An Empirical Examination of Stakeholder Groups as Monitoring Sources in Corporate Governance

ABSTRACT Insurers are formally and informally monitored by a variety of stakeholders, including reinsurers, agents, outside board members, and regulators. While other studies have generally examined these stakeholders separately, they have not accounted for the fact that there is some relation among the stakeholder groups, and the presence of these groups is likely to be jointly determined. By empirically controlling for these potential interrelations, we create a more complete assessment of the impact of these stakeholders/monitors on insurers' risk taking. Specifically, we find that the presence of some stakeholders offsets the degree or presence of others, and that most stakeholders/monitors are associated with a reduction of overall firm risk. INTRODUCTION The most recent financial crisis has once again moved the issue of corporate governance to the forefront of discussion among both academic researchers and practitioners. At the center of the debate are the apparently aggressive risk-taking activities of some firms, which have been cited as one of the causes of the crisis. The risk-taking behavior of the insurance industry is of particular concern given: (1) the importance of insurance to both individuals and businesses, (2) the impact on insurance consumers of insurers' financial condition, and (3) the important role of the industry in the overall economy. One of the critical issues raised in the debate regarding the risk-taking behavior of firms relates to the oversight of firms by a variety of stakeholder groups. Researchers and practitioners have questioned the ability of stakeholders to restrain managers from acting in their self-interest rather than in the interest of other stakeholders. The influence of various parties on firm value, performance, and risk taking has been empirically investigated using firms in a number of industries as well as using data from multiple countries (e.g., Klapper and Love, 2004; Huang, Hsiao, and Lai, 2007; Bowen, Rajgopal, and Venkatachalam, 2008).: One consistent finding is that multiple stakeholder groups have a significant impact on firm risk (e.g., John, Litov, and Yeung, 2008; King and Wen, 2011). (2) Drawing on prior research, this study focuses on the impact of both formal oversight of insurers (by outside directors) and informal oversight of insurers (by reinsurers and agents) on insurer risk-taking behavior. To a lesser extent, we also consider the influence of regulators through a proxy for regulatory stringency (i.e., indicator for being licensed in New York), as they also can play a significant oversight role. While all stakeholders may monitor the behavior of management, each has its own motivation and objectives. (3) For example, reinsurers doing business with insurers have an incentive to monitor the behavior of the ceding insurers (e.g., Garven and Lamm-Tennant, 2003; Doherty and Smetters, 2005; Plantin, 2006). Similarly, boards of directors, especially outside members of the boards, are meant to serve as monitors of management on behalf of firm owners, in addition to providing an important advisory function that brings valuable expertise and potentially important business connections to the firm (e.g., Linck, Netter, and Yang, 2008). Similarly, while their primary role is to distribute insurance products, agents also monitor insurers as part of their role as intermediaries between insurers and consumers. The incentives to monitor, however, may vary based on the type of agent (e.g., Regan and Tennyson, 1996; Regan, 1997). Accordingly, different stakeholders have different preferences when it comes to insurer risk taking, varying with their respective incentives and interests. We do not characterize the impact of any of these stakeholders as "good" or "bad," since such characterizations are subjective and vary depending on the perspective of the one making the assessment. However, a better understanding of the interrelationships of the stakeholders, as well as their respective impact on risk taking, will help to establish a more complete picture of the risk-taking behavior of firms. …