Probability Updating and the Market for Directors’ and Officers’ Insurance

• Author: Nancy R. Mansfield,Stephen G. Fier,Joan T. A. Gabel,Kathleen A. McCullough
• Date: 01 March 2015
• DOI: http://doi.org/10.1111/rmir.12029
• Published date: 01 March 2015

Risk Management and Insurance Review

C

Risk Management and Insurance Review, 2015, Vol.18, No. 1, 55-75

DOI: 10.1111/rmir.12029

PROBABILITY UPDATING AND THE MARKET

FOR DIRECTORS’AND OFFICERS’INSURANCE

Stephen G. Fier

Kathleen A. McCullough

Joan T. A. Gabel

Nancy R. Mansfield

ABSTRACT

Over the past decade, much attention has been given to the topics of corpo-

rate governance and corporate risk management. One increasingly important

insurance product associated with each of these issues is directors’ and officers’

(D&O) liability insurance. Given the interconnectedness that exists between

D&O insurance, corporate risk management, and corporate governance, we

exploit industry-specific D&O data to explain how industries most associated

with the corporate scandals of the early 2000s adjusted demand patterns during

periods of certainty and uncertainty. The rich data set coupled with dramatic

changes in the marketplace allows for the testing of insurance demand patterns

and enables us to offer insight into the market’s response to a unique type of

loss shock. The results of this study suggest evidence in favor of demand-side

probability updating, whereby those industries most associated with the corpo-

rate scandals of the early 2000s adjusted the demand for D&O insurance during

periods of greater uncertainty.

INTRODUCTION

Prior literature documents that both individuals and firms tend to alter the purchase of

insurance products after a major loss event, even if the event does not directly impact the

purchaser (e.g., Shelor et al., 1992; Froot and O’Connell, 1997; Browne and Hoyt, 2000).

Following the occurrence of a major loss event, consumers reassess the likelihood and

size of potential future losses. If consumers anticipate an increase in future losses, they

update purchasing behavior to reflect updated expectations. This increase in insurance

demand following a loss event and resulting from actual or perceived increases in

Stephen G. Fier, School of Business Administration, University of Mississippi, University, MS

38677; phone: 662-915-1353; e-mail: sfier@bus.olemiss.edu. Kathleen A. McCullough, Col-

lege of Business, Florida State University, Tallahassee, FL 32306; phone: 850-644-8358; e-mail:

kmccullough@cob.fsu.edu. Joan T. A. Gabel, Robert J. Trulaske Sr. College of Business, Univer-

sity of Missouri, Columbia, MO 65211; phone: 573-882-6688; e-mail: gabelj@missouri.edu. Nancy

R. Mansfield, J. Mack Robinson College of Business, Georgia State University,Atlanta, GA 30302;

phone: 404-413-7473; e-mail: nmansfield@gsu.edu.

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56 RISK MANAGEMENT AND INSURANCE REVIEW

actuarial losses has been termed “probability updating” (Froot and O’Connell, 1997,

1999).1

In this study,we conjecture that the corporate governance failures in the early 2000s, the

implementation of the Sarbanes–Oxley Act (SOX), and the recent financial crisis have

altered both actual and perceived corporate-governance-related risks and ultimately,

D&O exposure. Given the nature of the corporate scandals and the long-tail loss pat-

terns of D&O claims, the market shocks may not manifest quickly in terms of realized

losses. Thus, in some ways, a reaction in the D&O market would be attributed to the

increased likelihood of rising losses rather than a spike in current losses, thus creating

a unique loss shock. Further, for the most part, the corporate governance failures were

isolated to certain key industries rather than across the U.S. economy as a whole. This

isolation suggests that the changes in the D&O market are likely to impact these indus-

tries differently based on the potentially heightened litigation-risk exposure stemming

from the scandals and increased scrutiny. This unique loss shock was coupled with the

introduction of the SOX, which, while intended to act as a stabilizing force for public in-

vestors, increased the perceived risks faced by directors and officers (D&O). As SOX was

implemented, there was uncertainty as to the types of claims as well as the magnitude

of potential future settlements.

In many ways, the D&O market was at the epicenter of these corporate shocks. D&O

liability insurance is commonly recognized as one of the primary risk management

tools to mitigate the costs attributed to D&O-related risks.2Prior D&O literature argues

that the purchase of this coverage is related to a variety of factors including litigation

risk and/or insolvency risk (Core, 1997). This implies that many firms likely revisited

their D&O coverage during this period of time, presumably due in part to the increase in

perceived risk. Furthermore,it has been suggested that D&O insurance is used to monitor

firm managers (e.g., Core, 1997; O’Sullivan, 1997), with some studies finding evidence

that D&O purchases relate to weak corporate governance and managerial opportunism

(e.g., Core, 2000; Chalmers et al., 2002), while other studies have failed to find evidence of

managerial opportunism related to D&O insurance purchases (Boyer,2003). Tothe extent

that D&O purchases can impact corporate governance and managerial opportunism, the

headlines related to corporate scandals further underscore the importance of revisiting

the changing demand for D&O insurance during times of great uncertainty.

In this study, we examine the occurrence of the corporate scandals in the early 2000s

and the resulting SOX legislation and their relation to the demand for D&O insurance.

Our analysis provides a better understanding of the potential shock that these events

represented to the D&O liability insurance marketplace and allows us to investigate

behavioral changes that took place with respect to the purchaser.

We hypothesize that changes in the demand for D&O insurance varied across indus-

tries during the period from 1991 through 2007, based on industry-specific expectations

1Similar to the demand-side argument that we discuss in this study, Lai et al. (2000) argue that

insurer expectations regarding future losses or expenses can impact the price and/or supply

of coverage. As discussed in the “Data and Methodology” section of this study, we control for

both demand- and supply-side factors in our models.

2In general, D&O policies provide coverage for expenses associated with director and officer

personal liability,such as defense and settlement costs.