Directors' and Officers' Liability Insurance, Corporate Risk and Risk Taking: New Panel Data Evidence on The Role of Directors' and Officers' Liability Insurance

• Published date: 01 December 2015
• DOI: http://doi.org/10.1111/jori.12107
• Date: 01 December 2015

DIRECTORS’AND OFFICERS’LIABILITY INSURANCE,

CORPORATE RISK AND RISK TAKING:NEW PANEL DATA

EVIDENCE ON THE ROLE OF DIRECTORS’AND OFFICERS’

LIABILITY INSURANCE

M. Martin Boyer

Sharon Tennyson

ABSTRACT

This article develops and tests hypotheses regarding the relationship

between directors’ and officers’ (D&O) insurance purchase and firm size,

governance characteristics, and business risk, using a unique panel data set

on Canadian firms for years 1996–2005. The data permit examination of the

determinants of insurance pricing, ownership and coverage limits, and the

effects of insurance on board characteristics and earnings management.

Results using panel data methods and controlling for endogenous prices and

endogenous selection into insurance ownership provide strong statistical

evidence for the view that D&O insurance markets take corporate risk into

account, but that insurance leads to greater risk taking.

INTRODUCTION

Members of the board of directors of publicly traded corporations in many countries

around the world face personal liability for breach of the duties of care and loyalty to

the company’s shareholders (Romano, 1991).

1

Imposing liability is thought to aid in

aligning managers’ incentives with the interests of shareholders by providing

shareholders with a mechanism for recouping losses brought about by director

malfeasance. Permitting shareholder suits is also a means to deal with the classic

Martin Boyer is affiliated with HEC Montr

eal (Universit

e de Montr

eal), Montr

eal, Canada.

Sharon Tennyson is affiliated with Cornell University. The authors can be reached via e-mail:

martin.boyer@hec.ca, sharon.tennyson@cornell.edu

1

For more on the jurisprudence regarding directors’ and officers’ liability insurance, see Priest

(1987), Bradley and Schipani (1989), Knepper and Bailey (1998), Emerson and Clarke (2003),

Baker and Griffith (2010), and Heys and Berenblut (2012).

© 2015 The Journal of Risk and Insurance. Vol. 82, No. 4, 753–791 (2015).

DOI: 10.1111/jori.12107

753

agency problem, acting as a disciplinary force on managers and directors (see Becht,

Bolton, and Roell, 2003; Bauer, Braun, and Moers, 2008).

2

One puzzle long recognized in the literature is that the enforcement power of

shareholder liability threats are often mitigated by corporations purchasing directors’

and officers’ (D&O) insurance on the board’s behalf.

3

This reduces the directors’ and

officers’ financial risk associated with such suits,

4

and raises the obvious concern

that the deterrent effects of the shareholder liability threat are reduced (Baker and

Griffith, 2010). This may result in reduced board oversight of managers’ activities

and of the financial condition of the firm (Barrese and Scordis, 2007; Bradley and

Chen, 2011; Rees, Radulescu, and Egger, 2011). This concern was the main reason

why D&O insurance was not allowed in many continental European countries until

very recently (see Gutierrez, 2003; Werder, Talaulicar, and Kolat, 2005; LaCroix,

2009).

5

Specific moral hazard effects of D&O insurance may include inefficient investments

(Lin, Officer, and Zou, 2011), aggressive accounting (Cao and Narayanamoorthy,

2011; Boyer and Hanon, 2012), and other actions that benefit management at the

expense of shareholders (O’Sullivan, 1997; Chalmers, Dann, and Harford, 2002; Chen

Yi, and Lin, 2012). In such cases, a firm’s purchase of D&O insurance may reflect

opportunism by an entrenched management or board, which receives insurance

benefits but does not pay the full cost of insurance.

There are, however, theor etical reasons to expect t hat D&O insurance purchase

could enhance the value o f the firm. Drawing on the th eory of corporate insurance

2

DuCharme, Malatesta, and Sefcik (2004) argue, for instance, that discovered false earning

signals have important reputational consequences that result in a higher difficulty of raising

capital in the future. The threat of a shareholder suit may reduce earnings restatements and

thus increase the value of the firm. McTier and Wald (2011) present an alternative view that

shareholder suits arise from “legal rent seeking” by opportunistic plaintiffs’ attorneys who sue

firms that experience large stock price drops in order to expropriate a settlement from the

firm’s D&O insurance policies (also see Beck and Bhagat, 1997).

3

Of course, D&O insurance policies exclude losses arising from deliberate fraud or dishonesty.

4

D&O insurance policies offer three different types of coverage, which are called “sides” in the

insurance business (Griffith, 2006). “Side A” (or individual) coverage ensures direct

reimbursement for directors and officers when a company is unable (for legal reasons or

because of bankruptcy) or does not wish to reimburse them. “Side B” (or corporate) coverage is

the most common type of D&O coverage, and ensures that a company will be reimbursed for

any amounts paid to claimants on behalf of the directors and officers. The third form of

coverage is “Side C” (or entity) which provides for direct reimbursement of costs that the

company itself may incur from D&O related suits. Most D&O insurance policies consist of a

mix of all three types of coverage (Towers-Watson, 2011). Also see Weisdom, McCord, and

Williams (2006) for more on the topic.

5

Besides D&O insurance policies, there are several other contracts that ensure peace of mind to

directors and officers in their day-to-day decision making. For example, in Canada and in

most U.S. states, corporations are allowed to indemnify directors for legal expenses associated

with lawsuits in which they are not found negligent; in these cases D&O insurance may

increase moral hazard by increasing directors’ indemnification (Romano, 1991, 2006).

754 THE JOURNAL OF RISK AND INSURANCE

purchase, financial risk transfer through insurance is efficiency enhancing for

some firms: benefits are mor e likely for smaller firms, fi rms with higher costs

of financial distress, and firms with higher growth op portunities (Mayers and

Smith, 1982, 1990). Protec ting directors from liability exposure may also imp rove

firm management, since lia bility exposure may induce m anagers to forego risky

positive net present value projects (Mayers and Smit h, 1987) and risk-averse

outside directors may be d ifficult to attract if expo sed to liability risk (Prie st,

1987).

Moreover, it has been pointed out that insurers can counter moral hazard by engaging

in presale monitoring of corporate government of D&O insurance applicants and

negotiating changes in a firm’s corporate governance as a condition for obtaining

insurance. Examples include diluting the power of the chairman of the board and

increasing the number of outsiders on the audit committee (Holderness, 1990). This

idea is consistent with corporate insurance theory, which recognizes that insurance

can increase firm value through specialized service provision. This has come to be

known as the insurer monitoring hypothesis; in this view one valuable service of D&O

insurers may be monitoring of the firm’s directors and officers (Bhagat, Brickley, and

Coles, 1987; Holderness, 1990; O’Sullivan, 1997; Baker and Griffith, 2007, 2010; Boyer

and Stern, 2014).

6

Despite the active theor etical interest and the growing importance of D&O

insurance among corpor ations worldwide,

7

the relative merits of th ese alternative

points of view are not well unde rstood. The determinant s of D&O insurance

purchase, its role in board co ntracts, and the effects o f D&O insurance protec-

tion on corporate risk ta king remain subjects of debate. This is likely due to t he

fact that corporate purchases of D&O insurance are not widely disclose d

except where mandated b y law, which has limited th e scope of empirical

6

Another version of the monitoring argument is that D&O insurance functions to precommit

shareholders to bring suits against negligent directors when litigation is costly and

directors have limited wealth (Bhagat, Brickley, and Coles, 1987; Sarath, 1991; Gutierrez,

2003; Chang and Yeh, 2011). See Parry and Parry (1991), Chang and Yeh (2011),

Kremslehner (2011), and Rees, Radulescu, and Egger (2011) for alternative models of D&O

insurance.

7

Guti

errez (2003) reports that D&O insurance was rarely used in continental Europe because it

reduces director accountability; she writes that D&O insurance was “forbidden in Germany,

where the legislature considers that its use would both reduce the levels of diligence of

directors and increase the compensatory demands of plaintiffs” (p. 517). However, the

German Corporate Governance Code of 2002 now allows directors to have such insurance (see

Werder, Talaulicar, and Kolat, 2005; Talaulicar and Werder, 2008). LaCroix (2009) posts the

following: “Most large European companies carry some amount of D&O insurance, although

the perceived level of D&O insurance coverage need varies among countries.” D&O insurance

protection has become the norm for directors in Taiwan (see Chen and Li, 2010). Towers-

Watson (2011) reports that 47 percent of for-profit organizations with international operations

purchased a local D&O policy in a foreign jurisdiction in 2010, whereas 2 years before, only 2

percent of respondents with international operations had purchased a local policy in a foreign

jurisdiction.

DIRECTORS’AND OFFICERS’LIABILITY INSURANCE 755