We examine the relationship between derivatives hedging, risk-taking, and managerial compensation from an enterprise risk management perspective in U.S. property-liability insurance companies. We find that derivatives usage is negatively related to various risks, supporting the stabilizing effect of derivatives hedging on insurer’s risk-taking. Our evidence also shows that derivatives hedging is negatively associated with CEOs’ compensation. These results suggest that board of directors may utilize derivatives as part of an overall risk management strategy to manage investment and leverage risks, and in turn, respond to changes in their risk appetite by structuring CEO’s incentive-compensation contracts accordingly. We also provide evidence that reinsurance strengthens the negative impacts of derivatives usage on risk-taking and managerial compensation, consistent with the complementarity hypothesis. Lastly, we show that the negative impact of derivatives hedging on insurer’s risk-taking and CEO compensation is more pronounced in firms with more internal tournament incentives.

Keywords: Derivatives Hedging; Executive Compensation; Risk Taking; Tournament Incentives
JEL Classification: G22, G23, G32, M12