On Lawsuits, Corporate Governance, and Directors' and Officers' Liability Insurance

• Date: 01 December 2015
• DOI: http://doi.org/10.1111/jori.12043
• Author: Christine A. Panasian,Stuart L. Gillan
• Published date: 01 December 2015

ONLAWSUITS,CORPORATE GOVERNANCE,AND

DIRECTORS'AND OFFICERS'LIABILITY INSURANCE

Stuart L. Gillan

Christine A. Panasian

ABSTRACT

We examine whether information about firms’ directors’ and officers’ (D&O)

liability insurance coverage provides insights into the likelihood of

shareholder lawsuits. Using Canadian firms, we find evidence that firms

with D&O insurance coverage are more likely to be sued and that the

likelihood of litigation increases with increased coverage. These findings

are consistent with managerial opportunism or moral hazard related to the

insurance purchase decision. We also find that higher premiums are

associated with the likelihood of litigation, indicating that insurers price this

behavior. Taken together, the findings suggest that coverage and premium

levels have the potential to convey information about lawsuit likelihood, and

a firm’s governance quality, to the marketplace.

The last decade and a half has seen a dramatic upsurge in shareholder litigation

against firms, executives, and board members. Aggregate U.S. securities class-action

settlements increased from $1 billion between 1996 and 1999 to $10.6 billion in 2006

alone (Simmons and Ryan, 2006).

1

Similarly, securities-related lawsuits, including

class actions, are on the rise in Canada, with the latter increasing markedly since 2005

(Hays and Berenblut, 2011). The most significant source of litigation exposure for

directors and officers (D&O) arises from shareholder suits, and such suits are

Stuart L. Gillan is at the Department of Finance, Terry College of Business, 452 Brooks Hall,

University of Georgia, Athens, GA 30602. Gillan can be contacted via e-mail: sgillan@uga.edu.

Christine A. Panasian is at the Department of Finance, Sobey School of Business, Saint Mary’s

University, Halifax, NS B3H 3C3, Canada. Panasian can be contacted via e-mail: christine.

panasian@smu.ca. We would like to thank the anonymous referees, Scott Bauguess, Martin

Boyer, Bill Brown, George Cashman, Jack Cooney, Pat Fishe, Jim Garven, Jay Hartzell, Kent

Hickman, Chip LaLone, Darius Miller, Laura Starks, Mike Stegemoller, Sheridan Titman, John

Wald, Peter Westfall, David Williams, and seminar participants at Baylor University, Cal-State

Fullerton, East Tennessee State University, Gonzaga University, HEC-Montreal, Southern

Methodist University, Texas Christian University, University of Richmond, University of

Alberta, UT Austin, and UT San Antonio for helpful comments.

1

Excluding the Enron settlement of $7.6 billion.

© 2014 The Journal of Risk and Insurance. 82, No. 4, 793–822 (2015).

DOI: 10.1111/jori.12043

793

associated with significant shareholder wealth losses for firms (Bhagat, Bizjak, and

Coles, 1998).

2,3

While many firms now purchase D&O liability insurance to protect

corporate officers and directors by covering expenses and damages in the event that

the firm is sued, there is little work explicitly examining the link between such

insurance coverage and actual litigation.

We contribute to the literature by examining whether information contained in firms’

D&O insurance coverage provides insights into the likelihood of securities-related

litigation. Given that insurers incur costs when a client firm is sued, they have

financial incentives to assess client litigation risk and set insurance premiums

accordingly. Implicit in this pricing is the insurer’s assessment of how the firm’s

corporate governance may act to mitigate litigation risk. We provide updated

evidence on the factors associated with D&O insurance coverage and on how D&O

insurers price firm fundamentals and governance structures. In addition, our analysis

provides further insights into the potential for managerial opportunism in the D&O

purchase decision.

At a general level, our findings support the view that D&O insurance pricing and

coverage information have the potential to convey information about the probability

of lawsuit, and thus a firm’s governance quality, to the marketplace. Using a sample of

Canadian firms for which D&O insurance data are available, we find that firms

carrying D&O insurance are more likely to be sued relative to uninsured firms.

Further, we find that measures of “abnormal” or “excess” insurance coverage and

premiums are associated with lawsuit likelihood. This finding is consistent with D&O

insurers assessing firm-specific litigation risk, including excess coverage, and

factoring that into the premiums they charge. Our results also suggest potential

managerial opportunism (or alternatively moral hazard) in the insurance purchase

decision; managers who are more likely to be sued purchase D&O coverage, and more

of it. The findings are also consistent with the potential for moral hazard in that once

insurance is purchased (perhaps out of habit), managers may act in a manner that

leads to lawsuits (Boyer, 2003). We also find that larger firms, firms with higher free

cash flows (FCFs), and those previously sued have a higher propensity to be sued.

Moreover, we find that the probability of suit has increased over time and is

significantly higher for firms cross-listed in the United States compared to Canadian-

only listed firms.

When reexamining the association between D&O insurance premiums and firm-

specific characteristics, the evidence is supportive of prior work (e.g., Core, 1997,

2000; Boyer, 2003; Boyer and Tennyson, 2008). Larger firms and firms with fewer

growth opportunities (lower Tobin’s Q) are charged higher premiums. Similarly, we

observe higher premiums for firms with larger boards, severance and executive

2

“Directors’ and Officers’ Liability, 2006 Survey of Insurance Purchasing and Claims Trends,”

Tillinghast Towers Perrin, 2006.

3

In related work, Karpoff, Lee, and Martin (2008) report evidence that firms facing actions by

federal regulators and the Department of Justice lose, on average, 41 percent of their market

values.

794 THE JOURNAL OF RISK AND INSURANCE