Incentive Contracting and the Role of Participation Rights

Corporate limited liability creates incentives for owners to shift risks onto creditors by substituting high-risk assets for low-risk assets because it rewards owners with the benefits of risky activities while penalizing them with only a portion of the costs. However, since rational creditors understand these incentives, the ensuing agency cost is borne ex ante by owners, unless they can credibly precommit themselves not to shift risk onto creditors. This article considers one specific contractual arrangement that helps resolve the risk shift-ing problem in stock insurers: the inclusion of participation rights in insurance policies. We assume that the insurer chooses between two mutually exclusive investment portfolios, where the riskier portfolio is a mean preserving spread of the less risky portfolio. The primary purpose of this analysis is to demonstrate that participating insurance policies resolve the risk shifting problem for stock insurers. We also present empirical evidence on policyholder participation that is consistent with our theory