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This article shows that a corporate manager compensated in stock options makes corporate decisions to maximize stock option value. Overinvestment is a consequence if risk increases with investment. Facing the choice of hedging corporate risk with forward contracts on a stock market index fund and insuring pure risks the manager will choose the latter. Hedging with forwards reduces weight in both tails of corporate payoff distribution and thus reduces option value. Insuring pure risks reduces the weight in the left tail where the options are out-of-the-money and increases the weight in the right tail where the options are in-the-money; the effect is an increase in the option value. Insurance reduces the overinvestment problem but no level of insurance coverage can reduce investment to that which maximizes the shareholder value. ********** Most of the existing literature on the corporate demand for insurance rests either implicitly or explicitly on the notion that the decisions on corporate account are made to maximize the current shareholder value. Mayers and Smith (1982) began a discussion of the determinants of the demand for corporate insurance by noting that the "... corporate form provides an effective hedge since stockholders can eliminate insurable risk through diversification." Equivalently, the value of the insured firm is equal to that of the uninsured firm and insurance plays no role in the management of corporate risk. (1) The role insurance plays in managing corporate risk has since been clarified by Main (1983), MacMinn (1987), Mayers and Smith (1987), MacMinn and Han (1990), Garven and MacMinn (1993), and Han (1996). MacMinn (1987) shows that the risk-shifting problem can be solved with an insurance contract and so increase the value of the corporation; (2) similarly Mayers and Smith (1987) and Garven and MacMinn (1993) show that the underinvestment problem can be solved with insurance. (3) These results were derived assuming the maximization of current shareholder value. Stock option grants, however, have become an increasingly important component of executive compensation in the last two decades of the twentieth century (Murphy, 1998; Murphy, 1999). Stock options are supposed to align the incentives of management and shareholder since the options give management the incentive to increase the share price. The deductive foundation for this conventional wisdom has not been provided in the literature. Hence, the objective here is first to provide the link between the executive compensation scheme and corporate decision making, second to examine the impact of the executive compensation on the corporate demand for insurance, and third to examine the role insurance plays in aligning the interest of executives and shareholders. The literature on the demand for corporate insurance is one thread of the broader literature on risk management. In the risk management literature, Smith and Stulz (1985) consider a managerial motive that provides a linkage between compensation and corporate decision making. They show that the risk-averse manager compensated with stock will use forward contracts to hedge risk; they also show that when the compensation is stock options, the options will ultimately eliminate the incentive to hedge. (4) There is some empirical support for the managerial theory in Tufano (1996). (5) The Smith and Stulz model differs from that here because they do not allow the corporate executive to hold a portfolio on personal account or diversify that portfolio. The managerial analysis is reframed here and the corporate objective function is explicitly derived for the manager paid in stock options; then the analysis shows that the stock options eliminate the incentive to hedge with forward contracts. (6) This might suggest that neither will the manager use insurance to manage risk but this model shows that not all risk management tools are created equal. The forward contract reduces risk by eliminating weight from the tails of the corporate earnings distribution and this reduces the value of the stock options. …

This study uses the tick data for foreign-currency futures to examine risk–return relationships on macroeconomic announcements. This study—different from previous studies—examines the risk–return relationship by capturing the announcement effect on returns with announcement surprises and on volatilities with announcement dummies simultaneously in a Generalized Autoregressive Conditional Heteroskedasticity (GARCH) model. Strong risk–return relationships are detected for the first min after the announcements. Furthermore, the return–risk tradeoff ratios differ across currencies and across macroeconomic indicators. The same information can be more profitable when acted on the more liquid currency futures. © 2002 Wiley Periodicals, Inc. Jrl Fut Mark 22: 729–764, 2002

Using standard deviations and numbers of price changes calculated from tick data for currency futures, this study finds strong day‐of‐the‐week effects for both the Deutsche mark and Japanese yen, mild effects for the British pound, and no effects for the Canadian dollar after controlling for scheduled macroeconomic announcements and days to contract expiration. The day‐of‐the‐week effects are found to be caused either by Mondays’ low volatility, or by Thursdays’ or Fridays’ high volatility. This result suggests that the day‐of‐the‐week effects in the currency futures are not driven by the announcements of macroeconomic indicators as proposed in previous studies, but rather by other factors, such as private information‐based trading or by market microstructure. This study also finds that the announcements are processed equally across the days of the week for all four currency futures. © 1999 John Wiley & Sons, Inc. Jrl Fut Mark 19: 665–693, 1999

Recent occurrences of financial distress to some insurers have raised questions about whether the current guaranty system is adequate to protect policyholders. Four new systems have been proposed. Using the state preference model, it was found the Stewart's national system faring the best, if it adopts uniform regulation. Based on agency theory, the pre-assessment approach and the policyholder surcharge (or premium increase) recoupment method were found to be better than the current post-assessment approach and premium tax offset method. Furthermore, uniform policy limits and regulations are recommended.

We examine if the trading restrictions imposed on the futures market after the crash of 1987 had an impact on the informational lead-lag relationships between the cash ( NYSE composite), SP also, the cash market leads the options market. These results indicate that the imposed restrictions may have contributed to the observation of more numerous feedback and causal relationships in the post-crash period. The informational importance of the futures market did not diminish subsequent to the crash, although the futures transactions volume declined precipitously.

This article examines the role of insurance in shaping efficient compensation contracts and thereby in determining the value of the firm, assuming rational expectations. With fixed compensation, insurance coverage sufficient to eliminate insolvency is optimal. With compensation based on the firm's liquidating value, full insurance is optimal because it allows for a higher reliance on performance compensation, which then induces higher managerial efforts in both business operation and risk management and therefore a higher value of the firm. With compensation based on stock price, partial coverage or no coverage is optimal due to the cost arising from the imperfect impounding of the effect of insurance in the stock price.

Introduction Securitization is a process by which claims to cash flows from illiquid assets, such as car loans, mortgages, receivables, and leases, are transformed into traceable securities. The technology was introduced by Bank of America in 1977 and has been popularized through the issuance of mortgage-backed securities, which had a total volume of over $1 trillion outstanding in 1992. Securities backed by other assets also grew dramatically in the 1980s: from $1.2 billion in 1985 to $26 billion in 1988 (Bryan, 1989). The growing significance of securitization to banks and other financial services firms has been attributed to several factors that fall into two major categories. First, sale of mortgages through securitization is a form of regulatory arbitrage (Pavel, 1986; Greenbaum and Thakor, 1987; Pavel and Phillis, 1987; Kopff and Lent, 1988).(1) Securitization allows banking institutions to sell mortgages in capital markets and thereby frees up banks' capital for more lending. As a result, banks are able to originate loans (to earn fees) without permanently funding them. Second, securitization enables banks to sell mortgages at competitive prices and to redeploy the sale proceeds in assets, which allows more effective management of interest rate risk and better diversification of asset portfolios (Kopff and Lent, 1988, and Harvey, 1991). Although the amount of securitization is tremendous in banking and some other parts of the financial sector, it is rare in the insurance industry. Indeed, we have been able to identify only a few transactions: Prudential's sale of policyholder loans (PHLs), Cananwill's sale of premium loans, and the "sales" of premiums (with no securities issued) by General American Life and Monarch Capital. These transactions are used to analyze the benefits, costs, and issues of securitization unique to the insurance industry and to explain why securitization has not grown in the industry. The analysis suggests that these transactions are primarily motivated by tax and regulatory considerations and by the pursuit of capital at competitive costs. However, the prospect of securitization in the industry is not promising because (1) it is costly to transform unstable cash flows from insurance products into fixed-income securities, (2) regulations do not allow insurers to take the securitized assets or liabilities off the insurer's balance sheet, and (3) insurers have little demand for using securitization to diversify asset portfolios. The Securitization Process In a securitization transaction, at least four parties are involved: borrowers, originators (or sellers of assets), buyers of the assets, and investors in securities backed by the assets. The buyer can be a special purpose corporation (SPC) or a grantor trust, established solely to purchase assets and to issue securities against the assets to investors. In this way, the underlying assets are isolated from the originators' other assets and liabilities. The originators usually act (and are compensated) as servicers of the sold assets for collecting and distributing interest and principal payments. An asset-backed security (ABS) can be structured as a pass-through or a pay-through. A pass-through structure features equity financing with a trust passing interest and principal payments from the original borrowers to ABS investors. A pay-through transaction, however, raises capital by issuing both bonds and stocks, allowing active management of cash flows from the underlying assets to provide bondholders with stable cash flows. Guaranteed investment contracts (GICs), issued by banks or insurers, are commonly used for stabilizing cash flows by guaranteeing the rate of return on unscheduled principal repayments. To improve their marketability, most ABS issues have credit enhancement to protect investors against normal losses on the underlying assets.(2) Greenbaum and Thakor (1987) purport that the originator possesses sufficient information about the borrower's quality to design an appropriate schedule of guarantee. …

The Tax Deductibility of Premiums Paid to Captive Insurers: A Risk Reduction Approach ABSTRACT This article analyzes the tax deductibility of the insurance premiums paid to a captive insurer by its parent company. A risk reduction approach is used and differs substantially from those proposed in the previous literature and from what has been upheld by the government. Some of the results of this study are conistent with the government's position on this issue or the results of the previous literature and some are not. The analysis suggests that the degree of tax deductibility be determined by the relative contribution of the parent's own risks to the parent's total risks, including the parent's own risks and the outside risks underwritten by the captive. It is shown that the higher the relative contribution by the parent's own risks, the lower the degree of tax deductibility. About one-third of the largest 500 companies in the nation have formed captive insurers. While some of the corporations established captive insurers to secure liability coverages that were not provided by conventional insurers, many did so to save premium costs or to help stabilize the parents' earnings. As a result, the captive insurance industry experienced substantial growth in the 1970s. This growth, however, was halted at the beginning of the 1980s. One of the factors contributing to the setback was the Internal Revenue Service's (IRS) and the Tax Court's tough rulings against deductibility of premiums paid to captives by parent companies. Premiums paid to unaffiliated insurers are tax deductible, but those to captives are often questioned. In general, the Tax Court and the IRS have taken the same position with regard to the non-deductibility of premiums paid to captives which do not write unrelated business. However, the IRS's recent ruling 88-72, on premiums paid to captives writing substantial outside risks, conflicts with the Tax Court's decisions (the Gulf Oil case of 1987) and even the IRS's own General Counsel memorandums (GCMs 35483 and 38136). In Revenue Ruling 88-72, the IRS held that no level of outside risk will result in risk shifting, therefore premiums paid to captives writing outside risks are not tax deductible.(1) On the other hand, the IRS in GCM 35483 and the Tax Court in the Gulf Oil case ruled that premiums paid to the captive could be deductible, if the captive underwrote substantial external risks, indicating that the parent could thus pass its risk to unrelated policyholders insured with the captive. Smith (1986) investigates the issue of risk shifting and provides a quantitative analysis utilizing a portfolio approach. He maintains that the effect of risk shifting due to the captive underwriting outside risks should be gauged by the ratio of the parent's total risk with and without outside risks. Following this rationale, he concludes that the parent's total risk could increase by underwriting outside business which "has a much larger variance than parent's risk." He therefore supports the IRS's comments that writing outside risks does not constitute a risk shifting from the parent to outside policyholders. Hofflander and Nye (1984) examine the taxation of self-insurance and premiums paid to captives. They propose that if a firm's expected net income and the variance of the net income do not vary under different risk management strategies, then the IRS should hold the same position with regard to tax deductibility. They show, among other cases, that the following two arrangements satisfy their criterion: (1) a firm self-insures; and (2) the firm insures its own risk with a conventional insurer and its captive insures outside risks with the same loss distribution as itself. They conclude that if the IRS allows deductibility of premiums paid to a conventional insurer in arrangement (2), then the firm's self-insurance fund should also be deductible. …