The Value Implications of Directors' and Officers' Liability Insurance

Description

Directors’ and Officers’ liability insurance (D&O insurance) is an insurance policy paid by a company to cover its all directors and executives for legal liability arising from their activities on behalf of the company. D&O insurance purchase is prevalent in listed companies in common-law jurisdictions (e.g., North America and Hong Kong). Despite such popularity, to date there is no consensus as to whether D&O insurance benefits shareholders. Theoretically, there are two views. One view is that the purchase of D&O insurance represents managerial opportunism and the coverage insulates directors and executives from the threat of personal financial liability resulting from their corporate decisions, thereby lowering their incentives to act in the best interest of shareholders (i.e., the managerial opportunism hypothesis). In fact, most securities class action lawsuits in the US are brought by shareholders and are settled out of court within the D&O insurance coverage limit. The other view is that D&O insurance can be beneficial to shareholders because the scrutiny of a firm’s corporate governance and risk profile by the D&O insurer in underwriting provides a valuable monitoring function, because D&O insurance helps a company to attract high-caliber candidates serving as directors and officers, and/or D&O insurance encourages optimal risk taking (i.e., the benefit hypothesis). Empirically, evidence relating to D&O insurance (in particular, the incentive effects of D&O insurance) is sparse due largely to the difficulty in obtaining D&O insurance data at the firm level (only Canada requires companies disclose information on D&O insurance purchases that companies often deem to be sensitive and confidential).Taking advantage of the mandatory disclosure requirement in Canada, I plan to manually construct a unique and comprehensive dataset on D&O insurance for the period 1996-2008. The current study aims to examine 1) whether the prevalent usage of D&O insurance has a measurable effect on firm performance and valuation; 2) how corporate governance moderates the effect of D&O insurance on firm value; and 3) how do investors assess the marginal value of corporate cash holdings and capital expenditure in companies with substantial D&O insurance coverage. The project helps contribute to the longstanding and recently renewed debate regarding the merits of D&O insurance. The research output is of clear interest to scholars, millions of investors and securities regulators, and has strong local relevance.