THE RELATIONSHIP BETWEEN EXECUTIVE COMPENSATION AND FINANCIAL PERFORMANCE OF INSURANCE COMPANIES IN KENYA

ABSTRACT 
A manager whose compensation consists entirely of a fixed salary would have no incentive to increase shareholder wealth because the manager does not share in any of the resulting gains. This incentive problem can be reduced by making part of an executive’s compensation depend upon the firm’s financial performance. The study examined the relationship between executive compensation and financial performance of the insurance companies in Kenya. The specific objectives of the study were to examine the relationship between executive compensation and financial performance of insurance companies in Kenya and to characterize the executive compensation schemes among the insurance companies. The population of the study consisted of all forty eight (48) insurance companies registered with Insurance Regulatory Authority that have been in existence during the five year period to 2010. Secondary data was collected from Insurance Regulatory Authority annual reports. The study considered functional form relationship between the level of executive remuneration and key performance ratios by using a regression model that relates pay and performance. The study found a non-significant positive relationship between executive compensation, Capital adequacy and solvency margin ratios since P>0.05. Further the study found a non-significant relationship between claims and expense ratios since P>0.05. The negative correlation suggests claims and expenses to be prudently managed to maximize shareholders returns. This implies that the performance ratios are not key considerations in determining executive compensation among the insurance companies in Kenya. This study recommends sensitization of executives to align their payment to financial performance measures because they are directly linked to shareholder’s wealth maximization. Further, the results showed that, more than 66% of Kenyan insurance companies characterize executive remuneration into basic salary, fringe benefits and bonus plans while less than 42% characterize into stock options, Longterm incentives plan and golden parachutes.

CHAPTER ONE 
INTRODUCTION 
Background of the study 
Executives who are improperly compensated may not have the incentive to perform in the best interest of shareholders, which can be costly to the shareholders. The level of executive compensation and its relationship to firm financial performance are central issues in a generally heated debate among legislators, corporate directors, economists, financial journalist and compensation professionals (Lambert and Larcker, 1985). 

The common proposition underlying executive compensation is that in order to motivate executives to spend effort and work for the best interest of the shareholders, compensation contracts should include some form of incentive component (Murphy, 1998). Such an incentive component should establish a link between executive compensation and the performance of the firm they manage. Shareholders are mainly interested in maximizing their wealth. Executive compensation can be used as an effective instrument for creating value for shareholders by improving their firm performance (El Akremi et al 2001). 

Remuneration to executives serves as an incentive that affects decisions made and strategies adopted by an executive, both of which affect firm performance. It has a motivational effect and is an indicator of value for executives. It is a means for executives to realize rewards for their efforts. In corporate context, executives participate in the firm’s profitability. Therefore, when executive makes sound decisions and engages in profitable strategies, the executive and the organization realize financial enrichment (Finkelstein and Boyd, 1998). 

Chief Executive Officer (CEO) has responsibilities as a communicator, decision maker, leader, and manager. The officer oversees the company’s strategy and operations therefore requiring compensation for the work. It is the responsibility of the compensation committee of the board of directors to design executive compensation contracts (Murphy, 1998). The right compensation should be the minimum amount it takes to attract and retain a qualified individual. The plan should be designed to motivate the executive to perform in accordance with the company’s objectives and risk tolerance (Lambert and Larcker, 1985). 

The separation of ownership from management creates agency problems in corporation. Agency problems arise in the form of time horizon and risk aversion. Managers may adopt the short term decision horizon and maximize current period performance. Shareholders wealth maximization is more closely linked to corporate long term profitability, than to short term profitability. Therefore they would prefer that managers take a long term decision horizon (Gupta, 2011). 

The risk aversion problem arises when managers are paid only fixed salary and management performance is not tied to firm performance. Fixed salaries may motivate managers to prefer safe projects because they expect no incremental from the success of risky projects but could lose their jobs if such projects fail. Shareholders would prefer managers to be less risk-averse and to accept projects with greater risk, and correspondingly greater expected payoff, to increase shareholder wealth. To better align the interests of owners and managers, corporations adopt a wide variety of executive compensation plans. Performance plans lengthen the managers' decision horizon by rewarding them on the achievement of certain accounting-based measures over a long period performance (Gupta, 2011). Executive compensation packages generally include a mix of short-term and long term incentives. The compensation plans include salary, annual bonus, perquisites, stock options, restricted shares, golden parachutes, gratuity, and pension (Murphy, 1998). 

Insurance companies comprise of complex set of contracts among policy holders, stockholders, and managers. Substantive disagreements are likely to exist within these classes of claimholders with respect to time preference and opinions concerning what constitute the best corporate policies for the firm to follow. Agency problems and their attendance cost do arise when both parties to the agency relationship are self-interested and it is costly to write and enforce the contracts (Garven, 1987). In the context of agency theory, management incentive compensation plans are viewed as an important means of reducing the inherent conflicts (Lambert and Larcker, 1985). Firms in insurance industry face the same agency problems just like other firms in other industries. Therefore this study sought to examine the relationship between executive compensation and financial performance of insurance companies in Kenya.

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Item Type: Kenyan Postgraduate Material  |  Attribute: 56 pages  |  Chapters: 1-5
Format: MS Word  |  Price: KSh900  |  Delivery: Within 30Mins.
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