Inherent Virtue or Inevitable Evil: The Effects of Directors' and Officers' Insurance on Firm Value

• Published date: 01 September 2018
• Date: 01 September 2018
• Author: Derrick W. H. Fung,Jason J. H. Yeh
• DOI: http://doi.org/10.1111/rmir.12104

Risk Management and Insurance Review

C

Risk Management and Insurance Review, 2018, Vol.21, No. 2, 243-288

DOI: 10.1111/rmir.12104

FEATURE ARTICLE

INHERENT VIRTUE OR INEVITABLE EVIL:THE EFFECTS

OF DIRECTORS’AND OFFICERS’INSURANCE ON FIRM

VALUE

Derrick W. H. Fung

JasonJ.H.Yeh

ABSTRACT

Whether directors’ and officers’ (D&O) insurance improves firm value is a

controversial issue. We perform a literature review about the effect of D&O

insurance and find mixed results. The proponents of D&O insurance believe it

enhances corporate monitoring and improves firm value, while the opponents

of D&O insurance argue that it creates a moral hazard problem and dimin-

ishes firm value. Against this backdrop, we argue that the trade-off between

the monitoring and moral hazard effects depends on the information acquired

by the outside directors. Using a sample of listed Canadian firms, we find that

(1) a change in D&O insurance coverage has no net effect on a firm’s subse-

quent value when we ignore the information acquired by outside directors, (2)

an increase in D&O insurance coverage improves a firm’s subsequent value

when the outside directors are well informed, and (3) an increase in D&O in-

surance coverage reduces a firm’s subsequent value when the outside directors

are poorly informed. Our findings are robust to endogeneity checks and have

important implications for the regulation of D&O insurance.

INTRODUCTION

It would be difficult for the Court to over-emphasize the importance of the director’s statutory

rights of access to corporate information. They are the foundation of the system of corporate

governance. . . . Directors cannot be expected to carry out any of their substantial responsibil-

ities, including their fiduciary duties and their duties to attend to the solvency of the company

and its general management, unless they can be sure of having full and unfettered access to

the documents of the company.

Extract from the judgment for the court case Fox v, Gadsden (2003) NSWSC 748

Derrick W. H. Fung works at Department of Mathematics and Statistics, School of De-

cision Sciences, Hang Seng Management College, Shatin, New Territories, Hong Kong;

email: derrick.fung@yahoo.com.hk. Jason J. H. Yeh works at Department of Finance,

The Chinese University of Hong Kong, Shatin, New Territories, Hong Kong; email: ja-

sonyeh@baf.cuhk.edu.hk. Derrick W. H. Fung is the correspondingauthor. He can be reached at

(852) 6204–9423.

243

244 RISK MANAGEMENT AND INSURANCE REVIEW

The information acquired by outside directors is an important element in corporate

governance research.In this study, we examine the relationship between information and

the effectiveness of directors’ and officers’ (D&O) insurance in the context of corporate

governance. As earlier studies have not examined the information acquired by outside

directors, they have yet to reach a consensus on whether D&O insurance helps create

firm value. Although the merits of D&O insurance are well documented, this type of

insurance is viewed with skepticism by many researchers.

The proponents of D&O insurance believe it enhances corporate monitoring. Holderness

(1990) and MacMinn et al. (2012) suggest that D&O insurance can influence a director’s

decision to accept an offer of employment. Thus, providing D&O insurance may help

the firm to recruit and retain talented outside directors, who are likely to be effective

representatives of shareholders for corporate monitoring due to their independence

from management. In addition, Holderness (1990) and O’Sullivan (1997) find empirical

evidence that D&O insurance plays an important monitoring role in public companies.

When a company applies for D&O insurance, the insurer is expected to carry out an

extensive review of the governance structure of the company and the background of the

directors (Baker and Griffith, 2007), which providesan incentive for the insured company

to improve its corporate governance to negotiate for lower insurance premiums. This is

consistent with Core’s (2000) finding that D&O insurance premiums reflect the quality

of a firm’s corporate governance. The aforementioned benefits of D&O insurance are

collectively referred to as the “monitoring effect.”

However,the opponents of D&O insurance argue that it creates a moral hazard problem.

Insurance payouts reimburse directors for the cost of lawsuits against breaches of their

fiduciary duties,1thus undermining the disciplinary effect of shareholder litigation.2

Barrese and Scordis (2006) argue that the moral hazard arising from D&O insurance

leads to opportunistic managerial behavior that can reduce firm value. Chalmers et al.

(2002) find a significant negative relationship between the 3-year post-IPO stock price

performance and D&O insurance coverage purchased in conjunction with the IPO. Lin

et al. (2011) report that acquirers with higher levels of D&O insurance coverage tend

to pay higher acquisition premiums during mergers and acquisitions and exhibit lower

synergies afterwards. Lin et al. (2013) also suggest that D&O insurance leads to higher

loan spreads. The aforementioned shortcomings of D&O insurance are collectively re-

ferred to as the “moral hazard effect.”

As the monitoring and moral hazard effects offset each other, the net effects of D&O

insurance on firm value remain unclear, which may explain whythe results of empirical

studies have been mixed. Table 1 summarizes the results of some empirical studies that

have examined the effects of D&O insurance on firms. We observe that the empirical

studies in this field (e.g., O’Sullivan, 1997; Lin et al., 2013; Chi and Weng, 2014; Li

and Liao, 2014; Boyer and Tennyson, 2015; Egger et al., 2015; Gillian and Panasian,

2015; Jia and Tang, 2016) have mainly focused on a particular effect of D&O insurance

and rarely examined the direct effect of D&O insurance on firm value. Other studies

1According to Brochet and Srinivasan (2014), outside directors were also occasionally named as

defendants in securities class action lawsuits from 1996 to 2010.

2This argument is also consistent with the finding of Cheng et al. (2010) that securities litigation

is an effective disciplining tool for institutional owners.

INHERENT VIRTUE OR INEVITABLE EVIL 245

TABLE 1

Effects of D&O Insurance: Evidence From Empirical Studies

Authors Data Time Period Results

Empirical evidence supporting D&O insurance

BBC (1987) 28 U.S. firms 1967–1978 rFirms experience positive abnormal returns after announcing the purchase

of D&O insurance.

O (1997) 366 U.K. firms 1991 rIn large firms, the monitoring of mangers is facilitated by D&O insurance.

rSmall firms are less reliant on D&O insurance to monitor managers than

large firms.

KN (2015) 196 U.S. firms 2004–2008 rPositive association between abnormal D&O insurance coverage and

current and future profit performance.

HK (2018) 512 Korean firms 2002–2008 rD&O insurance improves firm value when compared with noninsured

firms.

rThe positive effect of D&O insurance on firm value is pronounced when

firms have greater growth opportunities.

Empirical evidence against D&O insurance

CDH (2002) 72 U.S. IPO firms 1992–1996 rNegative association between the amount of D&O insurance coverage at the

IPO and the 3-year post-IPO stock price performance of the firm.

rInsurers do not charge abnormally high insurance premiums for coverage

purchased in advance of poor performance.

(Continued)