DIRECTORS’ AND OFFICERS’ LIABILITY INSURANCE AND FIRM VALUE

• Author: Joon Ho Hwang,Byungmo Kim
• DOI: http://doi.org/10.1111/jori.12136
• Date: 01 June 2018
• Published date: 01 June 2018

© 2015 The Journal of Risk and Insurance. Vol. 85, No. 2, 447–482 (2018).

DOI: 10.1111/jori.12136

447

DIRECTORS’AND OFFICERS’LIABILITY INSURANCE AND

FIRM VALUE

Joon Ho Hwang

Byungmo Kim

ABSTRACT

This study examines the effect of directors’ and officers’ liability (D&O)

insurance on firm value. Previous studies are divided on the value

implication of D&O insurance: some argue for various benefits of being

covered by D&O insurance, whereas others focus on the managerial

opportunism stemming from being insured. In order to address whether

D&O insurance increases firm value, we utilize a sample of quoted Korean

companies from a period in which the disclosure of D&O insurance

information was mandatory and there was a significant cross-sectional

variation in the firms’ coverage of D&O insurance. We find that controlling

for the endogeneity of D&O insurance coverage, D&O insurance increases

firm value compared to noninsured firms. We also find evidence that the

increase in firm value is pronounced for firms with greater growth

opportunities, which suggests that D&O insurance can help firms to better

convert growth opportunities into higher firm value.

We examine the effects of directors’ and officers’ liability insurance (hereafter referred

to as “D&O insurance”) on firm value. D&O insurance covers corporate directors and

officers against claims arising from their activities as representatives of the firm. Being

covered by D&O insurance can affect the incentives of directors and managers, and

these incentives can in turn affect corporate decision making and consequently firm

value. Although earlier studies have argued for the different benefits of D&O

insurance to the insured company (Mayers and Smith, 1982; Holderness, 1990; Core,

1997, Zou and Adams, 2008), recent studies stress the agency cost stemming from

having D&O insurance (Chalmers, Dann, and Harford, 2002; Lin, Officer, and Zou,

2011; Chen, Li, and Zou, 2015). Considering that the empirical evidence so far does not

provide a clear answer to whether D&O insurance acts as a value-adding or a

Joon Ho Hwang is at the Korea University Business School. Hwang can be contacted via

e-mail: joonhwang@korea.ac.kr. Byungmo Kim (corresponding author) is at the Department of

Business Administration, Dankook University. Kim can be contacted via e-mail: bmkim@

dankook.ac.kr. This work was supported by the National Research Foundation of Korea Grant

funded by the Korean Government (NRF-2013S1A2A1A01033232).

448 THE JOURNAL OF RISK AND INSURANCE

-destroying mechanism to the company, we explore how D&O insurance affects

future firm value by using a unique sample of D&O insurance data.

When firms are faced with lawsuits, many of them, typically under an indemnifica-

tion arrangement, reimburse directors, and officers for the costs of lawsuits. D&O

insurance in turn reimburses the firm for these costs. Therefore, a firm purchases

D&O insurance in order to cover directors and managers for legal liability on behalf

of the company. D&O insurance usually provides both corporate and personal

coverage. Corporate coverage reimburses the firm when the firm indemnifies

directors or officers for the costs of a suit. Personal coverage provides direct payment

to directors or officers when the firm is not able to indemnify them for legal reasons or

because of financial distress.

1

Typically, D&O insurers will pay the claim as long as

directors and officers have acted in good faith (Ferris et al., 2007).

2

Therefore, as D&O

insurance can change the liability risk of managers and directors, D&O insurance can

affect their behaviors in corporate decision making.

Studies are divided between documenting the positive side of D&O insurance and the

negative side thereof. On the positive side, studies argue that D&O insurance can

provide various benefits to the insured company. For example, D&O insurers can

provide valuable monitoring services to the firm, such as scrutinizing the firm’s

governance structure during the underwriting process (Bhagat, Brickley, and Coles,

1987; Holderness, 1990; O’Sullivan, 1997; Core, 2000), have a comparative advantage

in providing claims adjudication or settlement services to the firm (Mayers and Smith,

1982), help attract competent and talented directors and officers and reduce the

compensation necessary for these people if D&O insurance serves as a substitute of

conventional form of compensation (Mayers and Smith, 1982),

3

and lower the firm’s

likelihood of bankruptcy (Core, 1997; Zou and Adams, 2008). Another potential

benefit that has not been addressed in the literature is the possibility that D&O

insurance can alleviate the risk averseness of decision makers. If a firm is covered by

D&O insurance, directors and officers can become less risk averse and less likely to

reject risky but value-adding projects. This aspect of D&O insurance implies that the

insurance will be more beneficial to firms with greater investment opportunities.

As for the negative side of D&O insurance, studies that examine the factors of D&O

insurance coverage decision find results that are generally consistent with the

managerial opportunism argument. As the purchase of the insurance typically does

not need shareholder approval, directors and officers can purchase D&O insurance in

order to serve their own interests. Core (1997) finds that for Canadian firms, corporate

1

More specifically, a typical D&O insurance policy (1) provides litigation costs for claims made

against individual directors and officers for their wrongful acts to the extent which

indemnification does not apply (personal coverage or “A-Side Coverage”), (2) reimburses the

firm for its indemnification payments (corporate reimbursement coverage or “B-Side

Coverage”), and (3) provides optional coverage for the corporation’s own liability (entity

securities coverage or “Insuring Agreement C”).

2

In many cases, litigations are settled without trial, and directors and officers are presumed to

have upheld their fiduciary duty as long as they do not admit to bad faith.

3

However, Core (1997) finds no empirical support for this hypothesis.

D&O INSURANCE AND FIRM VALUE 449

governance and managerial entrenchment affect the decision to purchase D&O

insurance. Specifically, firms with greater insider voting control are more likely to

purchase D&O insurance and carry higher coverage. Core (2000) observes that these

firms also pay higher insurance premiums. According to Zou et al. (2008), the demand

for D&O insurance in China has a positive relationship with respect to the degree of

conflict between controlling shareholders and minority shareholders, which suggests

that D&O insurance is used to protect controlling shareholders and their agents

(directors and managers) against the litigation risks arising from the expropriation of

minority interests. Boyer and Stern (2012) find that at the time of an IPO for Canadian

firms, income trusts pay more for the same D&O insurance coverage than common

equity firms. They argue that because income trusts have a more opaque governance

structure, the higher D&O insurance premium for income trusts reflects their

litigation and governance risks. In a recent study, Boyer and Tennyson (2015) estimate

the determinants and effects of D&O insurance for firms in Canada and show that

greater D&O insurance coverage leads to more aggressive earnings management,

which is consistent with moral hazard argument.

The aforementioned evidence so far suggests that the value implication of D&O

insurance is unclear.

4

There are some studies that examine how D&O insurance

affects outcomes of certain corporate events. For example, Lin, Officer, and Zou (2011)

examine the effect of D&O insurance on the outcomes of mergers and acquisitions

(M&A) decisions in Canada and find that acquirers with higher levels of D&O

insurance coverage experience lower announcement-period stock returns, pay higher

acquisition premiums, and exhibit lower synergies. Chalmers, Dann, and Harford

(2002) use a proprietary data of 72 IPO firms and find that firms with greater coverage

of D&O insurance have worse 3-year post-IPO stock returns. The general theme of

these studies is that considering that D&O insurance insulates directors and officers

from the cost of litigation, these people are more likely to act in a self-interested and

opportunistic manner. Although these studies examine the effects of D&O insurance

coverage, the analyses are limited to certain corporate events, such as M&A and IPO,

during which the likelihood of litigation is high. Another study that provides a value

implication of D&O insurance is the study by Bhagat, Brickley, and Coles (1987), who

report a positive stock price response to a relatively small sample of 25 New York firms

around the announcement of a D&O insurance purchase. Overall, previous literature

does not provide a definitive answer to the effect of D&O insurance on firm value.

This study contributes to the literature by directly examining the relationship

between D&O insurance and firm value using a large sample of D&O insurance data.

4

For example, Lin et al. (2011, p. 508) notes “...while our study identifies one potential cost of

D&O insurance in the M&A setting, it cannot address whether D&O insurance unambigu-

ously increases or decreases firm value.” Other related studies find insignificant results with

respect to the changes in director liability. Janjigian and Bolster (1990) study the impact of

Delaware’s decision to allow companies to eliminate director liability and find no significant

difference between the performance of firms in Delaware and other states. Brook and Rao

(1994) examine the effect of the firm’s adoption of provisions aimed at limiting director liability

and find insignificant stock price reactions. These studies suggest that there must be both

benefits and costs to the changes in directors’ liability coverage.