Compensation and Board Structure: Evidence From the Insurance Industry

ABSTRACT Monitoring by outside board members and incentive compensation provisions in executive pay packages are alternative mechanisms for controlling incentive problems between owners and managers. The control hypothesis suggests that if incentive conflicts vary materially, those firms with more outside directors also should implement a higher degree of pay-for-performance sensitivity. Our evidence is consistent with this control hypothesis. We document a relation between board structure and the extent to which executive compensation is tied to performance in mutuals: compensation changes are significantly more sensitive to changes in return on assets when the fraction of outsiders on the board is high. INTRODUCTION A long-standing proposition in organizational economics is that more diffuse ownership reduces incentives to monitor managers and limit managerial perquisite consumption (Berle and Means, 1932). However, dysfunctional managerial incentives can be controlled through an array of governance mechanisms. In this article, we focus on two such mechanisms--board structure and pay-for-performance compensation. Our analysis provides evidence on the monitoring role of the board of directors as well as the effectiveness of pay-for-performance compensation. Importantly, it identifies a positive association between pay-for-performance sensitivity and board structure in mutual insurance companies, consistent with the hypothesis that these two policies are complements. Others have analyzed these control mechanisms. Fama (1980) argues that monitoring by independent directors helps reduce contracting costs that arise between owners and managers. Rosenstein and Wyatt (1990) provide evidence of the importance of independent directors by documenting significantly positive stock returns at the announcement of the appointment of outside directors but returns that are indistinguishable from zero for announcements of inside-director appointments. (1) There also is substantial empirical research that examines the argument by Holmstrom (1979) and Shavell (1979) that tying pay to performance helps reduce contracting costs. This research documents a positive relation between changes in executive compensation and both accounting- and market-based performance measures. (2) Yet these control mechanisms typically are analyzed in isolation--even though they are endogenous and theory suggests important interactions in their selection. Holmstrom and Milgrom (1991) argue that organizational choices represent the selection of an organizational system. In their model, activities compete for an executive's attention and there is a tendency for the levels of incentives provided for the different activities to be complementary in the severity of the contracting problem. They suggest that a critical aspect of organizational analysis is to explain how various policy choices are intertwined, and they derive sufficient conditions for policy choices to be correlated across firms. But we argue that because ownership concentration varies substantially across most populations of common stock companies, the conditions necessary to ensure that policies will be correlated in the cross-section are usually violated. (3) Our data allow us to control for variation in ownership concentration; it is from the insurance industry--an industry with a large contingent of mutual companies. Unlike stock companies, where ownership concentration varies widely, mutuals are diffusely owned. The more limited variation in ownership concentration within this population of companies increases the likelihood of identifying the hypothesized complementary relation between board structure and pay-for-performance compensation. Our mutual insurance company data also control another potential problem. Mutual ownership rights are inalienable; hence, control mechanisms that require alienable ownership rights (like executive stock options) are infeasible. …