Does Directors and Officers’ Liability Insurance Induce Bank Risk‐taking? Evidence from Taiwan

• Date: 01 February 2017
• DOI: http://doi.org/10.1111/ajfs.12163
• Author: Kuei‐Fu Li,Yi‐Ping Liao
• Published date: 01 February 2017

Does Directors and Officers’ Liability

Insurance Induce Bank Risk-taking?

Evidence from Taiwan*

Yi-Ping Liao

Department of Accounting, Ming-Chuan University, Taiwan, Republic of China

Kuei-Fu Li**

Department of Accounting, Ming-Chuan University, Taiwan, Republic of China

Received 22 December 2014; Accepted 21 October 2016

Abstract

This study investigates the effect of directors and officers’ (D&O) insurance on bank risk-tak-

ing. Using data from Taiwan banks, we find that: (i) the level of D&O insurance coverage is

positively associated with risk-taking; and (ii) this positive relationship is less pronounced for

banks whose insurers are highly credit-rated or specialists in the D&O insurance market.

Overall, considering the severe consequences of greater bank risk-taking, our findings high-

light the need for regulators to monitor the use of D&O insurance policies by banks.

Keywords Directors and officers’ (D&O) insurance; Insurance companies; Bank risk-taking;

Credit rating; Industry specialization

JEL Classification: G22, G30, G34

1. Introduction

Directors and officers’ (hereafter D&O) insurance policies protect directors and execu-

tives from liabilities arising from the decisions made and actions taken on behalf of the

company. The insurance marketplace for D&O insurance policies is worth US$10 billion

in written premiums, according to an estimate by Allianz Global Corporate & Specialty.

1

Towers Watson’s survey

2

also indicates that D&O insurance is an important component

of compensation packages, while Lin et al. (2013) further point out that D&O insurance

is an important consideration for directors when deciding whether to sit on the board.

*We are grateful for the support of the Ministry of Science and Technology (Grant numbers:

MOST 103-2410-H-130-009 and 103-2410-H-130-014).

**Corresponding author: Kuei-Fu Li, Department of Accounting, Ming-Chuan University,

250 Zhong Shan N. Rd., Sec. 5, Taipei 111, Taiwan. Tel: +886-2-28824564 ext.2166, Fax:

+886-2-88615782, email: kfli@mail.mcu.edu.tw.

1

Refer to http://www.agcs.allianz.com/assets/PDFs/risk%20insights/AGCS-DO-infopaper.pdf

2

Refer to http://www.businessinsurance.com/assets/pdf/TowersWatsonDOSurveyFinal.pdf

Asia-Pacific Journal of Financial Studies (2017) 46, 64–86 doi:10.1111/ajfs.12163

64 ©2017 Korean Securities Association

In the banking industry, practitioners consider it critical for banks to buy D&O

insurance (Graham, 2010), while regulators monitor its purchase (FDIC, 2013).

Despite the high prevalence of D&O insurance, few studies have examined how it

affects bank risk-taking. Considering the severe economic consequences that can result

from greater risk-taking by banks (Reinhart and Rogoff, 2009; Besancenot and Vran-

ceanu, 2011), it is critical to understand the role of D&O insurance in bank risk-tak -

ing. Specifically, we hypothesize that D&O insurance induces bank risk-taking for two

reasons. First, with the protection of D&O insurance, the threat of lawsuits is less

effective in steering directors and officers toward performing due diligence (Core,

1997; Lin et al., 2013). Hence, they may become less meticulous when evaluating the

risks involved in every decision. Second, even if directors and officers still perform

due diligence, D&O insurance protection inclines them toward acting more in line

with the incentives of bank stockholders (i.e. taking on high-risk projects).

We further investigate whether the characteristics of insurance firms affect the

D&O insurance–bank risk-taking relationship, because proponents of D&O insur-

ance believe that insurance firms would play a monitoring role during the course of

underwriting such policies (Holderness, 1990; Core, 2000), although very little

empirical evidence is available. Because Baker and Griffith (2007) argue that the

failure to monitor effectively is due to a lack of adequate knowledge and experience,

we predict that insurers who have more in-depth knowledge about underwriting

D&O insurance policies would be more capable of setting an appropriate insurance

premium that promotes sufficient managerial efforts. In other words, such insurers

would mitigate the adverse effects of D&O insurance on risk-taking.

In this study, we use data from Taiwan banks, because details on firm-level

D&O insurance coverage are not available

3

for most firms in the rest of the world,

including the US. In contrast, related disclosure is mandatory and appears in a uni -

form format in Taiwan. Based on data from Taiwan commercial banks between

2008 and 2011,

4

we first investigate the relationship between D&O insurance and

bank risk-taking. The term “risk-taking” in the banking industry is more likely to

refer to the risks arising from all aspects of activities in daily operations, and the Z-

score is the most commonly applied proxy for bank risk-taking (e.g., Laeven and

Levine, 2009; Adhikari and Agrawal, 2016). We find that D&O insurance coverage

is positively related to the negative value (or the natural logarithm of the negative

3

In the context of emerging markets, particularly the Asia-Pacific region, the use of Taiwan

data is not uncommon (Wang et al., 2008; Yu, 2010; Chang et al., 2013; Chou et al., 2013;

Yan et al., 2016). According to the data shown in The Asian Banker, in the whole Asia-Pacific

region, 10 Taiwan banks are listed in the 2014 Top 150 banks ranking, based on bank asset

size. Hence, even though the empirical results may not be generalizable to all other financial

markets without reservations, they will at least provide implications for financial markets or

regulators in the Asia-Pacific region.

4

The sample period starts with 2008, because D&O insurance has been publicly available

since that year.

D&O Insurance and Bank Risk-taking

©2017 Korean Securities Association 65