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How Directors’ Liability Insurance Increase the Cost of Equity

PUBLISHED : Wednesday, 02 May, 2018, 3:33pm
UPDATED : Monday, 07 May, 2018, 2:18pm

[Sponsored Article]

Directors’ and officers’ liability insurance and the cost of equity
CHEN, Zhihong
Journal of Accounting and Economics 61 (2016)

Shareholder litigation is important to investor protection and stock market development because it encourages managers to be more transparent. But it also represents a risk to firms and their leaders, who may face allegations of wrongdoings such as breaching their fiduciary duties and violating securities law. Directors’ and officers’ (D&O) liability insurance has become a way to protect these leaders at the company’s expense. But as Zhihong Chen, Oliver Zhen Li and Hong Zou argue, the cost of insurance is not the only way in which companies pay.

In a study of D&O insurance coverage in Canada, they show that it also affects the cost of equity because it lowers the quality of financial reporting and other information from the firm and makes it easier for D&Os to engage in risk-taking that is not necessarily beneficial to the firm.

“Our evidence is consistent with the notion that D&O insurance shields D&Os from the discipline of shareholder litigation and lowers their level of care and vigilance in business decisions,” they said.

“Furthermore, it may lead to deterioration in financial reporting and disclosure quality that increases information asymmetry and non-diversifiable estimation risk, leading to a higher cost of equity.”

The authors looked at D&O insurance coverage in 2,000 firm-year observations and ruled out other explanations for the impact on the cost of equity.

For example, they showed high risk in itself was not a driver for their findings by demonstrating that the cost of equity changed after, not before, an increase in D&O coverage: a one-standard deviation increase in coverage was followed by an increase in the cost of equity of about seven per cent of the sampling mean.

They also addressed the “risk anticipation argument”, meaning the purchase of D&O insurance might signal private information on the part of the director or officer that there was now increased risk, and that this was the reason for a negative market reaction. While it was impossible to rule this out, several tests and a case study of Nevada pointed to D&O coverage in itself being the trigger for increased cost of equity.

Nevada made a swift change to its corporate law in 2001 that had similar effects to D&O insurance coverage on liability because D&Os were no longer liable for a breach of duty of care and were only liable for behaviours that breached the duty of loyalty and intentional fraud.

“We found the cost of equity after this law change became significantly higher for Nevada-incorporated firms than for a sample of matched non-Nevada-incorporated firms. The result could not be attributed to changes in the macro-economic conditions in Nevada. So taken together, although it is difficult to completely rule out the risk anticipation argument, the positive association between D&O insurance and the cost of equity does not appear to be entirely driven by D&Os’ private information,” they said.

Finally, the study explored the channels through which D&O insurance increased the cost of equity and found it was likely due to the resulting poorer information quality and greater risk-taking that was consistent with lower vigilance or diligence on the part of the D&Os. The risk-taking was not found to be beneficial to shareholders.

The authors acknowledge D&O liability insurance is probably here to stay given the demand from risk-averse D&O candidates, agency incentives among boards, and securities litigation. Nonetheless, “our results have an important policy implication that supports mandating the disclosure of D&O insurance,” they said.