Insurance within the firm

marginally significant.

The variability in compensation induced by the incentive scheme adopted depends on
b_uσ_u (ignoring the reaction to transitory shocks, which is virtually zero, both economically
and statistically), as can be seen from equation (21). Since the overall standard deviation
of the shocks to wage growth is 0.1179, one can infer that roughly 8 percent of the total
earnings variability can be explained by firm-specific risk (see the last row of Table 7), while
the remaining component is related to workers specific shocks.

7.2 Insurance and firm-worker characteristics

As we saw in Section 2 the principal-agent model of wage determination implies that the
response of wages to performance varies in predictable ways with workers’ risk aversion,
the curvature of the effort function, the variance of shocks to firm performance and the
elasticity of performance with respect to effort. As Aggarwal and Samwick (1999), among
others, argue forcefully, these implications are the most useful for the empirical assessment of
the model, particularly to discriminate it from alternative models that predict a correlation
between firm performance and worker compensation. We now address this issue directly,
using the wealth of matched employer-employee data at our disposal. In particular, we go
beyond the prediction tested by Aggarwal and Samwick that the sensitivity of compensation
to performance should decline with the variance of performance and consider also the other
implications of the model. In addition, we also consider further predictions coming from
generalizations of the basic principal-agent model that can be tested with our data set.

For workers characteristics, we can exploit outside information on risk aversion derived
from experiments to construct a measure of risk aversion and study its relation with the
level of wage insurance. The degree of insurance might also depend on the occupational
status. In particular, the optimal contract for CEOs and executives should prescribe more
incentives in the light of the greater responsiveness of firm performance to their effort.
Another characteristic that may help explain differences in the amount of insurance received
is tenure. Gibbons and Murphy (1992) show that when there are career considerations,
i.e. concerns about the effect of current performance on future compensation, the explicit

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