretion. This extension is important because, by focusing on publicly traded insurers, these results become applicable to publicly traded firms outside the insurance industry. …