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INSURER OPACITY, CEO COMPENSATION, AND CRASH RISK

Abstract:

The complex and opaque nature of insurer liabilities, coupled with equity-based

compensation packages for insurer executives, potentially increase incentives for

insurers to hoard bad news that may contribute to stock price crash risk. We provide

the first empirical evidence on the relation between insurer opacity, CEO

compensation structure, and insurer crash risk. Opacity is measured by three marketbased

proxies; the analyst forecast error, bid-ask spread, and organizational

complexity, and one accounting-based proxy; the unexpected cash flow from

operations. The latter is intended to capture financial reporting opacity. We find that:

(i) insurer opacity is significantly positively associated with stock price crash risk,

(ii) insurers with greater CEO equity incentives exhibit higher crash risk. To address

potential endogeneity concerns, we introduce a semi-natural experiment, the passage

of the Regulation Fair Disclosure (FD) in 2000, as an exogenous shock to opacity,

and employ a difference-in-differences framework to estimate our extended model.

With this approach, we find that: (iii) crash risk decreased in the period following

the passage of Regulation FD, with the greatest diminutions occurring for the mostopaque

insurers. Our results support the importance of providing proper incentives

to insurer managers to reduce news hoarding, to increase disclosure, and to mitigate

information asymmetry on the part of the regulators and firms.

KEYWORDS: macro-term structure model, forward-looking multi-horizon policy

rule, survey expectations, bond risk premia (JEL G12, E37, E43, E44, E52, C13)