Directors’ and Officers’ Insurance: Ordinary Corporate Expense or … · 2015-08-21 · John...
Transcript of Directors’ and Officers’ Insurance: Ordinary Corporate Expense or … · 2015-08-21 · John...
Directors’ and Officers’ Insurance: Ordinary Corporate Expense or Valuable
Signaling Device?
May 11, 2011
Christine Kang*1
Department of Economics
Stanford University
Stanford, CA 94305
Under the direction of
Professor Michael Klausner
ABSTRACT
After many years in which directors have used directors’ and officers’ (D&O) coverage to shield
themselves from personal responsibility for corporate failure, directors at Enron and WorldCom
have been forced to pay $31 million out of their own pockets to settle securities class action
lawsuits stemming from two of the largest corporate governance scandals in U.S. history. These
settlements have brought the question of director's liability to the foreground, generating interest
in the extent to which a firm’s D&O liability coverage reveals valuable information regarding its
quality of corporate governance. Since insurers are expected to perform a thorough examination
of the directors for whom insurance protection is sought, there is reason to believe that poor
governance increases litigation risk and thus the size of the insurance premium. Using a sample
of D&O premiums gathered from the proxy statements of firms cross-listed in the U.S. and
Canada, I find a significant negative relationship between D&O premiums and variables that
proxy for the quality of firms’ governance structures. This association is robust to a number of
alternate specifications. As further evidence that the D&O premium reflects the quality of a
firm’s corporate governance, the proxies for weak governance are positively related to excess
CEO compensation. Overall, these results suggest that the D&O premium can be a useful
measure of the quality of a firm’s governance.
Keywords: corporate governance, D&O insurance, premium, litigation risk
*I would like to thank Professor Klausner for his guidance, support, and encouragement through
every step of the research and writing process. Without his help, the task of writing a thesis
would have seemed immensely difficult. I am grateful to Professor Geoffrey Rothwell, Professor
John Shoven, and Nipun Kant for their continuous advice and helpful discussions since the early
stages. Alex Gould was also instrumental in motivating my interest in this topic. Finally, I would
like to thank my family and friends for their intellectual and emotional support, which have
rendered this a rewarding process.
May 2011 Kang 2
CONTENTS
1 Introduction 3
2 Primer on D&O Insurance 9
2.1 D&O Policy Coverage. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
2.2 D&O Insurance and Shareholder Litigation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
2.3 Market for D&O Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
2.4 What Matters in D&O Underwriting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
3 Literature Review 20
4 The Model 28
5 Empirical Model 32
6 Data 38
6.1 Proxies for Governance Structure Quality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
6.2 Proxies for Business Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
7 Results 45
7.1 Analysis of the Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
7.2 Sensitivity Tests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
7.3 Direct and Indirect Effects of Governance Structure Quality . . . . . . . . . . . . . . . . . . . . 54
7.4 Confirmatory Analysis Using Excess CEO Compensation . . . . . . . . . . . . . . . . . . . . . . 56
7.5 Secondary Analysis Using Audit Committee and Finance Variables . . . . . . . . . . . . . . 58
8 Conclusion 66
9 Appendix 71
References 87
May 2011 Kang 3
1. INTRODUCTION
“What you’re really underwriting when you underwrite D&O is you’re underwriting the people. You’re
underwriting the senior management, the quality of the management team.”
― D&O broker, Baker and Griffith (2007)
As representatives of the corporation, directors and officers are liable for the
corporation’s actions. More importantly, the directors and officers are personally responsible for
those actions, and accordingly their personal assets are at risk in the event of a lawsuit against the
corporation and its management. Following the recent loss of confidence in corporate
governance resulting from the debacle of corporate giants like Enron, Worldcom, Adelphia, and
Anderson, corporate managers are facing greater risk of lawsuits originating from angry
shareholders who feel they were kept in the dark regarding the company's operations. These
lawsuits are not only reserved for large, high-profile companies. According to a 2002 survey by
insurance consulting firm Tillinghast-Towers Perrin, 19% of firms had at least one lawsuit
brought against their directors in the previous ten years (Tillinghast 2002). One way for a
corporate director to protect his personal wealth in the event of a lawsuit is to have the
corporation buy insurance on his behalf. This insurance is known as Directors’ and Officers’
(D&O) insurance.
In recent years, D&O insurance has become a core component of corporate insurance.
Given that it has become a commonplace of the financial world that disappointed investors will
charge corporations and their directors and officers with securities fraud when a company’s stock
drops significantly in price, it is not surprising that as many as 95% of Fortune 500 companies
maintain directors’ and officers’ liability insurance (Gische 2000). Walter Wriston, former chief
May 2011 Kang 4
executive of Citicorp and director of nine companies highlights the importance of D&O
insurance to board members when he asserts, ―I don’t know of anybody who would join a board
without [liability] insurance‖ (Boyer 2003). Wriston so claims because directors and officers can
be held personally liable for corporate missteps. For instance, shareholders can sue managers for
violating their fiduciary duty to the shareholders. The most common reason that shareholders sue
is related to corporate disclosure, though there are a host of other reasons, such as derivatives
suits, for which shareholders will take action. Without D&O insurance, directors and officers put
their personal assets, which are often substantial, at risk when they agree to serve. In order to
attract and retain capable and skilled directors and officers, then, D&O insurance has become a
practical necessity in today’s litigious corporate environment.
In terms of coverage, D&O insurance covers the financial loss of managers from
settlements, judgments, and defense costs in the case of lawsuits. There are typically three parts
to a D&O policy. Part A refers to personal liability and pays the non-indemnifiable expenses
directly to the directors and officers, given that they have acted in good faith. Parts B and C refer
to corporate liability. Part B reimburses the corporation for the expenses they pay on behalf of
directors and officers, and Part C, entity coverage, provides the corporation itself insurance in the
case of lawsuits.
It is important to note that the insurance company only indemnifies the corporation and
manager if the manager acted in good faith on behalf of the company. The purpose of D&O
insurance is to protect the innocent director who is held liable for undesirable business
occurrences beyond his immediate control. Fraudulent actions are thus not covered. In fact, this
issue is presently very sensitive with insurers, since some have alleged such fraud in regards to
the managers of Enron and other recent scandals. In the case of Worldcom, for instance, the
May 2011 Kang 5
insurance companies rescinded their policies. D&O insurers must consistently and accurately
decide what is covered, for what reason, and for how much on a case-by-case basis.
Yet it is precisely this case-by-case nature that makes D&O insurance a rich testing
ground for economic theories of behavior under risk and insurance contracting. D&O insurers
customize policies for each company, taking into account its specific risk characteristics.
Consequently, when placed properly, D&O policy is one of the most specialized types of
business insurance and requires a high degree of detail and special handling on the part of the
insurance broker, who acts as the insured’s consultant and adviser (Kuchta 2001). The types of
coverage required and the price vary widely and, unlike auto collision insurance, no two policies
are the same. This provides an opportunity to explore what corporate insurers perceive as risky
and how they price it. Griffith (2007) provides a comprehensive account of the detailed and
thorough process through which insurers price their policies. Only after multiple written
applications, extensive interviews with management, and detailed examination of the firm’s
financial statements, legal documentations, and litigation history, does the D&O insurer decide
whether and how to provide a firm coverage.
Griffith, among others, have suggested that because D&O insurers must correctly assess a
company’s and management’s risk to protect their bottom line, D&O insurance premiums may
be a reflection not only of a firm’s business risk but also of its quality of corporate governance.
Good governance, then, ought to lead to less litigation. The argument proceeds as follows:
corporate governance constraints are designed to control mangers, who may otherwise act
opportunistically. By preventing defections from shareholder interests that lead to lawsuits,
better corporate governance should result in less shareholder litigation (Griffith 2006). Less
May 2011 Kang 6
litigation means less likelihood that the insurer would have to pay out, and thus a lower premium
for the firm.
This theory that quality of corporate governance is negatively related to the size of D&O
premium has generated significant interest because, if true, it means the D&O premium could
provide investors a better measure of governance quality than existing alternatives. While
several governance indices have emerged to fulfill the need for governance risk assessment,
these indices are themselves criticized by academics and practitioners. As underlined in Bebchuk
and Hamdani (2009), governance indices suffer from many different methodological
shortcomings. And because some governance factors are neither adequately specified nor
publicly available, one has to wonder how much remains unknown (Baker and Griffith 2007). A
superior alternative to using ad hoc corporate governance indices would be to use the third-party
assessment made when a D&O underwriter provides liability insurance for a company’s directors
and officers. This measure of corporate governance quality would be a valuable piece of
information for investors when assessing potential investments between companies since
shareholders arguably want managers who will act in their best interests. Managerial agency
costs needlessly destroy firm value. Thus, careful monitoring of managers who act on behalf of
shareholders is necessary, especially given the asymmetric information problems generated by
the financial crisis of 2008. Should D&O insurers provide such monitoring by capturing
corporate governance quality in the premiums that they charge firms, there is reason for the SEC
to mandate public disclosure of U.S. D&O insurance policies.
While the theory underlying the relationship between corporate governance quality and
D&O premiums has generated substantial interest, it has not received much empirical attention,
especially in the U.S., where such information on D&O insurance is not publicly available. Core
May 2011 Kang 7
(2000) performed the leading study examining Canadian data to determine whether D&O
premiums can be related to corporate governance variables. Hypothesizing that D&O premiums
are a function both of business-specific risk factors and governance-related risk factors, Core
separated proxy variables relating to each. Grouping measures of ownership structure, board
independence, and management entrenchment together as indicators of ―governance quality,‖ on
the one hand, and firm size, financial performance, and U.S. exchange listing as proxies for
―business risk,‖ on the other, Core regressed each variable against D&O premiums. The D&O
premium regressions test whether there is information in the governance structure variables
incremental to the business risk control variables, and whether the coefficients on the governance
structure variables are consistent with the interpretation that weaker governance increases
litigation risk. He found five of the nine governance quality variables to be individually
statistically significant and all of them to be collectively significant and with the predicted
coefficient signs (Core 2000). Significant governance quality variables—including insider stock
ownership and voting control, director independence, and executive employment contracts
enabled Core ultimately to conclude that Canadian data supports a negative association between
D&O premiums and governance quality.
One of the variables Core found to be most significant, however, underscores the study’s
inherent limitations. If a Canadian firm is also listed on a U.S. exchange, exposing it to U.S.
securities litigation, the firm has significantly higher D&O premiums. This emphasizes the
difference between U.S. and Canadian liability risks. At least with regards to shareholder
litigation, and perhaps representative litigation generally, the legal systems between the two
countries are different enough to make cross-country comparisons somewhat tenuous. As a result,
May 2011 Kang 8
although Core’s study ultimately supports a link between corporate governance and D&O
insurance, U.S. data are needed to confirm the results.
Given the importance to investors and regulators regarding whether D&O premiums can
explain factors such as quality of corporate governance and litigation risk, this paper builds upon
Core (2000) to address this question. My paper’s contribution is three-fold. First, I test the
robustness of Core’s model using a sample of U.S. cross-listed firms and verify that the negative
relationship between governance quality and size of premium holds for firms exposed to U.S.
securities litigation. My results have potential policy implications for disclosure of information
regarding D&O insurance in the U.S. Second, my recent data allow me to explore the relative
importance of corporate governance in a ―soft‖ insurance market. Baker and Griffith (2007) find
that some questions are less substantial now than they were in a harder market when premiums
were higher and capacity was lower. I test their conclusion that D&O brokers seek to price
―culture‖ and ―character‖ by using variables such as executive compensation to proxy for these
underlying governance values. I also include variables that Bebchuk, Cohen, and Ferrell (2009)
find indicate management entrenchment and limits on shareholder power. Finally, as the
corporate governance literature is premised on Jensen and Meckling’s (1976) agency theory and
the principal-agent problem, I discuss how certain governance structures can mitigate agency
costs. I then empirically test for such a relationship. The ensuing analysis reveals that D&O
insurance can serve as a valuable signaling device of corporate governance quality, thereby
enriching the relatively small applied literature on these important issues.
The rest of the paper is organized as follows: Section 2 describes unique features of D&O
insurance. Section 3 discusses the key literature related to D&O insurance. It will look at
proposed theories of what D&O insurance decisions can tell us about a company’s corporate
May 2011 Kang 9
governance, monitoring, and vulnerability to managerial opportunism. Section 4 presents
comparative statics on an illustrative principal-agent model. Section 5 develops the hypothesis
and econometric model. Section 6 explains the data and presents descriptive statistics. Section 7
discusses the empirical results and Section 8 concludes.
2. PRIMER ON DIRECTORS’ AND OFFICERS’ INSURANCE
Navigating today’s corporate environment can be extremely difficult. While corporations
can be held liable for their behavior, they are not the only ones. Directors and officers of
companies face the possibility that, even if they diligently discharge their duties to their
stockholders, their stockholders may still sue them. Recognizing that the risk of personal liability
makes being a director or officer of a public company unattractive, most companies purchase
directors’ and officers’ (D&O) insurance to protect their representatives. In addition to
mitigating the risk of incurring personal liability, a principal purpose of this insurance is to help
companies recruit and retain good directors and officers.
In addition to protecting current directors and officers and recruiting quality new ones,
D&O insurance provides coverage when indemnification is not available. Most companies have
indemnification policies in which they agree to protect directors and officers who act in good
faith. However, certain claims by law may not be indemnified, such as shareholder derivative
suits in which shareholders sue directors and officers on behalf of the firm (Core 2000). The firm
might also be willing but financially unable to provide monetary protection, such as in the case
of bankruptcy. A secondary purpose, then, of D&O insurance is to protect directors and officers
when indemnification is not possible.
May 2011 Kang 10
Understanding the general structure of D&O insurance, in addition to its purpose, will
help inform the model relating D&O premiums to corporate governance quality. Thus, in the
follow sections, I discuss D&O insurance as follows: First, I explain the key elements of D&O
coverage. Second, I examine the preponderance of D&O claims triggered by shareholder
litigation. Next, I discuss the market for D&O insurance and then conclude with an explanation
of the D&O underwriting process.
2.1 D&O Policy Coverage
As previously mentioned, a typical D&O policy sold to a publicly traded corporation
contains three different types of coverage, known as Side A, B, and C. ―Side A‖ coverage
protects individual managers from the risk of shareholder litigation and is what most non-
specialists think of as D&O insurance. However, D&O policies also contain two other, less
widely known types of coverage. The second type, known within the industry as ―Side B‖
coverage, reimburses the corporation for indemnification payments to officers and directors. And
the third type, ―Side C‖ coverage, protects the corporation itself from shareholder litigation in the
case in which the corporate entity itself is sued.
All D&O policies have the effect of shifting the risk of shareholder litigation from
individual directors and officers and their corporations to a third-party insurer, such as Chubb or
AIG. When shareholders sue their officers or directors, the insurer almost always pays (Black,
Cheffins, and Klausner, 2006). Covered losses include legal fees incurred in defense of claims,
compensatory damages, and settlement amounts, which are substantial, though admittedly
skewed due to a handful of very large and high-profile settlements. The average settlement value
for the years 2002-2005 was $22.3 million, significantly higher than the average settlement value
May 2011 Kang 11
of $13.3 million for the years 1996-2001 (Baker and Griffith 2007). Given these large figures, it
is not surprising that D&O insurance has become a practical necessity for public firms since its
rise in popularity in the mid-1960s.
2.2 D&O Insurance and Shareholder Litigation
Directors and officers most often seek protection against shareholder claims. Thus, most
economists estimate litigation risk using shareholder litigation risk. According to Tillinghast-
Towers Perrin’s (2003) Directors and Officers Liability Survey, about one-half of D&O
insurance claims against public companies in Canada and the U.S. are brought by shareholders.
The remainder is filed by other stakeholders of the company, such as employees and customers,
or even competitors and government regulatory agencies. A myriad of reasons may trigger
lawsuits: illegal acts, violations of security laws, self-dealing, imprudent or negligent
management, bankruptcy, executive compensation, and violations of fiduciary duty to
shareholders (Boubakri and Galleb 2008). Of these reasons, the most common is inadequate
corporate disclosure; other frequent reasons are shareholder suits related to stock or public
offerings and unnecessary takeover defenses in the face of a merger or acquisition. While the
possible grounds for complaints are many, the basic concern underlying these types of claims is a
divergence between managerial conduct and shareholder welfare—the problem, in other words,
of agency costs (Baker and Griffith 2007). Whether the claim is that managers looted the
company or negligently managed it or lied to investors in order to inflate their own compensation
packages, the basic concern is that management has sought to serve its own interests rather than
the interests of its investors.
However, apart from shareholder suits, directors and boards foresee new risks for
triggering a company’s D&O coverage in the year ahead. New compensation disclosure rules
May 2011 Kang 12
and recent high profile exit packages may lead to increased litigation in the area of executive
compensation and severance packages (Directors 2010). With the increasing importance attached
to corporate social responsibility, directors’ due diligence on environmental issues is another
potential source of litigation. More broadly, new risks could be embedded in any changes made
in Congress or in the enforcement mentality of the Department of Justice and other enforcement
agencies on insider trading, salary disclosure, and the failure to report suspicious activity
centering on Currency Transaction Reports and Suspicious Activity Reports (Directors and
Boards 2007). So while the usual suspects—activist shareholders and M&A activity—continue
to create opportunities for a claim, directors and officers are always vulnerable to new
accusations of wrongdoing.
2.3 The Market for D&O Insurance
The D&O insurance market has three key participants: corporate buyers, insurance
brokers, and insurance company sellers. The corporate buyers are typically the ―risk management‖
officers of companies. They purchase D&O policies from specialized insurance brokers, expert
intermediaries who facilitate the transaction and act as the insured’s consultants and advisers.
After having carefully accessed all relevant financial and business risks associated with the
applying company, these brokers negotiate with insurance companies on behalf of the insured.
Attributes of the sale of D&O coverage relevant to my study are discreteness of limits
and correlation of limits with market size. Insurance brokers sell coverage limits by layers of
$1,000,000, although the most important steps are $5,000,000 (Boyer 2004). This step-wise
characteristic of the D&O insurance limit is known as ―sticky points‖ and becomes relevant
when trying to precisely measure the amount of coverage demanded by corporations.
May 2011 Kang 13
Moreover, the amount of D&O insurance corporate buyers purchase correlates with their
company’s market capitalization. According to Tillinghast, in 2005, small-cap companies with
market capitalizations between $400 million and $1 billion purchased an average of $28.25
million in D&O coverage limits compared to large-cap companies with market capitalizations in
excess of $10 billion, who purchased an average of $157.69 million in D&O coverage
(Tillinghast Towers Perrin 2005). The positive correlation between size and coverage makes
sense since the largest companies are more likely to attract lawsuits—not only are they more
visible in the press but also they offer higher potential payoffs for plaintiffs’ lawyers. D&O
brokers assemble towers of coverage for their clients according to these two principles.
On the opposite spectrum from the buyers and brokers are the insurance company sellers,
or carriers, that actually provide the coverage and cover expenses in the case of litigation. D&O
liability insurers are what Baker and Griffith (2007) call the ―financiers of shareholder litigation
in the American legal system,‖ paying on behalf of the corporation and its directors and officers
when shareholders sue. Chubb supplies the majority of D&O coverage in Canada while Chubb
and AIG together dominate the U.S. market. While these two market leaders hold approximately
50% market share in premium terms, the U.S. D&O insurance market is becoming increasing
competitive, with 53 suppliers offering policyholders expanded options (Green 2010).
Soft pricing has been driven mostly by new insurers entering the D&O liability market
during the past two years, many sparked by revelations last fall of financial troubles at American
International Group Inc., XL Capital Ltd., and Hartford Financial Services Group Inc. The three
companies fared better than some had anticipated, though, leaving more insurers than ever
offering D&O liability coverage. Increased supply has consequently driven down rates (Phillips
1). This is a classic illustration of the cyclicality of insurance underwriting—―hard markets‖ in
May 2011 Kang 14
which underwriters become more selective and less willing to offer high limits are followed by
―soft markets‖ in which underwriters loosen standards in an attempt to salvage profits. While the
recent shift in the D&O market to the ―soft‖ phase is good news for companies seeking insurance,
it signals tighter profit margins for D&O liability underwriters.
2.4 What Matters in D&O Underwriting
Underwriting is the process that insurers use to decide whether or not to offer coverage to
prospective insureds, and if so, at what amounts and at what price. Since the process of
underwriting D&O insurance is considered highly personal (as compared to fire insurance, for
example), legal scholars and economists have taken steps to determine the key criteria that
determine pricing. Professors Tom Baker of the University of Connecticut and Sean Griffith of
Fordham have reported on their empirical effort to understand what makes D&O underwriters
comfortable and influences their pricing decisions. They conducted detailed interviews with over
forty well-respected D&O professionals between 2004 and 2006 and uncovered two ―pillars‖ of
D&O underwriting: one, the financial health of the company and, two, the quality of that
company’s governance. Using this framework, the authors analyzed responses to the following
questions, which directly pertain to my study: What information do underwriters ask for during
this process? What information do they value most? And finally, what do they believe best
predicts shareholder litigation risk?
a. Financial Analysis
According to their survey study, underwriters believe they can ―out-select‖ their peers.
To do so, underwriters first look to financial and objective data: information from public filings,
private databases or analysis services, claims history, company knowledge of pending litigation,
May 2011 Kang 15
and especially any intent to acquire other companies or issue securities. Underwriters and
investors, however, analyze risk in fundamentally different ways. Baker and Griffith explain:
Insurers, unlike investors, do not look favorably upon high-growth companies. Insurers
focus more on downside risk because they have a fixed return (the policy premium) that
is modest in relation to their exposure to loss (the policy limits), while equity investors
have a fixed exposure to loss (their initial investment) and a potentially unlimited upside
(their share of the business’s growth). (30)
In other words, when assessing the risk a company brings to the table and pricing policies,
insurers prefer the stability of mature companies to the volatility of new ones. Insurers demand
higher premiums from riskier companies. For instance, Tony Galban, senior vice president and
underwriting manager for directors’ and officers’ liability insurance at Chubb, states that a start-
up company with nebulous business plans is likely to face closer scrutiny from D&O
underwriters and pay $10,000 annually for $2 million in D&O coverage (Directors 2010). This
substantial payment is necessary to compensate D&O insurers for the increased likelihood of
litigation from company failure and stock volatility. Thus, a company’s growth stage is an
important input into underwriters’ assessment of litigation risk.
Equally important to insurers is a company’s market capitalization, which signals the
potential magnitude of payout. Paul Rauner, president of Chicago Risk Services, an insurance
brokerage in the Midwest, explains that small, established private companies are considered low-
risk by underwriters and could pay as little as $500 per million in annual premiums. Large public
companies, on the other hand, are typically considered high-risk and pay anywhere from $10,000
to $30,000 per million in annual premiums (Directors 1). The reason for this discrepancy is that
underwriters use market capitalization as a gauge of both litigation frequency and severity.
May 2011 Kang 16
Larger companies are sued more often and for greater amounts so therefore must pay higher
premiums.
In addition to considering a potential insured’s market capitalization, insurers note the
company’s industry affiliation. Insurers associate industry with litigation frequency—some
industries are sued more often than others. While the industries sued most often fluctuate
somewhat from year to year, in 2005, the three industrial sectors receiving the most securities
class action filings were consumer noncyclical, consumer cyclical, and financials. The year
before, however, the top three industries in terms of filings were consumer noncyclical,
technology, and communications (Cornerstone Research 2006). Despite the ever-shifting
categorizations of highest-risk industries, these findings point to which industries D&O
underwriters classify as high-risk.
b. Governance Factors
While business intelligence informs the basic modeling of policy premiums, Baker and
Griffith argue that corporate culture and governance practices differentiate one risk from another
and, in turn, determine underwriters’ willingness to negotiate. But before further discussion, I
pause to define corporate governance, a ubiquitous but nebulous term. Some, such as Shleifer
and Vishny (1997) define corporate governance as the ways in which suppliers of finance to
corporations assure themselves of getting a return on their investment. This paper, however,
takes a broader view on these issues and subscribes to Gillan and Starks’ (1998) view of
corporate governance as the system of laws, rules, and factors that control operations at a
company. Irrespective of the particular definition used, corporate governance is an important
component of the insurer’s pricing equation, because without taking this into account, insurers
would be unable to differentiate between firms with otherwise identical business characteristics.
May 2011 Kang 17
Economists agree that corporate governance enters into the insurer’s pricing matrix
because insurers stake their own capital on their risk assessments and therefore have optimal
incentive to carefully analyze governance risk. Other third-party evaluators of corporate
governance, such as equity analysts, Institutional Shareholder Services (ISS), and ratings
agencies, including Moody’s and Standard & Poor’s, operate on a fee-for-services model and
therefore do not suffer when a rating is incorrect (Baker and Griffith 2007). D&O insurers, on
the other hand, stake their own capital on their governance assessments and suffer directly from
any error in evaluating risk.
In addition, Baker and Griffith point out that, unlike mutual funds, pension funds, and
other diversified equity investors, insurance companies cannot eliminate the nonsystemic risk of
firm-specific governance. Mutual funds are able to eliminate nonsystemic risk by building
diversified portfolios, but insurance underwriting occurs in a competitive market in which not
every insurer receives a portion of every risk. This means that each insurer’s portfolio is different,
with insurers that are skilled at distinguishing good and bad risks predictably building better
portfolios than those who are not. Since institutional equity investors can diversify away this
type of risk, they have less incentive to develop expertise in distinguishing good and bad risks.
Similarly, bondholders can control their downside risk by a system of priority and security
interest. In contrast, insurers have no such mechanisms to protect against faulty risk assessments.
Given this particular structure of incentives, one expects insurers to develop expertise in
distinguishing good and bad governance risks and to build these assessments into their pricing
models for D&O insurance.
However, financial motivation is in itself insufficient to claim that D&O insurers can
accurately price policies. But insurers have an added advantage: they can assess the prospective
May 2011 Kang 18
insured’s corporate governance on the basis of information beyond that which is publicly
available in the company’s securities filings or other public documents. The first piece of
nonpublic information that insurers possess comes in the form of a written application and
questionnaire that prospective clients submit for initial review. The application requests
information directly related to the quality of a firm’s corporate governance. For instance,
questions pertain to earnings management and related-party transactions because these actions
frequently trigger securities litigation and derivatives lawsuits. The application also asks for the
board’s takeover planning, which can indicate entrenchment and the possibility that shareholder
suits will result from acquisition-related activity.
Perhaps most importantly, underwriters interview management, during which they delve
into deeper ―governance issues‖ than the board’s structure and upcoming plans. Baker and
Griffith (2007) report that, in these meetings, underwriters are keen to know how company
policy determines incentives for executive action, such as executive compensation formulas, the
strength of internal controls, and the compliance culture, especially the vigor of insider-trading
prohibition. Baker and Griffith’s study further reveals that underwriters consider process and
controls when contemplating business acquisitions just as important as the M&A activity itself.
If dissatisfied with corporate officials’ responses in these interviews, underwriters can request
sensitive information or confidential documents to enable the underwriters to complete their
evaluation. Such disclosures are typically made pursuant to non-disclosure agreements (NDAs).
Since the insurer is not an equity analyst or rating agency, the company has no obligation to
disclose the information to the market. Because underwriters can commit to confidentiality, they
can base their pricing on non-public information not already reflected in a company’s share price.
May 2011 Kang 19
Essentially, it is possible that the D&O underwriting process successfully delves into both
conventional and ―deep governance‖ issues and incorporates this information into the premium.
c. Summary and significance
As economists and legal scholars have pointed out, insurance companies that write D&O
insurance will presumably use all available information as to a company's financial condition and
the efficiency of its governance procedures. Baker and Griffith’s paper offers insight into how
D&O underwriting works and what type of information is embedded in the premium. Rather
than simply reflecting the business risk of a firm, such as the size and industry in which it
operates, the premium should reveal underwriters’ subjective assessment of governance and
internal controls. The underwriters’ detailed inquiries include questions of ethics, morality, and
humility in both personal conduct and in conduct of the business. Arrogance and excessive risk
taking are markers for bad risks. (Even the number of speeding tickets by the CEO was taken to
be an indicator of D&O risk.) Overcommitment to growth, excessive risk taking, and aggressive
earnings-per-shares targets may create a culture where individuals may be tempted to act
opportunistically at the expense of shareholders.
After collecting a comprehensive set of public information and non-public information,
insurers enter their assessment of the firm’s risk into a ratemaking matrix (Baker and Griffith
2007). As this matrix yields only a premium given the amount of coverage demanded, we would
like to know if governance quality is embedded in the premium. Or, as Boyer (2004) puts it to
financial economists, would it be possible to design a profitable investment strategy based on the
D&O information contained in management proxies? Many would agree that D&O insurance
information is a better signal than the CEO's age and could be construed as part of the
compensation package of the directors and officers of the corporation. With detailed information
May 2011 Kang 20
available regarding the compensation of top executives and the structure of the board, it appears
almost paradoxical that information as easy to present as the D&O insurance policy limit,
deductible and premium, and so informative as to the governance health of a firm does not find
its way to U.S. proxy statements. A major goal of this study is to determine whether empirical
evidence supports this call for public disclosure.
3. LITERATURE REVIEW
In this section, I discuss the three main hypotheses surrounding D&O insurance: the
relationship between D&O premiums and corporate governance, the determinants of D&O
insurance demand, and the presence of moral hazard in insured firms. I also briefly discuss
agency theory, which forms the basis of any study on corporate governance.
The empirical literature on D&O insurance is relatively recent, as the majority of studies
occurred within the past decade. While economists increasingly conduct studies with newer data
and data from different countries, few have studied issues unique to D&O insurance. This is
mainly due to the lack of public information prior to 1990. The Cadbury report in the United
Kingdom and the Dey report in Canada changed that by mandating their respective securities
commissions to make available information on the risks publicly traded corporations face and the
tools they use to manage those risks. Following the 1992 Dey Report, disclosure of basic
information regarding D&O insurance (i.e. policy limit, premium and deductible) in firms’
financial statements became the norm in Canada. This allowed a handful of academics to analyze
the determinants of the purchase of D&O insurance, as well as the factors affecting premiums.
Core (1997) conducted the pioneer study, using publicly available Canadian data on 222
firms whose fiscal year ended in 1994 to test for the main determinants of the D&O insurance
policy limit and deductible. Perhaps unsurprisingly, he found that litigation risk and the cost of
May 2011 Kang 21
financial distress are the main determinants related to D&O purchase decisions. In his 2000
study, however, Core posed a more interesting question: if insurers can price litigation risk, and
corporate governance is a component of litigation risk, does this mean that insurers can
accurately assess the quality of corporate governance? Using variables that proxy for quality of
corporate governance, Core (2000) conducted a F-test and found the corporate governance
variables to be statistically significant determinants of the premium, even after controlling for
business risk, such as firm size, financial performance, and U.S. exchange listing. The combined
evidence that all the coefficients had the predicted signs, that five of nine proxy variables were
individually significant, and that the corporate governance proxy variables were collectively
significant led Core to conclude that the information contained in the D&O premium is a useful
summary measure of the quality of a firm’s governance. His study verified his hypothesis: D&O
premiums are higher for firms with weaker governance structures.
This result has important implications. In a world in which we do not have reliable
measures of corporate governance quality, Core’s (2000) findings suggest that capital market
participants might consider using D&O insurance premiums as indicators of governance quality.
Griffith (2006) argues that the type of insurance package purchased by a particular firm may
convey information concerning the firm’s likely motives in purchasing it and, by extension,
provide some gauge of the extent of agency costs within the organization. Furthermore, should
insurers successfully separate good governance risks from the bad, the price of a firm’s D&O
policy represents the insurer’s assessment of the quality of the firm’s corporate governance.
Equipped with this information, investors may adjust their reservation values, thereby creating a
discount on the share price of firms whose D&O policies reveal high agency costs or low-quality
corporate governance. This discount might even incentivize firms to improve their corporate
May 2011 Kang 22
governance (Griffith 2006). The essence of the argument for disclosure, then, is that the
information contained in D&O policies is potentially valuable for investors and can even
encourage better governance practices within firms.
One of the variables Core found to be most significant, however, underscores the study’s
inherent limitations. If a Canadian firm is also listed on a U.S. exchange, exposing it to U.S.
securities litigation, the firm has significantly higher D&O premiums. This emphasizes the
difference between U.S. and Canadian liability risks. Litigation is so common in the U.S that
some firms consider it a normal business expense, in contrast to the Canadian market where
litigation is less common (Kaltchev 2004). The Canadian legal system is less conducive to
nuisance suits over stock price declines because it is less favorable to entrepreneurial plaintiffs’
lawyers (Baker and Griffith 2007). These cross-border differences suggest that, while Core’s
study supports a link between corporate governance and D&O insurance, ultimately data from
my study are needed to confirm the result.
One reason why D&O insurance has not been studied more empirically in the U.S. is that
D&O insurance data are not publicly available. As a result, most past studies rely on U.K. and
Canadian data. So far, the existing D&O insurance studies focus primarily on the demand for
insurance. After Core (1997) showed that litigation and distress risks are the major determinants
of D&O insurance purchases in Canada, O’Sullivan (2002) investigated the determinants of
D&O insurance demand in the U.K. He used probit analysis and found that insured companies
are larger and are more exposed to U.S. litigation. Insured companies also experience greater
share price variability, exhibit lower levels of managerial ownership, and possess greater non-
executive representation on their boards than their uninsured counterparts. O’Sullivan
May 2011 Kang 23
contributed to the literature by uncovering U.K. firms’ revealed preferences in purchasing D&O
insurance and by providing a detailed profile of the types of companies who buy D&O insurance.
Also seeking to understand which factors explain the corporate demand for insurance,
Boyer (2003) used a recent sample of 318 Canadian firms, regressing the demand for D&O
insurance on corporation size, return characteristics, credit worthiness, litigation environment,
and corporate governance. He found none of these to be determinants of the demand for D&O
insurance. Even corporate governance, which Tufano (1996) found to be an important
determinant, played no role. The most important factor that determined the amount of D&O
insurance coverage purchased was last year’s purchase. Boyer (2003) interpreted this as evidence
of managerial habit; that is, managers make an optimal decision this period before waiting to see
future results. Since results may take years to materialize, in the interim, they make the same
D&O purchase decisions. This ―persistence‖ theory is Boyer’s (2003) most notable contribution
to the literature on Canadian D&O insurance.
While Boyer (2003) interprets the significance of the lagged limit as solid evidence that
habit is the main driver of D&O insurance demand, other authors take issue with that. They
argue that its significance may mean that the risk exposure of companies may remain unchanged
from year to year, explaining why companies purchase the same limit year after year. Habit
would not be the true reason in this case. To resolve this debate, Kaltchev (2008) used
proprietary U.S. panel data from 1997-2003, consisting of 113 public companies. Kaltchev found
support for Boyer (2003) by verifying the significance of the lagged limit. However, the result
that inertia plays an important role in the structure of the D&O insurance policy is not as
important in Kaltchev’s study as in Boyer’s. In analyzing Kaltchev’s results, Boyer (2003)
attributed the difference in results to four factors. First, U.S. corporations do not behave in the
May 2011 Kang 24
same way as Canadian corporations do. Second, Kaltchev uses information from a unique
insurance broker whereas he uses publicly available information. Third, the period under study is
different, as Kaltchev (2008) uses more recent data. Finally, Boyer’s data includes a wider range
of years, which allows him to better test the organizational inertia hypothesis. No matter whose
results are more robust, the persistence theory has important implications for my study. By
positing that firms’ D&O insurance decisions are explained not by corporate governance or
likelihood of financial distress but by mere inertia, it raises the question of how much D&O
insurance can really reveal about corporate governance.
My study contributes to the literature by using recent data and testing Core’s (2000)
model on a sample of firms cross-listed on the Toronto Stock Exchange and a U.S. stock
exchange. Like Core (2000), I study the relationship between D&O premiums and corporate
governance. In doing so, I adopt a view on corporate governance consistent with a
straightforward agency perspective. The agency problem is an important element of the
contractual view of the firm, developed by Coase (1937), Jensen and Meckling (1976), and Fama
and Jensen (1983). The essence of the agency problem is the separation of ownership and
control—shareholders, the owners of the firm, find it difficult to ensure that the managers, who
act as their agents, do not expropriate or waste their funds on unattractive projects.
One theoretical framework often used in the corporate governance debate to address
agency problems is principal-agent theory. Unlike neoclassical theory, which assumes that effort
choices and costs are observable, principal-agent theory supposes that some costs are private
information. In a typical principal-agent problem, an owner hires a manager to run his firm for
him. The firms’ performance, represented by gross profit, Π, depends on the manager’s effort e
and also a chance variable ε, determined after e is chosen:
May 2011 Kang 25
Π = ƒ(e, ε)
The model assumes that the manager’s effort choice is observed only by him. Thus, for a
contract in which the manager’s compensation is I, a direct function of e cannot be enforced
(Hart 1995). The optimal contract is second-best in that the manager’s compensation must be
based on realized profit, Π: I = I (Π), rather than effort e.
Principal-agent theory is useful for explaining why managers are often given
performance-related pay in the form of shares or stock options. By making I sensitive to Π,
incentive contracts motivate managers to act in the interest of the owners. However, Hart (1995)
argues that the theory itself does not provide a role for governance structure. The reason is that,
despite being second-best in the sense that I depends on Π as opposed to e, optimal principal-
agent contracts are comprehensive. A contract specifies all parties’ obligations in all future states
of the world whereas governance structure exists to provide a way to decide on future actions not
specified in an initial contract.
Nonetheless, principal-agent theory has been applied to D&O insurance by construing
D&O insurance to be part of the directors’ and officers’ compensation package. Maria Gutierrez
(2003) presents a model in which D&O insurance is used as a commitment device for
stockholders to monitor the behavior of corporate directors. The paper follows in the steps of
Sarath (1991) but innovates by having an uniformed principal purchase insurance on behalf of an
informed agent because the insurer cannot observe ex post the agent’s true effort. While
Gutierrez presents a detailed game-theoretic model of the optimal contract between managers
and shareholders, her model has limited empirical applications. Thus, in Section 5, I develop a
testable model based on the broader agency cost theory to study the relationship between D&O
premiums and corporate governance.
May 2011 Kang 26
Although I primarily focus on testing whether D&O insurance premiums reflect
corporate governance quality, an important part of the literature focuses on the theory of
managerial opportunism. Managerial opportunism, as defined by Chalmers, Dann, and Harford
(2002) is the use of superior information by rational managers to sell shares when the public
valuation of the company’s shares exceeds management’s valuation estimate. The idea of
corporate insiders taking advantage of external shareholders has often been studied in the context
of insider trades, as evidenced by Seyhun (1986), Lee (1997), and Kahle (2000). However,
Chalmers, Dann, and Harford (2002) creatively examine the hypothesis of managerial
opportunism from the context of directors’ and officers’ liability insurance. According to their
hypothesis, the amount of D&O insurance bought by an IPO firm is inversely related to the
firm’s ex post stock price performance. That indicates that managers use their superior
information to assess the probability of exposure to legal liability. The authors use similar
characteristics as in Core (2000) to find factors normally influencing D&O insurance demand.
They run cross-sectional regressions of D&O purchase amount to IPO size, leverage, average
revenue, standard deviation of these revenues, average operating income, standard deviation of
the operating income, age of the firm, percentage of outside directors, among others. The
variable of interest, long-run stock performance, appears to be negatively related to the amount
of insurance purchased (Chalmers, Dann, and Harford 2002). The relationship holds for each of
raw returns, book-to-market, and size-adjusted returns. They interpret these results to be
consistent with the managerial opportunism hypothesis, provided we treat the three-year future
returns as a proxy for managers’ private information.
Chalmers, Dann, and Harford’s (2002) paper draws on previous work by Bhagat,
Brickley, and Coles (1987), Holderness (1990), and Core (1997, 2000). It fits squarely among
May 2011 Kang 27
the subset of literature studying the effects of D&O insurance purchase decisions on shareholder
wealth. Many opponents of D&O insurance believe that shielding managers from personal
liability creates a moral hazard problem and increases the likelihood that they will violate their
duty of loyalty. Chalmers, Dann, and Harford’s (2002) results certainly justify these concerns.
In response to Chalmers, Dann, and Harford’s (2002) argument that mandatory disclosure
of D&O insurance details limits potential opportunism, Boubakri and Ghalleb (2008) recently
tested the managerial opportunism hypothesis in a new context: the purchase of D&O insurance
around the time when Canadian firms are getting ready to proceed with their seasoned equity
offerings (SEOs).The authors claim that the Canadian context is interesting mainly because the
reporting of D&O insurance details is mandatory. They examine whether informed managers
modify their behavior regarding the purchase of D&O insurance when their firm are about to sell
SEOs. After controlling for other cross-sectional determinants of D&O insurance coverage, they
find a significant negative relation between the amount of D&O insurance purchased and
subsequent firm performance. This result is surprising because the imposition of a public
disclosure is supposed to make the D&O insurance purchases a useless tool for extracting private
benefits from private information. This result is also perplexing because one would presume that
incentives and opportunities to act opportunistically are more limited for SEOs than for IPOs.
Thus, any evidence of predictable post-issue returns for SEO issuers based on available D&O
insurance information poses an even stronger challenge to the efficient markets theory than the
evidence on IPOs (Boubakri and Ghalleb 2008). Using univariate tests, they document that
managers do significantly change their D&O insurance purchase around the equity offering dates.
This suggests that managers time their purchase of insurance to coincide with their equity-
offering surge. This makes sense only when there is opportunistic behavior. The major
May 2011 Kang 28
implication of this study is that the imposition of a mandatory reporting may not alleviate the
opportunistic behavior of managers through the purchase of D&O insurance despite economic
theory to the contrary.
Overall, the D&O insurance literature mostly revolves around these central ideas: the
corporate governance hypothesis proposed by Core (2000), the corporate inertia hypothesis
introduced by Boyer (2003), and the managerial opportunism hypothesis presented by Chalmers,
Dann, and Harford (2002). The existing D&O insurance studies focus primarily on the demand
of insurance. Few studies focus on D&O insurance premiums and whether the insurance
premium is sensitive to firms’ corporate governance practices, which is the subject of my study.
Select studies use data from the U.K., China, and Taiwan to test various hypotheses, though
those results are not directly comparable to the U.S. There is much more to be studied in regards
to the U.S., especially because the only two other U.S. studies, Kaltchev (2008) and Chalmers,
Dann, and Harford (2002), use small data sets in concentrated time periods. The inability to
seamlessly apply foreign results to the U.S. means that we can greatly benefit from a careful
study of whether D&O insurers translate their assessment of governance risk into the premium.
Should this be the case, there is considerable motivation to argue that the disclosure of details
regarding D&O insurance decisions, as is required by some countries, is valuable.
4. THE MODEL
This section presents a basic principal-agent model that is used to derive predictions as to
how the parameters of the D&O insurance premium change with various exogenous influences.
The basic model of Garen (1994) is utilized, with adaptations for the case at hand. Garen’s model
is used to study the CEO’s relative performance pay. In this paper, however, I construe D&O
May 2011 Kang 29
insurance to be part of the salary portion of the CEO’s compensation package as Boyer (2003)
does. This allows me to compute comparative statics for how the D&O premium should change
with variables, such as market capitalization and volatility.
In this model, the CEO is the risk averse agent. Stockholders are the principals. It is
assumed that stockholders hold a diversified portfolio and thus are subject only to the firm’s
systematic risk.
Let the CEO’s utility function be given by2
, ( )-
where Y is CEO income, µ is CEO effort, ρ is the coefficient of absolute risk aversion, and .5kµ2
is the cost of effort.3 The CEO’s income is modeled as a linear function of the firm’s net revenue,
R, as .
The firm’s rate of return is defined as net revenue over market capitalization. It is given
by ⁄ , where V is market capitalization and represents unobserved, random
influences on the firm’s return. Assume that is normally distributed with mean zero and
variance . It follows that the net revenue of the firm is .
I assume that each CEO allocates part of his salary to the risk-free asset, which earns
and part to the market portfolio, which earns . Given this setup and substituting in the
expression for R, CEO income is:
( ) ( )
where and is the random part of the market return assumed to be
normally distributed with mean zero and variance .
2 This specific functional form is adopted to ease the derivation of comparative statics.
3 In this model, k is equal to the ratio of incentive pay to effort over the elasticity of effort with respect to b1,
following Jensen and Murphy (1990).
May 2011 Kang 30
Given the discussion above, expected utility can be written as
( ) * [ ( )
]+
where
,
and is the covariance of the firm and the market return. The CEO maximizes expected utility
subject to effort and the portfolio mix, M.
Owners of the firm are assumed to be diversified stockholders. The capital asset pricing
model implies that the minimum return necessary to attract investors is , where is
the covariance of market and shareholder returns and q is ( )
Shareholders seek to maximize
expected returns net of the required return, .
Since we defined as the return to stockholders, its expectation is given by
( ) ,( ) - . The covariance of the market and stockholder returns is
( ) Since shareholders maximize expected returns net of ( ) , they
wish to choose to maximize
( )
( )
subject to the constraint that the CEO acts to maximize expected utility.
The solution for is given by
( )
Recall that is the pay performance sensitivity. An increase in the variance of the firm’s
return lowers . An increase in the firm’s market capitalization also tends to lower . These
May 2011 Kang 31
two effects reinforce one another, since variance enters into CEO income as a multiple of and
Consider now the effects of the exogenous variables on the salary portion of executive
compensation, of which the D&O insurance premium is a component. This is given by . It
must be set to meet the CEO’s reservation utility constraint. Therefore, differentiating with
respect to the exogenous variables yields the desired expressions. They are
and
(
)
where
is the slope of the CEO’s indifference curve between and . Because
< 0,
the D&O premium rises with as long as the CEO’s indifference curve slopes downward. A
similar result holds for total market capitalization, V.
Garen (1994) notes that the general intuition for these findings is as expected from
principal-agent theory. The specific breakdown of executive pay involves a trade-off between
incentives and insurance. As the output the agent produces becomes inherently riskier (volatility
increases), the insurance component of pay is increased and the incentive component is reduced.
Although the model is defined for CEO compensation because that data is readily available, the
predictions of the model apply to director and executive compensation in general. Specifically,
as is discussed in Section 7, Analysis of Results, market capitalization and volatility do indeed
significantly and positively affect the D&O premium.
May 2011 Kang 32
5. EMPIRICAL MODEL\
This paper determines whether D&O insurers value corporate governance risk by testing
whether variables that proxy for corporate governance can explain the D&O insurance premium.
The underlying premise is that D&O insurers price litigation risk, which has two components:
business risk and governance structure quality. Business risk refers to objective risk factors that
insurers initially consider, such as market capitalization, industry, jurisdiction, assets, revenue,
and credit rating. After analyzing these business risks, the insurer considers subjective factors,
such as corporate governance quality, that distinguish otherwise identical firms.
The econometric model I use builds on that of Core (2000) with the null hypothesis that
the D&O insurance premium reflects only the firm’s business risk. A proponent of this view
might claim that D&O underwriters use increasingly objective criteria to evaluate litigation risk
because they have access to a large stock of detailed information. The alternative hypothesis is
that the premium also reflects the insurer’s assessment of the quality of the firm’s governance
structure. Under the alternative hypothesis, D&O insurance can reveal valuable, otherwise not
measurable, information about the strength of a corporation’s management.
Corporate governance enters the D&O premium through its effect on litigation risk. D&O
insurers seek to price litigation risk and choose a premium equal to the expected value of
litigation costs. This cost can be approximated by (risk of lawsuit × size of lawsuit). As
discussed in Section 2.2, shareholder risk is the most important type of litigation risk that public
corporations face. Shareholders, it can be said, sue for bad behavior. Thus, firms with good
governance structures that keep shareholder value high face lower litigation risk and are
considered less risky by D&O insurers. These governance structures keep shareholder value high
by reducing agency costs, as described in Jensen and Meckling’s agency cost model (Jensen and
Meckling 1976). The objective of this study, then, is to find management arrangements that
May 2011 Kang 33
reduce agency costs and thus litigation risk. These arrangements are hypothesized to be
positively associated with management diligence and negatively associated with management
entrenchment and opportunism.
Core (2000) states that a sufficient condition for the quality of corporate governance to be
priced in the D&O premium is that the quality of governance structures varies in cross section
for otherwise identical firms and that it is too costly for the insurer to just exclude all claims
arising from weak corporate governance. To adopt Core’s definition, corporate governance is
characterized as strong (weak) if it allows shareholders to impose tight (loose) constraints on
managers’ actions. Presumably, a firm with weaker governance has greater litigation risk
because the manager of such a firm is more likely to take actions inconsistent with shareholders’
interests. Because business risk (firm size, profitability, etc.) also increases litigation risk, a
firm’s D&O premium is hypothesized to be a function of the quality of corporate governance and
its business risk:
D&O premium= ƒ (governance structure quality, business risk) (1)
Key Assumptions
This function is an expression of the alternative hypothesis from which Core derives an
econometric model that assumes (1) the firm and insurers have symmetric beliefs about the
probability and distribution of D&O losses, and (2) the D&O insurance market is perfectly
competitive. The first assumption about symmetric beliefs is reasonable since the D&O
insurance application process is structured to enable the insurer to obtain complete information
about the applicant’s risk factors. When a firm initially applies for D&O insurance, it must
submit an extensive written application that details the firm’s past litigation experience, its past
May 2011 Kang 34
and future business activities, biographical data on its directors and officers, and its ownership
structure (Baker and Griffith 2007). The firm must truthfully reveal any information pertaining to
its litigation risk or else risk being denied coverage in the event of a claim. In addition to
reviewing the application, which is renewed yearly, the D&O insurer conducts background
checks on the firm’s management and often requests interviews with management. The
comprehensive application and renewal process suggests minimal asymmetric information—the
insurer and the firm share similar beliefs about the firm’s litigation risk at the time the insurance
is priced.
The second assumption of perfect competition is reasonable given the current economic
environment in 2009. Core asserts that perfect competition holds for the Canadian D&O
insurance market, though it applies to the U.S. as well. According to speakers at the Professional
Liability Underwriting Society’s D&O Symposium in February 2010, tough competition
continues to put pressure on prices. When top insurers such as AIG and XL Capital Ltd. faced
troubles during the financial crisis of 2007-2008, barriers to entry fell. New players are emerging
in the U.S.—53 companies are currently underwriting D&O coverage and offering policyholders
coverage options heretofore unavailable (Green 2010).
Assuming symmetric information and competitive markets, we can further specify how
a firm purchases D&O insurance. It chooses the limit it desires and is charged a premium equal
to its litigation risk plus a mark-up. After the firm completes the application process and chooses
a limit and deductible, the insurer sets a premium by adjusting the ratebook premium for that
chosen limit and deductible to reflect the difference in that firm’s risk from the average risk. The
firm’s premium can be modeled as a product of the insurer’s overhead and profit factor, the
idiosyncratic litigation risk of the firm, and the conditional expected loss, which is a function of
May 2011 Kang 35
the limit and deductible. Since the premium is a product of these terms, the logarithm of the
premium is linear in the firm’s litgation risk, the unconditional loss, and a constant:
log(premium) = β0 + β1 litigation risk + β 3 log (E[ratebook loss | limit, deductible] ) + ε1 (2a)
or, equivalently:
premium = ( ℮ β0
) (℮ β1risk
) (℮ β3 log (limit)
) (2b)
As the conditional expected loss is unobservable, Core uses log (limit) as its proxy because the
limit a firm desires closely reflects the losses it expects it will incur. In this model, the dependent
variable is log (premium) and independent variables are the proxies for governance structure
quality and business risk:
log(premium) = β0 + β1 litigation risk + β 3 log(limit) + ε1 (3)
Assuming litigation risk is determined by governance structure quality and business risk, we
obtain:
log (premium) = β0 + β1 governance structure quality + β 2 business risk + β 3 log(limit) + ε1 (4)
To define log(limit), which is the amount of insurance a firm decides to purchase, note that high
risk and highly levered firms have greater expected losses so would purchase greater limits (Core
1997). Figure 1 in the Appendix shows that firms with larger market capitalizations do indeed
purchase greater coverage. Thus, business risk is part of the D&O purchase decision. O’Sullivan
(1997) and Kaltchev (2008) find evidence that corporate governance also influences firms’ D&O
May 2011 Kang 36
purchase decisions. Like the premium, then, the limit is a function of governance quality and
business risk:
log (limit) = γ0 + γ1 governance structure quality + γ2 business risk + ε1 (5)
And substituting in the expression for log (limit), the reduced form of the model is:
log (premium) = δ0 + δ1 governance structure quality + δ2 business risk + β3 ε2 + ε1 (6)
where the total effect is δi = βi + β3 γi, the sum of the direct effect, βi, of the variable on log
(premium) and its indirect effect by increasing log(limit), β3 γi,. This is the model I estimate.
Consistent estimates for this reduced-form model are obtained under the standard assumption
that the governance structure and business risk variables are uncorrelated with ε1 and ε2. The
reasoning for E (ε1 ε2 ) = 0 is discussed in the next section. A final assumption is that the
governance structure and the risk variables are exogenous or predetermined at the time of
insurance pricing decision. This assumption is consistent with the assumption of symmetric
contracting in which the firm decides what limit it wants to purchase and the insurance company
charges it a premium adjusted for its conditional expected loss.
Statistical methodology
To examine the association between the level of D&O premium and governance structure
quality and business risk, I use the reduced form specified in Equation (6). In this regression
equation, the dependent variable is log (premium) and the independent variables are the proxies
for governance structure quality and business risk defined in Table 1. In order to estimate
May 2011 Kang 37
Equation (6), I must first include ε2 as an independent variable. This is the error term from
Equation (5), which expresses log (limit) as a function of governance structure quality and
business risk. Thus, ε2 represents information in the limit that is orthogonal to the proxy variables.
As Core (2000) notes, one reason this information arises is because limits are sold in ―sticky
points.‖ As discussed in Section 1, insurance brokers sell coverage limits in discrete multiples of
$1,000,000, although the most important steps appear to be $5,000,000. Thus, even if the firm’s
desired limit were completely determined by the proxies for litigation risk, because of the
discreteness in the actual limit, there will be information in the residual limit that will be
associated with the premium.
To estimate ε2, I conduct a first-stage regression of log (limit) on the proxies for
governance structure quality and business risk to obtain ε 2, the residual of log (limit). I then
estimate the following second-stage regression:
log (premium) = δ0 + δ1 governance structure quality
+ δ2 business risk + β3 residual of log(limit) + ε1 (7)
The residual of log (limit) controls for information in log (limit) that is associated with the
premium. The total effect δ 1 is the sum of the variable’s direct effect on log (premium) and its
indirect effect on log(premium) through its effect on the amount of coverage purchased,
log(limit).
To test the joint hypothesis of the governance variables, I conduct a partial F-test (p=0.05)
that all the corporate governance variables are equal to zero. Rejecting the null hypothesis means
that the variables significantly explain the model for log (premium). To test the robustness of my
specification, I perform a number of sensitivity tests to ensure that omitted variables are not
influencing the effects I measure for the governance structure variables of interest. Overall, if the
May 2011 Kang 38
results show that all the coefficients have the predicted signs, that the majority of the variables
are individually significant, and that the variables are collectively significant, then they would be
consistent with the hypothesis that the information contained in the D&O premium is a useful
summary measure of the quality of a firm’s governance.
6. DATA
The initial sample consists of a cross section of the 1,498 publicly traded companies
listed on the Toronto Stock Exchange (TSX), which is the largest stock exchange in Canada. The
Toronto Stock Exchange represents a broad range of businesses from Canada, the United States,
and Europe. Of this initial sample, 176 firms that have fiscal years ending between June 1, 2009,
and May 31, 2010, are cross-listed on a U.S. Exchange (NYSE, AMEX, or NASDAQ). I use
cross-listed firms because exposure to the more litigious U.S. legal environment has been found
to be a significant determinant of the D&O premium (Core 2000). Exposure to U.S. securities
litigation risk makes the sample firms close proxies for U.S. firms. Since D&O insurance
information is not publicly available in the U.S., the best alternative is to use cross-listed firms
that both abide by U.S. securities law and disclose their D&O policy details. Due to their dual
listings in Canada and the United States, these firms have also adopted governance structures
consistent with the best practice guidelines of the Canadian securities regulatory authorities, the
rules of the SEC, and the Sarbanes-Oxley Act of 2002. Observance of U.S. corporate governance
listing standards further strengthens the comparability between my sample and U.S. firms.
Excluded from the sample of 176 cross-listed firms are Exchange Traded Funds, split
share corporations, investment funds, limited partnerships, and other special purpose issuers. I
also eliminated income trusts because they exist only in Canada, are not incorporated like
May 2011 Kang 39
traditional companies, and have more byzantine corporate structure that Boyer (2004) found to
be priced into the D&O premium. From this sample of 176 cross-listed firms, a subsample of 92
firms are used in the analysis of D&O premiums. This subsample of 92 firms was obtained by
eliminating 84 firms for the following reasons: (1) the firm does not carry D&O insurance (66
firms); (2) either premium or limit data are not disclosed or disclosed for only part of the D&O
coverage (14 firms)4; (3) missing proxy statement (3 firms); and (4) new company with an IPO
in the previous year (1 firm).5 Eleven of the 92 firms are U.S.-incorporated firms and so are
subject to U.S. state law rather than U.S. securities law. These U.S.-incorporated firms are
identified with a dummy variable, as described in Table 1.
This 92-firm subsample represents ten different industry sectors. In order of decreasing
proportion they are: mining, diversified industries, life sciences, technology, financial services,
oil and gas, clean technology, communication and media, utilities and pipelines, and real estate.
My sample consists of a relatively large percentage of mining companies (38%), though this
feature simply reflects the broader Toronto Stock Exchange, which is a world leader in mining
and oil and gas. Figure 3 in the Appendix shows a detailed industry composition of the sample.
Canadian D&O insurance data is publicly available— the Ontario Business Corporations
Act required firms to disclose the aggregate premium, total amount of insurance, and deductible
or co-insurance in regards to D&O insurance purchased in the previous year. As such, I use a
cross section of the most recent D&O insurance data available, which is disclosed in the online
4 Some firms disclosed only the premium paid for coverage or the annual limit. As both amounts are needed in the
empirical analysis, those firms were excluded from the sample. Also, firms that disclosed only the premium paid for
the corporate coverage or the personal coverage portion of their D&O policy were dropped because this partial
premium is not comparable to a premium paid for the aggregate D&O policy.
5 I exclude firms that offered an IPO in the previous year to reduce the incidence of any information asymmetry
between the insurance carrier and the company as documented by Chalmers et al. (2002), who report that typically
there are huge increases in insurance limits (or coverage is initiated) and premiums around the time a company
makes an IPO.
May 2011 Kang 40
database SEDAR (www.sedar.com). SEDAR contains the documents and securities filings of all
publicly traded Canadian companies. I hand collect the D&O insurance data, which include
details on D&O insurance coverage amounts, premiums paid, and corporate deductible, from the
proxy statements and annual reports of each firm. Following the methodology employed by Core
(2000), Boyer (2004), and Bourbakri (2008), if there is no mention of the existence of D&O
insurance policy in these filings, I consider the firm uninsured. According to responses I received
from Canadian business lawyers and D&O brokers, uninsured firms are usually small and
venture companies in Canada that have not yet secured coverage or find it prohibitively
expensive.
After gathering information on the logarithm of D&O insurance premium and limits, I
create proxy variables for governance structure quality and business risk. The next subsection
discusses nine characteristics of corporate governance that agency theory literature has found to
affect agency costs. These governance structure variables were collected from the proxy
statements of each firm. The second subsection discusses a set of control variables for business
risk. These business risk variables were created using the company’s annual report and stock
price data from Compustat and Capital IQ. Following Core (2000), all independent variables are
measured as of the end of the fiscal year 2009, prior to the purchase of D&O insurance, under the
assumption that the D&O policy was purchased at the beginning of the most recent fiscal year.
Table 1 in the Appendix presents the definitions, predicted effect on the premium, and
descriptive statistics of the two sets of explanatory variables. All figures are in U.S. dollars.
6.1 Proxies for Governance Structure Quality
Firms with weaker governance are hypothesized to have higher D&O insurance
premiums. To proxy for the firm’s governance quality, I use three measures of ownership
May 2011 Kang 41
structure, three measures of board independence, and three measures of management
entrenchment as in Core (2000). These measures are based on prior research, which supports that
corporate governance is stronger when insiders own more stock, when insiders have less voting
control, and when there is monitoring by outside blockholders. The corresponding variables for
ownership structure are:
INS_VALUE, the percentage of share value owned by inside directors
INS_VOTE, the percent of share votes controlled by inside directors
OUT_BLOCK, a dummy variable equal to one if an outside blockholder owns 10% of
the firm, and zero otherwise
It is well-known that insider control of shares has competing aligning and entrenching
effects on management. INS_VALUE intends to captures the incentive alignment effect, while
the insider voting variable (INS_VOTE) captures the entrenchment effect and works in the
opposite direction. INS_VALUE should have a negative relationship with the D&O premium
because, as insiders hold more of the value of the firm, their incentives are better aligned with
those of shareholders. I predict a positive coefficient for INS_VOTE, as this would be consistent
with an entrenchment effect from insider voting control (Morck, Shleifer, and Vishny, 1988;
Stulz, 1988). INS_VALUE and INS_VOTE are empirically distinct for firms with dual class
structures (18.5% of the firms in the sample). Finally, OUT_BLOCK is predicted to have a
negative coefficient because concentrated ownership of shares by outside shareholders increases
the incentive to monitor and mitigates free-rider problems (Shleifer and Vishny, 1986).
Core (2000) also observes that corporate governance is stronger when the board is
independent of the CEO. This is the case because a board may fail to exercise the necessary
May 2011 Kang 42
oversight if its CEO is also chair of the board and significantly influences both the selection of
directors and the board’s agenda. The following variables measure board independence:
DIR_OUT, the number of outside directors as a percentage of total directors
DIR_APP, the percentage of outside directors appointed by the CEO
CEO_COB, a dummy variable equal to one if the CEO is also the board chair, and zero
otherwise
Corporate governance is expected to be strong when the board is independent of the CEO, where
board independence is positively related to the percent of outside directors appointed by the CEO
and negatively related to whether the CEO is chair of the board. For instance, Dechow, Sloan,
and Sweeney (1996) find that firms accused by the SEC of fraudulent reporting have fewer
outside directors and are more likely to have a CEO who is also board chair. Outside directors
are thought to provide monitoring benefits to shareholders because they are more objective. In
my sample, the mean of the dummy variable CEO_COB is 0.163, lower than Core’s mean of
0.536. This difference reflects the increased adoption of separate CEO and board chairman
positions as a corporate governance best practice.
Finally, to measure management entrenchment, I use:
CONTRACT, a dummy variable equal to one if top executives have employment
contracts, and zero otherwise
GOLD_PAR, a dummy variable equal to one if top executives have golden parachutes,
and zero otherwise
May 2011 Kang 43
POIS_PILL, a dummy variable equal to one if the firm has a poison pill, staggered board,
or other takeover deterrents, and zero otherwise
Top executive employment contracts are expected to weaken corporate governance by
entrenching managers, though this effect is lower when golden parachutes are part of the contract.
Golden parachutes are clauses in executive employment contracts that provide executives with
lucrative severance packages in the event of their termination. Golden parachutes, when attached
to employment contracts, are expected to weaken this entrenchment effect by aligning managers’
incentives so that they are less likely to resist takeovers. Hence, the predicted coefficient on the
dummy variable CONTRACT is positive but on golden parachutes (GOLD_PAR) is negative.
POIS_PILL is expected to be positively associated with the D&O premium. Since the
takeover market provides a mechanism for controlling agency problems, takeover deterrents,
such as poison pills, staggered boards, and other tactics close down this mechanism and increase
entrenchment. One example of entrenchment is that managers may resist takeovers in order to
preserve their jobs. Consistent with takeover deterrents increasing entrenchment, Borokhovich,
Brunarski, and Parrino (1997) find that firms adopting antitakeover charter amendments receive
fewer takeover bids and pay higher CEO compensation. Nelson (2005) finds that firms that
adopt poison pills and other takeover deterrents underperform benchmark portfolios.
Underperformance matters because many D&O claims originate from shareholder challenges to
takeover defenses. Thus, takeover defenses may lead to higher D&O premiums because they
proxy for an increased risk of litigation by shareholders seeking to remove these deterrents.
May 2011 Kang 44
6.2 Proxies for Business Risk
While the joint coefficients of interest are the proxies for corporate governance quality, I
must control for business risk because firms with higher business risk are expected to have
higher premiums. Five variables proxy for business risk:
CEO_EXP, the logarithm of the number of years that the CEO has served on the board of
directors, where a low CEO_EXP increases litigation risk
ROE, a proxy for financial performance expected to be negatively related to the D&O
premium
SIZE, firm size measured as the logarithm of market value of equity, predictably
positively related to premium
PRIOR_LIT, equals one for companies that have disclosed pending or prior litigation,
and zero otherwise
US_OPS, equals one for firms with U.S. operations, and zero otherwise
CEO_EXP intends to measure the benefits of having an experienced CEO net of any
entrenchment effect and should be associated with lower litigation risk. The firm’s annual return
on equity (ROE) proxies for financial performance and is expected to be negatively related to the
D&O premium. Return on equity is an important variable because D&O claims often arise
because of poor financial performance (Wyatt Company 1993). Moreover, the variable SIZE,
which is the logarithm of market capitalization, is included as a control variable because larger
firms are expected to have higher litigation risk and thus pay higher premiums. Figures 1a and b
in the Appendix show the positive relationship between the D&O premium and limit and market
May 2011 Kang 45
capitalization. Financial variables ROE and SIZE, as of fiscal year-end 2009, were collected
using Computstat and Capital IQ.
In addition to return on equity and size, litigation history (PRIOR_LIT) is a factor that all
D&O insurers examine. Firms with pending or past litigation pose a higher risk to insurers and
must be charged a correspondingly higher, experience-rated premium. In accordance with
economic intuition, SIZE and PRIOR_LIT are expected to bear large positive coefficients.
Litigation data was collected using the Stanford Securities Class Action Clearinghouse database.
The last variable, US_OPS is included because of the differences in the Canadian legal system.
Canadian D&O premiums are lower than those in the U.S. because of the more litigious legal
environment in the U.S. Thus, I control for the fact that 12% of my firms are incorporated in the
U.S. and thus subject to U.S. state law. Table 2 in the Appendix presents the correlation matrix
between the dependent variable, log (premium), and the independent variables.
7. RESULTS
7.1. Analysis of Results
The association between the D&O premium, governance structure quality, and business
risk is examined using Equation 7, which is developed in Section 5. This regression equation
includes as the dependent variable log(premium) and as the independent variables the proxies for
governance structure quality and business risk defined in Table 1, ―Descriptive Statistics.‖ Also
included as an independent variable is ε2, the error term from Equation 5, which expresses
log(limit) as a function of governance structure quality and business risk. The residual of
May 2011 Kang 46
log(limit) controls for information in log(limit) orthogonal to the other regressors, which may
arise due to discreteness in coverage limits.
To estimate the model specified in Equation 6, I first regress log(limit) on the proxies for
governance structure quality and business risk to obtain ε 2, the residual of log(limit). I then
estimate the second stage regression of log(premium) on the same proxies and the residual of
log(limit):
log (premium) = δ0 + δ1 governance structure quality
+ δ2 business risk + β3 residual of log(limit) + ε1
In order to test the robustness of Core’s (2000) findings, I adopt his governance structure
variables. The regression model in column 1 of Table 3 shows that Core’s results are robust—the
governance structure variables add significant explanatory power to the model for log(premium).
The model has significant explanatory power (adjusted R2 = 81.4%), and with the exception of
the proxies for CEO independence, the governance structure variables and business risk variables
have the predicted signs. Four of the nine governance structure variables are significant. A partial
F-test (p=0.001) rejects the hypothesis that the coefficients on all the governance structure
variables are equal to zero, which means that the variables add a significant amount of
explanatory power to the model for log(premium). The combined evidence that the majority of
the governance structure variables have the predicted signs, that four of the variables are
individually significant, and that the variables are collectively significant is consistent with the
hypothesis that the D&O premium reflects the quality of the firm’s corporate governance.
Comparing my results to those of Core (2000), I draw three main conclusions. First,
Core’s results are robust over time. He used a cross section of firms with fiscal year ends
May 2011 Kang 47
between June 1, 1993 and May 30, 1994 whereas I use a very recent sample of firms with fiscal
year ends between June 1, 2009 and May 30, 2010. Given that we both hand-collect samples
from public proxy statements and have similar sample sizes (Core used 110 firms and I, 92
firms), our similar results suggest that the ability of corporate governance structure variables to
explain the D&O premium is persistent over time. Second, Core’s results are robust to firms
exposed to U.S. securities litigation. Whereas Core used an all-Canadian sample, I use a sample
of firms cross-listed on the Toronto Stock Exchange (TSX) and a U.S. Exchange (NYSE,
NASDAQ, AMEX). Previous research and interviews with D&O brokers find the U.S. securities
litigation environment to be more litigious than that of Canada. Thus, I use cross-listed firms as
proxies for U.S firms. These firms are suitable proxies because they are exposed to SEC laws
and subject to U.S. corporate governance standards yet are still required by the TSX to disclose
their D&O details. My sample yielded more significant values and better fit (adjusted R2 = 81.4%
compared to 76.3%) than Core’s, suggesting that corporate governance quality matters even
more for U.S. firms. As D&O details are not currently publicly disclosed in the U.S., my results
provide empirical support for D&O disclosure as a way to provide investors and institutions with
a measure of corporate governance quality superior to ad hoc governance indices.
Finally, my results deviate from Core’s only in the predicted sign on the proxies for CEO
independence: DIR_OUT, DIR_APP, and CEO_COB. Core found a significant negative
relationship between the D&O premium and DIR_OUT and a positive relationship between the
D&O premium and DIR_APP and CEO_COB. His results suggest that good corporate
governance and lower premiums are associated with boards independent of CEOs; that is, firms
have lower premiums if they have more outside directors, fewer outside directors appointed by
the CEO, and separate CEO and board chairman positions. Core’s findings are generally
May 2011 Kang 48
consistent with prior governance literature, which espouses the merits of CEO independence.
However, my sample yields a significant negative relationship between the D&O premium and
DIR_APP and CEO_COB and a positive relationship between the premium and DIR_OUT, even
after controlling for CEO experience. One possibility for the opposite signs on these
―independence‖ proxy variables is that D&O underwriters do not consider CEO influence on the
board to be an indication of bad governance. Baker and Griffith (2007) discovered in their
interviews with forty D&O professionals that D&O underwriters put more of an emphasis on
their ―feel‖ of the board dynamics than on standard notions of board independence. While years
of experience attempts to control for CEO skill, it is possible that D&O underwriters are in fact
assessing CEO skill in DIR_APP. A significant and negative coefficient on DIR_APP would be
consistent with underwriters charging a lower premium to firms with more outside directors
appointed by the CEO—those firms have CEOs with longer tenures and thus possibly more skill.
Overall, D&O underwriters are concerned with pricing litigation risk. Having a more skilled
CEO with considerable experience with the board can lower such risk such that, ceteris paribus,
that firm would pay a lower D&O premium.
While Core’s governance structure variables are significant determinants of the D&O
premium, I use factor analysis to improve on his model. Note that INS_VOTE and INS_VALUE
in Table 8 seem to explain factor 1, which Core calls ―ownership.‖ The results of the improved
model are shown in column 2 of Table 6. The positive and significant coefficient on INS_VOTE
is consistent with an entrenchment effect from insider voting control, and the negative and
significant coefficient on INS_VALUE is consistent with an incentive alignment effect that
occurs when insiders own more of the firm. This result complements Shleifer, and Vishny (1988)
and Stulz (1988) by highlighting the importance of the dual role of stock ownership in
May 2011 Kang 49
entrenching and motivating managers. Both variables are significant at the 1% level and specify
that for a 1% increase in insider voting control (insider ownership value), the D&O premium
increases by 8.125% (decreases by 0.018%).
Improving on Core’s regression specification, I drop OUT_BLOCK for lack of
explanatory power and CONTRACT for its high correlation with GOLD_PAR. OUT_BLOCK
has been found in previous studies to be insignificant, consistent with the offsetting effects of
outside shareholders: they simultaneously increase governance structure quality and litigation
risk because they use lawsuits as a substitute monitoring device (Romano, 1991). Like Core, I
find that inference is unaffected when OUT_BLOCK is dropped from the regression.
I replace the two dropped variables with a new variable INC_COMP, which is the
percent of total CEO compensation that consists of short-term incentive payments. Short-term
incentives consist primarily of year-end cash bonuses and exclude incentive-aligning long-term
stock compensation. I include INC_COMP as a proxy for intrafirm incentives. Through
extensive interviews with over forty D&O professionals, Baker and Griffith (2007) find that
D&O underwriters pay attention to executive compensation, not because it creates liability risk
in and of itself, but because it suggests something about the culture of incentives and constraints
within a firm. A CEO whose total compensation consists almost entirely of year-end cash bonus
as opposed to salary or vested options is incentivized to take larger than normal risks to
maximize share price, which is the most commonly used measure of firm and CEO performance.
In fact, incentive pay has been proven to significantly increase the probability of a shareholder
class action lawsuit. One study suggests that the fast-vesting options representing a substantial
component of current executive pay may give managers incentives to self-deal by, for example,
May 2011 Kang 50
manipulating earnings, and that such misbehavior ultimately triggers class action lawsuits (Asaro
2005).
Replacing OUT_BLOCK and CONTRACT with INC_COMP improves the fit of the
model (adjusted R2=82.3%). A 10% increase in INC_COMP increases the D&O premium by
21.64%, or by about a factor of two. This is a considerable increase in the premium from the
short-term incentive component of CEO compensation. INC_COMP is individually significant,
and an F-test of Model 1 versus Model 2 rejects the hypothesis that INC_COMP is irrelevant.
The coefficient on POIS_PILL is positive but insignificant, and its insignificance is
consistent with the aforementioned finding that U.S. D&O underwriters are more concerned with
firm constraints and incentives than with specific legal defenses. For instance, Baker and Griffith
(2007) note that staggered boards and poison pills are not key determinants of D&O pricing.
Only if directly questioned do the D&O underwriters address takeover defenses, such as poison
pills. Instead of takeover defenses, D&O underwriters try to assess whether top management is
―riskier than the norm‖ (Baker and Griffith 2007). Thus, my findings in column 2 that
INC_COMP is positive and significant (p=0.05) and that POIS_PILL is positive but insignificant
support qualitative evidence presented in Baker and Griffith (2007).
In addition to INS_VOTE, INS_VALUE, DIR_APP, and INC_COMP, GOLD_PAR is
positive and statistically significant at the 5% level. This provides evidence for the hypothesis
that governance structure quality decreases when managers entrench themselves by obtaining
lucrative exit options. The exponentiated coefficient of GOLD_PAR is the ratio of the geometric
mean for the firms with golden parachutes to that of those without golden parachutes. In terms of
percent change, adding a golden parachute provision increases the D&O premium by about
41.9%, holding all other variables constant, since ℮(0.350)
= 1.419. Although GOLD_PAR is
May 2011 Kang 51
intended to proxy for management entrenchment, factor analysis presented in Table 8 shows that
it and INC_COMP explain much of factor 2. Factor 2 reflects ―excess compensation,‖ which
signals to the D&O insurer management’s risk attitude and the firm’s internal constraints. A
board that pays its CEO excess amounts for short-term stock performance and a change of
control is more likely to be overly optimistic of firm growth forecasts and potential deals.
Overall, the alternate specification in column 2 improves on Core’s model, as shown in
column 1. A partial F-test rejects the null hypothesis that the coefficients on all the governance
variables are 0 (F=31.31, p = 0.001) and increases the fit of the model due to additional
explanatory power from INC_COMP and reduced correlation between variables in Core’s
original specification (see correlation matrix in Table 2).
As expected, all of the business risk variables are significant and, thus, effective control
variables. Each is significant at the 10% level, and all but one is significant at the 5% level. The
significant positive coefficients on SIZE and PRIOR_LIT support my hypothesis and economic
intuition. Larger firms are more likely to be the subject of litigation and must pay a higher
premium due to higher frequency and severity of claims. As both SIZE and the premium are
logarithmic, the coefficient on SIZE takes on the interpretation of an elasticity. For a 1% increase
in market capitalization, the D&O premium increases by 0.235%. This large and positive effect
is as predicted by the model developed in Section 4. The positive coefficient on PRIOR_LIT is
consistent with the findings of Romano (1991), and with the explanation that D&O insurers are
concerned about spillover effects of pending litigation, that prior litigation has a negative
reputational effect, and that prior litigation may itself be a manifestation of weak governance. A
firm that has prior or pending litigation pays a D&O premium about 38.3% higher than that of an
equivalent firm with no litigation, since ℮ (0.324)
= 1.383. The magnitude of the effect of
May 2011 Kang 52
PRIOR_LIT on the premium is very close to that of GOLD_PAR (38.3% versus 41.9%). This
suggests that the effect on the premium of prior litigation is comparable to the effect of adding a
golden parachute to the executive compensation package.
ROE is negative as expected, indicating that firms with better operating performance
have lower litigation risk because the majority of claims are securities suits for unexpected drops
in stock price. US_OPS is negative and significant, which is particularly interesting given my
sample. This means that firms that are incorporated in the U.S. but not listed on a U.S. exchange
pay lower D&O premiums, confirmatory evidence that it is exposure to the more litigious U.S.
securities environment and not U.S. state law that matters for D&O insurance.
Finally, the coefficient on the residual of log(limit) is highly significant and positive,
which indicates that information in the limit that is orthogonal to the governance structure and
business risk variables is significantly associated with log(premium).
In sum, columns 1 and 2 of Table 6 lend support to the idea that a firm’s D&O premium
varies inversely with its governance quality. This is the basic prediction of agency theory.
Among particular findings to note is that dual class stock is a governance red flag to D&O
insurers. The presence of dual class stock (in 18.5% of the sample) causes INS_VALUE to differ
from INS_VOTE because certain classes of stock have more voting rights than others but all
shares have equal value. Both INS_VALUE and INS_VOTE as significant at the 0.001% level
and have opposite signs. Higher INS_VOTE is associated with higher D&O premiums because
dual class structures raise suspicion of management entrenchment. Another interesting finding is
that it is U.S. securities law, rather than U.S. state law, that leads to greater shareholder litigation
risk. The coefficient on US_OPS is negative and significant in all panels of Table 6. Lastly, the
May 2011 Kang 53
unexpectedly negative coefficient on DIR_APP reflects the difficulty in identifying ―good‖
CEOs using objective criteria. A CEO who appoints a majority of the directors could exhibit
undue influence on the board; however, that CEO may also have appointed many directors
because of his long tenure and success in his position. Ultimately, there are limits to what a
CEO’s years of experience can tell us about his intelligence and his integrity. This is essentially
what DIR_APP is suggesting—there is a range of how much of a good CEO is too much.
Despite this last point, the results in Table 6 reveal valuable insights that can be applied to future
research concerning D&O insurance and governance quality.
7.2 Sensitivity Tests
The remaining panels of Table 6 present the results of sensitivity tests of the main model
presented in column 2 (column 1 is included to provide an immediate comparison to Core). I
perform a number of sensitivity tests to ensure that omitted variables are not inducing spurious
inference with respect to the governance structure variables. First, in column 3, I include the five
indicators for high-risk industries. Interviews with D&O underwriters and prior research (e.g.
Cornerstone Research 2008) suggest that the following industries experienced higher litigation
risk in Canada and the United States during the sample period: technology, finance,
communication and media, and pharmaceuticals/biotech. I include mining as the fifth industry
indicator variable. My sample is about one-third mining companies due to their high
representation on the broader TSX. Despite the individual significance of PHARMA and the
common presumption that industry membership is associated with shareholder suits, an F-test
(p=0.16) does not reject the restriction that the coefficients on the five risky industry indicators
are all zero. As shown in column 3, including these variables has no effect on inference with
respect to the governance structure variables besides increasing the significance of INC_COMP.
May 2011 Kang 54
In column 4, I include the logarithm of the corporate deductible as an additional regressor.
Although the inclusion of the variable tends to reduce the magnitudes of the coefficient estimates
(particularly INS_VOTE, GOLD_PAR, and US_OPS), inference on the governance structure
variables is unaffected. In results not presented in Table 6, I introduce STOCK_COMP, the
percentage of the CEO’s total compensation that consists of stock-based pay from stock and
option grants. The variable is highly correlated with INC_COMP and increases multicollinearity
problems in the regression without improving explanatory power, and its coefficient is not
significant. In order to assess whether board composition is relevant, I introduce LAWYER, a
dummy variable equal to 1 if the company’s lawyer serves on the board and WOMEN, the
percentage of the board that is female. However, LAWYER and WOMEN are neither
individually nor jointly significant. Hence, this measure of board diversity does not seem to
matter for D&O insurance. As predicted by the principal-agent model, VOLATILITY positively
affects the D&O premium but is not significant. If dummy variables indicating board interlocks,
majority voting policy for the board, and say on pay (a newly introduced shareholder advisory
vote on executive compensation) are included either separately or together in the regression, the
variables are not significant, the governance structure variables are collectively significant, and
the coefficients estimates on the other independent variables are similar to those in column 2.
7.3 Direct and Indirect Effects of Governance Structure Quality
Following Core (2000), I define the variable GOVERANCE_QUALITY as the sum of
the governance structure variables weighted by their estimated coefficients, δ i, shown in column
2 of Table 6, multiplied by negative one:
May 2011 Kang 55
GOVERNANCE_QUALITY (δ i INS_VOTE + . . .+ δ 8POIS_PILL) (8)
This variable is standardized to mean zero and unit variance. Column 1 of Table 9
presents OLS regression results for Equation (7) when this variable is substituted for the eight
variables that comprise it. The linear composite of governance quality provides a clearer
magnitude of the effect of governance quality on the D&O premium. The coefficient -0.446
indicates that a firm with corporate governance one standard deviation weaker than average pays
a D&O premium roughly 45% more than an otherwise similar firm. This total effect of
GOVERNANCE_QUALITY on the D&O premium is depicted in Figure 4, recognizing though
that other variables are not controlled for in the graph.
Column 1 of Table 9 shows the total effect of GOVERNANCE_QUALITY and the
business risk variables on log(premium). The total effect is estimated from the reduced-form of
Equation (7). Recall that the total effect from Equation (7) is δi = βi + β3 γi, the sum of the direct
effect, βi, of the variable on log (premium) and its indirect effect by increasing log(limit), β3 γi.
Thus, the estimated total effect of GOVERNANCE_QUALITY on log(premium) shown in
column 1 (-0.446) can be decomposed into the sum of its direct effect on log(premium), shown
in column 2 (-0.155), and its indirect effect on log(premium) through its effect on log(limit),
shown in column 3 (0.979×-0.322). Column 2 shows the direct effect of a variable on
log(premium) in excess of that variable’s indirect effect through log(limit). The significant
coefficient on GOVERNANCE_QUALITY in column 2 indicates that weaker governance is
associated with significantly higher premiums even after controlling for the indirect effect that
weaker governance has on increasing the limits.
May 2011 Kang 56
7.4 Confirmatory Evidence Using Excess CEO Compensation
The preceding tests indicate that proxies for governance structure quality add
significant explanatory power to regression models for the D&O premium. While these results
suggest that these proxies for governance quality are associated with increased litigation risk, it
remains to be shown that these weaker governance structures make shareholders worse off. It
could be that certain firms are well-managed yet have governance structures that are considered
risky from the standpoint of the D&O insurer. To separate this effect and derive the link between
higher litigation risk and lower shareholder value, in this section I provide confirmatory evidence
that weak governance implied by the D&O premium have a statistically positive relation with
excess CEO compensation.
Core, Holthausen, and Larcker (1999), Hallock (1997), and other recent studies find that
CEO compensation in excess of its standard economic determinants is a proxy for weak
corporate governance that makes shareholders worse off. When corporate governance is weak,
CEOs can extract additional compensation from the firm. This often the case when the board of
directors is not independent of the CEO. Friendships arise out of board longevity, and with the
majority of the board sitting together for over a decade and managers who can remove directors
that they dislike, lack of dissention within the board room on matters such as executive
compensation is common. If the measure of weak governance implied by the D&O premium is
positively associated with excess CEO compensation, then this results suggests that the increase
in the D&O premium results from an assessment of weaker governance that makes shareholders
worse off and is not, as Core (2000) explains, simply an assessment of the increased litigation
risk of governance structures that allow for more managerial discretion.
May 2011 Kang 57
To test this hypothesis, I use a linear regression model in which the logarithm of total CEO
compensation is the dependent variable and GOVERNANCE_QUALITY, as defined by
Equation (8), is the variable of interest. The control variables for the economic determinants of
CEO compensation are SIZE, GROWTH (the market to book equity ratio as a proxy for growth
opportunities), firm performance (annual return, RETURN, and return on equity, ROE), and the
expected difference in CEO compensation for CEOs more exposed to the U.S. labor market
(US_OPS). With the exception of GROWTH and US_OPS, these are the same variables that
Core (2000) uses in this model. Table 3 contains definitions and descriptive statistics for the
compensation and governance variables.
The sample used in this analysis consists of the same 92 firms used in the analysis of the
D&O premium, and total CEO compensation is that as defined in the firms’ proxy statements.
Total CEO compensation is the sum of base salary, annual short term incentive awards, long
term equity award incentives, stock options, restricted stock units, and the value of any benefits
and perquisites. Compensation figures are collected from individual firms’ proxy statements for
fiscal year end 2009. Financial data for SIZE, GROWTH, RETURN, and ROE are collected
from Compustat and Capital IQ.
Model 1 of Table 10 shows that GOVERNANCE_QUALITY has the predicted negative
coefficient, indicating that excess pay is higher when governance is weaker. While the variable is
not significant at standard significant levels, the result provides evidence that the governance
structure variables underlying GOVERNANCE_QUALITY in fact proxy for the quality of the
firm’s governance structure. With the exception of RETURN, all the coefficients on the control
variables have the predicted signs consistent with research on the association between firm size,
growth opportunities, financial performance, and CEO compensation. As expected, SIZE is the
May 2011 Kang 58
most highly significant variable in both specifications in Table 7, as CEOs of larger companies
are compensated more highly.
Though GOVERNANCE_QUALITY does not yield a statistically significant relationship
with excess CEO compensation, we can conduct a more direct test of the hypothesis that D&O
premiums reflect weaker governance by using as a proxy for weak governance the residual
premium unexplained by the business risk variables and log(limit). PREMIUM_RESIDUAL is
obtained by excluding all the governance variables from Equation (7), which is equivalent to:
log (premium) = β0 + β2 business risk + β3 log(limit) + ε3 (9)
Because the governance variables have been omitted from the regression, PREMIUM
RESIDUAL captures any amount of the premium related to the firm’s governance structure. This
variable, as show in column 2 of Table 10, has a significant positive association with excess
CEO pay and provides additional confirmatory evidence that the D&O premium is higher when
corporate governance is weaker. This shows that in addition to measuring litigation risk, the
D&O premium captures a measure of weak governance that has been shown in the CEO
compensation literature to make shareholders worse off.
7.5 Secondary Analysis Using Audit Committee and Finance Variables
While this paper studies the effect of governance quality on litigation risk, it is worth
asking whether there are even more direct predictors of litigation risk. Since D&O litigation risk
primarily derives from stock price drops following earnings misstatements, I will look at factors
that affect financial restatements.
May 2011 Kang 59
A financial restatement revises public information previously filed with the SEC and
often leads to loss of investor confidence, SEC investigations, shareholder lawsuits, or rescission
of D&O coverage. Restatements occur for a number of reasons. The most frequent ones are
improper revenue recognition (either non-reported or misreported revenue), reporting of costs
and expenses, restructuring assets or inventory, accounting for mergers or acquisitions, and
securities transactions. According to Huron’s Annual Review of Financial Reporting Matters, the
three leading causes in 2008 were revenue recognition (16.4%), equity accounting (16%), and
reserves, accruals, and contingencies (14.1%). While the consequence of restatements depend on
their severity, in general, restatements call into question the company’s accounting methods,
internal control systems, and quality of leadership. As is relevant to this study, a financial
restatement is an almost certain precursor of a D&O suit. This is because restatements often
indicate broader corporate negligence or intentional misdeeds that could generate many more
claims.
Because restatements can result from either intentional or unintentional mistakes, for the
purpose of this analysis, I define two main causes of restatements: 1) audit committee and board
experience and 2) merger activity. Shareholders seek attentive and expert boards that will
exercise adequate oversight of the financials. They also want audit committees that have
financial expertise. A firm’s audit committee meets on a regular basis with management and the
external and internal auditors to discuss internal controls over the financial reporting process.
Since it is responsible for appointing the external auditors and reviewing and approving all
financial disclosure contained in the company’s public documents, the Audit Committee’s
diligence determines the likelihood of financial restatements, and consequently, shareholder suits.
The second cause of restatements, merger activity, is well-documented. Industries and companies
May 2011 Kang 60
that undertake many mergers or acquisitions expose themselves to litigation risk, whether from
violations of fiduciary duty, erroneous purchase accounting, or lucrative executive severance
packages. Thus, Audit Committee experience and merger activity are the main contributors to
D&O litigation risk from restatements. I next detail the variables and methodology for the
ensuing analysis.
To study the effect of audit committee and board experience and merger activity on D&O
litigation risk, I replace the governance structure variables in Equation (7) with the finance
variables shown in Table 4. Table 4 contains definitions and descriptive statistics. The variables
include:
CEO_EXP, the logarithm of the number of years the CEO has served in his position
CFO_EXP, the logarithm of the number of years the CFO has served in his position
CEO_EXP is predicted to have a negative coefficient, consistent with the finding that
CEOs with longer tenures having more skill and thus lower litigation risk. CFO_EXP, on the
other hand, is expected to have a positive relationship with the D&O premium, since longer-
tenured CFOs may be less vigilant about screening the financial statements for inaccuracies.
Other variables measure the board’s attentiveness to the financial statements and ability
to analyze them:
BOARD_MEET, the number of board meetings per year
BOARD_FIN, the percentage of the board with substantial finance or accounting
experience
The variable BOARD_FIN measures the collective financial expertise of the board. A
director is considered to have financial expertise if he has prior experience as a Chief Financial
Officer of a large public company, as a Certified Public Accountant or partner of a leading
May 2011 Kang 61
accounting firm, or senior positions in investment banking, private equity, or financial services.
The mean and medium for BOARD_FIN is about 30%, as shown in Table 4.
The next group of variables measures the length and scope of the company’s relationship
with its outside auditor and the extent of experience of the company’s Audit Committee:
AUDIT_TOTAL, the percentage of total audit fees attributed to audit and audit-related
fees
AUDIT_CONSULT, the ratio of audit to non-audit fees
AUDIT_MEET, the number of audit meetings per year
AUDIT_EXP, the percentage of the audit committee with substantial finance or
accounting experience
AUDITOR_YRS, the number of years the outside auditors have served in their position
The above variables correspond to D&O underwriters’ perspective on audit committee
expertise. Baker and Griffith (2007) interviewed over forty D&O professionals on the most
important information they consider when pricing policies. The interviewees’ responses include,
―How often does the Audit Committee meet? What is the length and scope of the company’s
relationship with outside auditors? What percentage of fees is paid for auditing versus consulting
fees? Has the company changed auditors or restated its financials in the past three years?‖ I
include these five variables to proxy for these issues, with a lower D&O premium associated
with a higher percentage of audit fees, more frequent audit committee meetings, and more
experienced audit committee members. The percentage of Audit Committee members with
financial expertise is as defined in BOARD_FIN. Since 2002, however, the provisions of the
Sarbanes–Oxley Act have required that at least one ―audit committee financial expert‖ is a
May 2011 Kang 62
member of the registrant’s audit committee (Redington 2006). The median of 33.3% reflects that
most audit committees consist of three members, one of which is a designated financial expert.
Finally, I include four dummy variables that are expected to increase the D&O premium:
RESTATE, equal to one if the firm has restated its financial statements in the past three
years
MERGER, equal to one if the firm has engaged in merger activity in the previous or
current year
OFF_BS, equal to one if the firm has off-balance-sheet entities for financial transactions
RELATED_PARTY, equal to one if the firm has related party transactions during the
policy year
Baker and Griffith (2007) and Redington (2006) report that D&O underwriters consider
firms with related party transactions or off-balance-sheet entities to be riskier. Off-balance-sheet
entities are assets or debts that do not appear on a company's balance sheet. For example, oil-
drilling companies often establish off-balance-sheet subsidiaries as a way to finance oil
exploration projects. Too often, however, as exemplified in the Enron scandal, off-balance-sheet
entities are used to artificially inflate profits and make firms appear more financially secure than
they actually are. A complex array of investment vehicles, including but not limited to
collateralized debt obligations, subprime-mortgage securities, and credit default swaps are used
to remove debt from corporate balance sheets and are potential sources of litigation.
The business risk variables used to control for this alternative set of explanatory variables
are the same as those used in the analysis of the D&O premium: SIZE, PRIOR_LIT, ROE, and
US_OPS. Data on CEO and CFO, board, and Audit Committee experience are collected from
individual firms’ proxy statements. Data on auditor fees, years of service, and number of Audit
May 2011 Kang 63
Committee meetings are obtained from firms’ annual information forms, or 20-Fs. Information
regarding whether a firm has related party transactions or off-balance sheet financing during the
policy year is disclosed in the firm’s annual report. Merger activity data, within the range of
January 2008 to December 2009, is collected from Thomson One Banker. Finally, Audit
Analytics, a specialized industry database is used to find whether a restatement occurred and for
what reason. It should be noted that the Audit Analytics database is especially useful because it
includes stealth restatements, which are financial statements that are restated in a quarterly or
annual report without formally filing a disclosure announcement in the SEC 8-K form (Her,
Young-Won, and Son 2010).
The regression model in column 1 of Table 11 shows that the audit committee and board
experience variables do not add as much explanatory power to the model for log(premium) as do
the governance structure variables. The model has an adjusted R2 of 40.0%, about half that of the
governance structure model. Column 1 includes as regressors the entire set of audit committee
and board variables outlined in Table 4. Of this set, BOARD_FIN and US_OPS are significant at
the 10% level and SIZE at the 5% level. This means that the determinants of the premium in this
model are the percent of the board with finance experience, the size of the company, and the
company’s jurisdiction. The significance of US_OPS is further evidence that companies
incorporated in the U.S. but not listed on a U.S. exchange pay lower premiums than equivalent
U.S. exchange-listed firms. It is somewhat surprising that the audit and board variables do not
explain more of the variance in the D&O premium. The reason for this is investigated further in
this section.
Column 2 of Table 11 takes as independent variables the five variables predicted to most
significantly affect the premium: AUDIT_CONSULT, AUDIT_EXP, BOARD_FIN, RESTATE,
May 2011 Kang 64
and MERGER. Like the model in column 1, the one in column 2 controls for size, return on
equity, prior litigation, and U.S. operations. The first point to note is that dropping seven of the
initial variables actually increases the adjusted R2 relative to the first model. Inference is
unaffected by doing so; as before, BOARD_FIN is significant at the 10% level, suggesting that
the percentage of the board with finance experience influences the firm’s D&O premium.
Secondly, despite the high correlation between restatements and D&O claims, the restatement
dummy variable is not significant. This result is not entirely surprising. Since not all restatements
trigger substantial market capitalization losses, restatements do not necessarily lead to securities
class action lawsuits. Investors are more likely to suffer large losses—and in turn file lawsuits—
if a company discloses revenue overstatements as opposed to balance-sheet misclassifications
(Turner and Weirich 2006). Thus, only restatements that are litigated positively affect the D&O
premium. Despite their low significance, the five explanatory variables in column 2 explain as
much of the D&O premium as the full set of variables in column 1.
In column 3, I include indicators for the five largest accounting firms to test whether the
identity of the company’s auditor affects the D&O premium. There is a dummy variable for
PricewaterhouseCoopers, Deloitte & Touche, Ernst & Young, KPMG, and other (representing all
other auditors). ERNSTY is omitted for collinearity. In decreasing order of representation in the
sample, KPMG serves 34% of the firms, PricewaterhouseCoopers and Deloitte & Touche each
serve 26%, Ernst & Young 10%, and other 4%. As shown in column 3, the auditor dummies are
themselves significant at the 5% level and increase the significance of the independent variables.
The auditor dummies are each negatively related to the D&O premium, with Deloitte & Touche
having the largest effect. However, an F-test (p = 0.13) does not reject the restriction that the
May 2011 Kang 65
coefficients on the indicators are all zero. Overall, the coefficients on the five auditor dummies
are too similar in magnitude to have substantial meaning.
The purpose of this section has been to examine an alternative set of determinants of the
D&O premium. Since D&O claims are usually triggered by poor stock performance following
financial restatements, I focus on which factors affect restatements. I identify and test a set of
variables that collectively try to measure the attentiveness and financial proficiency of the board.
However, unlike the governance structure variables of the previous section, this set of variables
was not collectively significant. I attribute this result to three main reasons.
The first reason is that questions, such as does the firm have complex off-balance-sheet
entities or frequent merger activity, matter, but are only part of the larger picture. When asked
which factors they consider when pricing D&O insurance, underwriters name the factors tested
in this analysis. Any one factor by itself, though, does not explain much. For instance, merger
activity is highly significant before controlling for size, prior litigation, return on equity, and U.S.
operations. This suggests that merger activity is indeed a component of D&O pricing, but is not
itself a direct determinant. This could said to be the case for many of the variables in this
analysis.
The second reason explaining the low significance of the audit variables is that the
variance of these variables occurs in a range that is unimportant. For instance, several of the
variables are constrained by law. Sarbanes-Oxley required each audit committee to have at least
one ―financial expert,‖ causing the variable audit committee experience to fluctuate closely
around 33.3% (one out of three members is an audit committee financial expert). Thus, though
more experienced audit committees are indeed associated with lower D&O premiums, the effect
is not significant. In addition to audit committee experience, auditor fees are also constrained by
May 2011 Kang 66
law. After the Enron and Arthur Andersen scandal, firms are restricted as to what percentage of
auditor fees consist of consulting fees versus audit fees. Moreover, auditors are so wary after
Arthur Andersen that D&O insurers and regulators think it unlikely that auditors would be
willing to engage in fraud in exchange for more tax and consulting fees. The law thus limits the
variance of several variables, which is important because D&O insurance is often priced taking
into account any extreme values.
A final reason for why the governance structure variables explain the D&O premium
better than the audit variables is that the audit variables are too coarse to differentiate between
good and bad risks. For instance, the variable BOARD_MEET tells us how many times a year
the board meets, whereas we really want to know, ―Does the board meet enough times?‖
Similarly, variables such as AUDIT_MEET and AUDIT_EXP are only second-best at
determining ―Is this is a good Audit Committee?‖ On the other hand, governance structure
variables, such as INS_VALUE and DIR_OUT, vary widely between firms and accurately
measure insider ownership and the percentage of outside directors, respectively. Overall, the
coded variables for audit committee and board experience are too rough to proxy for the
underlying factors.
8. CONCLUSION
Using a sample of D&O premiums gathered from the proxy statements of Canadian
companies, this paper finds a detectable variation in D&O premiums that is related to variables
that proxy for the quality of a firm’s governance. This association between the governance
variables and the D&O premiums is robust to a number of alternate specifications. The results
verify Core (2000), who used cross-sectional data from 1993, and improve upon his original
May 2011 Kang 67
model by including proxies for intrafirm incentive and constraints. By showing that the proxies
for weak governance are positively associated with excess CEO compensation, I provide indirect
evidence that D&O insurers charge firms higher premiums when firms adopt governance
structures that make shareholders worse off.
These results have important policy implications, particularly in the United States where
D&O insurance details are not publicly disclosed. My study provides empirical support for D&O
disclosure, which Baker and Griffith (2007) have advocated for using qualitative evidence from
extensive interviews and surveys. The direct evidence in this paper suggests that U.S.
shareholders would find the independent assessment contained in these premiums to be a useful
summary of the likelihood of litigation associated with firms’ governance structure. The indirect
evidence, however, suggests that the same shareholders could use this as an additional tool for
assessing the relative effectiveness of firms’ governance structures in maximizing shareholder
returns. Directly or indirectly, the results suggest that the D&O premium contains information
useful to investors.
Specifically, the D&O premium can be converted into a proxy for governance quality
with a few simple adjustments for market capitalization, coverage limits, and industry. One of
the most important firm-specific characteristics is market capitalization, as shown by the high
significance of SIZE in all regressions. To account for market capitalization, we can use a simple
ratio dividing a firm’s annual D&O premium by its market capitalization on the effective date of
policy. For this ratio to yield useful comparisons, though, it must control for insurance limits.
Baker and Griffith (2007) suggest adjusting the D&O premium ratio by recalculating the
premium per dollar of coverage:
May 2011 Kang 68
Per dollar premium = ( )
( )( )
By calculating the per dollar D&O premium, we adjust for firms’ coverage limits and market
capitalizations. We can account for industry differences by comparing the per dollar premium
within industries, similar to how P/E ratios and valuation multiples are used in practice. This per
dollar premium figure is easy to calculate and comparable across firms. In cases where firms are
already covered by equity analysts, disclosure of D&O insurance information may provide useful
supplemental information on governance quality due to underwriters’ unique access to non-
public information through non-disclosure agreements. There are many public companies that
don’t receive any analyst coverage at all, yet almost all firms purchase D&O insurance. For these
firms, the information signaled through the disclosure of D&O details may therefore be the only
reliable third-party assessment of governance quality. Evidently, D&O information contains
information valuable to capital market participants.
One may wonder, however, whether corporations try to manage insurance costs by
eliminating those governance features that lead to higher premiums. There are two possibilities.
The first is desirable: D&O premiums could provide companies incentives to improve their
corporate governance. By continually optimizing their governance structures, they can find
themselves paying consistently less for D&O insurance than their competitors and enjoying
higher earnings and improved share values. The second possibility is more Machiavellian: firms
could conceivably game the system by adopting ―good‖ governance practices while still
maintaining bad management practices. Empirical data suggests, however, that corporations do
not manage insurance costs. The average total premium has a small effect on the corporation’s
net income, so the marginal costs of regularly reviewing and revising internal governance
policies outweigh the marginal benefits of saving in policy premiums. Managers certainly could
May 2011 Kang 69
improve the firm’s bottom line by cutting their salaries, giving back benefit packages, and firing
loyal but ineffective allies, but they will generally be disinclined to do so. Overall, it would not
be surprising if bad managers to refuse to be (or just appear) good in order to reduce an expense
that is ultimately borne by shareholders. This is an important outcome. If firms fail to continually
optimize their corporate governance and firms with worse corporate governance pay more for
D&O insurance than firms with better governance, then investors can use D&O pricing as an
accurate proxy to evaluate the quality of a firm’s corporate governance.
If D&O insurance information signals the quality of a firm’s governance, as this paper
shows, it is logical to ask why this signal is not already being sent. Baker and Griffith (2007)
suggest three main reasons. The first is that the value of D&O policy information is purely
comparative. Relevance of a firm’s premium and payout limits emerges only upon comparison
with similarly situated firms—for instance, taking a broad industry-wise sample and controlling
for such variables such as market capitalization and volatility. I show, however, that the per
dollar premium serves as a decent substitute. The second reason that D&O information is not
disclosed in the U.S. despite its value to investors is that each of the firms within an industry is
disinclined to produce this information because of free rider effects. The information is of value
largely to investors of other firms who cannot be charged for it. Those firms may also fear
backlash from disclosing D&O details. When not placed in context, millions of dollars of D&O
insurance expense does not reflect well on the company’s management. This is a classic example
of a first mover disadvantage. Finally and most importantly, firms fear that mandatory disclosure
of D&O insurance details will encourage the filing of non-meritorious (nuisance) suits by
plaintiffs’ lawyers seeking to reach insurance assets. This is the most commonly voiced objection.
However, is unlikely that disclosure will change the dynamics of shareholder litigation. Plaintiffs’
May 2011 Kang 70
lawyers are well aware that average limits for companies with assets in excess of $100 million
are in tens of millions of dollars and can estimate a company’s coverage within a fairly accurate
range. Disclosure of details would not add anything substantial to lawyers’ arsenals. Free-riding,
first mover disadvantage, and fear of attracting nuisance suits are the main concerns hindering
the disclosure of D&O details.
However, other countries that now mandate D&O disclosure, such as Canada and the
United Kingdom, overcame these same issues. The results of my study using U.S. cross-listed
firms support a robust negative relationship between D&O premiums and quality of corporate
governance. This is a rich area for future research. Overall, there is a growing consensus inside
and outside academia that weak governance is costly to outside shareholders. This paper shows
that the D&O premium can be a valuable source of information, henceforth unavailable or
unknown to the general investing public, to mitigate some of the costs associated with weak
governance.
May 2011 Kang 71
9. APPENDIX
Figure 1a: Relationship between firms’ D&O limit and market capitalization
Figure 1b: Relationship between firms’ D&O premium and market capitalization
-
20,000,000
40,000,000
60,000,000
80,000,000
100,000,000
120,000,000
140,000,000
160,000,000
180,000,000
Small Cap ($400M-1B) Mid Cap ($1B-10B) Large Cap (>$10B)
Annual D&O Policy Limits by Market Capitalization Category
mean
median
-
200,000
400,000
600,000
800,000
1,000,000
1,200,000
1,400,000
1,600,000
Small Cap ($400M-1B) Mid Cap ($1B-10B) Large Cap (>$10B)
Annual D&O Policy Premiums by Market Capitalization Category
mean
median
May 2011 Kang 72
Figure 2: Relationship between firms’ D&O premium and premium paid for coverage
Figure 3: Industry Composition of 92 TSX-US cross-listed firm sample
Mining
Diversified
Industries
Life
Sciences
Technology
Financial
Services
Industry Composition
Table 1. Descriptive Statistics for the D&O premium and its Hypothesized Determinants
Variable Variable Definition Predicted
sign
Mean Median Min Max Std. Dev.
D&O insurance variables
D&O premium Dollar amount of annual D&O insurance
premium
799,194 443,501 40,466 4,694,717 894,007
Log (premium) Logarithm of D&O premium 12.998 13.002 10.608 15.362 1.156
D&O limit Annual D&O coverage limit 75,580,344 40,000,000 5,000,000 4.5×108
80,861,085
Log (limit) Logarithm of D&O limit 17.621 17.504 15.425 19.925 1.073
Governance structure variables
INS_VOTE Percentage of share votes controlled by inside
directors
+ 5.7% 0.4% 0.0% 94.1%
16.2%
INS_VALUE Percentage of share value owned by inside
directors
2.9%
0.4%
0.0%
61.7%
7.4%
OUT_BLOCK =1 if an outside blockholder owns over 10% of
the stock
0.500
0.500
0.000
1.000
0.503
DIR_OUT Number of outside directors as a percentage of
the total number of directors
76.9%
80.0%
0.0%
100.0%
15.1%
DIR_APP
Percentage of outside directors that start board
service after CEO joins board
+ 63.7%
66.7%
0.0%
100.0%
33.3%
CEO_COB =1 if the CEO is also board chair + 0.163 0.000 0.000 1.000 0.371
May 2011 Kang 74
CONTRACT =1 if the CEO or any other top executive has
employment contract
+ 0.826 1.000 0.000 1.000 0.381
GOLD_PAR =1 if the CEO or any other top executive has a
golden parachute
0.826 1.000 0.000 1.000 0.381
POIS_PILL =1 if the firm has a poison pill or any other
takeover restriction
+ 0.163 0.000 0.000 1.000 0.371
INC_COMP Percentage of total CEO compensation
consisting of short-term incentive (bonus)
payment
+ 17.6% 16.0% 0.000 53.0% 14.8%
The sample consists of 92 observations. All variables are measured at the end of the fiscal year 2009 or for the fiscal year ending prior to the year of purchase of D&O insurance.
Dollar amounts are in U.S. dollars.
May 2011 Kang 75
Table 1. continued
Variable Variable Definition Predicted
sign
Mean Median Min Max Std. Dev.
Business risk variables
CEO_EXP Logarithm of the number of years
CEO has served on the board
1.517 1.609 0.000 3.258 0.936
ROE Net income before extraordinary items
divided by ending equity
-0.77% 2.9% -741.9% 697.7% 126.5%
SIZE Logarithm of year end market cap + 21.074 20.852 15.453 25.146 2.488
PRIOR_LIT
=1 if the firm experienced litigation
during the past 10 years
+ 0.152 0.000 0.000 1.000 0.361
US_OPS
=1if the firm is headquartered in the
U.S. and has U.S. sales or assets
+ 0.120 0.000 0.000 1.000 0.326
The sample consists of 92 observations. All variables are measured at the end of the fiscal year 2009 or for the fiscal year ending prior to the year of
purchase of D&O insurance. Dollar amounts are in U.S. dollars.
Table 2. Correlation Matrix of D&O premium and its Hypothesized Determinants
Table 3. Descriptive Statistics for CEO Compensation and tis Hypothesized Determinants
Variable Variable Definition Predicted
sign
Mean Median Min Max Std. Dev.
CEO compensation
Total compensation Total of (1) base salary; (2) annual
incentive payments; (3) the estimated
value of option grants and grants under
long-term incentive plans; plus (4) the
cash value of any benefits and perquisites
3,865,045
1,770,766
11,572
21,205,815
4,164,168
Log (Total compensation) Logarithm of total compensation 14.491 14.387 9.356 16.870 1.324
Explanatory variables
GOVERNANCE_QUALITY
Standardized linear composite of the
governance structure quality variables
defined by Equation (8)
0.000 0.025 -2.913 2.259
1.000
SIZE Logarithm of year end market cap + 20.833
20.472
15.391
25.074
2.491
GROWTH Market to book equity ratio + 2.209
1.682
-9.353
20.132
3.388
RETURN Percentage annual stock return + 79.6%
50.4%
-84.9%
722.3%
131.9%
ROE Net income before extraordinary items
divided by ending equity
+ -0.8%
3.2%
-741.8%
697.7%
126.5%
US_OPS =1if the firm is headquartered in the U.S.
and has U.S. sales or assets
+ 0.120
0.000
0.000
1.000
0.326
May 2011 Kang 78
The sample consists of 92 observations. All variables are measured at the end of the fiscal year prior to the year during which CEO compensation is earned, except for RETURN
and ROE, which are measured in the fiscal year during which the compensation is earned. Dollar amounts are in U.S. dollars.
Table 4. Descriptive Statistics for the Audit and Finance Experience Determinants of the D&O premium
Variable Variable Definition Predicted
sign
Mean Median Min Max Std. Dev.
Audit and finance variables
AUDIT_TOTAL Percentage of total auditor fees
attributed to audit and audit-related fees
88.6% 92.5% 24.0% 100.0%
12.8%
AUDIT_CONSULT Ratio of audit to non-audit fees 262.1
12.5
0.308
893.5
126.5
AUDIT_MEET Number of audit meetings per year 5.686
5.000
1.000
12.000
2.249
AUDIT_EXP Percentage of audit committee with
substantial finance or accounting
experience
44.8%
33.3%
0.0%
100.0%
24.7%
AUDITOR_YRS
Number of years of company’s
relationship with outside auditors
+ 10.700
8.000
1.000
41.000
890.6%
CEO_EXP Logarithm of the number of years the
CEO has served in this position
6.107 5.000 1.000 24.000 5.156
CFO_EXP Logarithm of the number of years the
CFO has served in this position
4.686 4.000 1.000 17.000 3.896
BOARD_MEET Number of board meetings per year 10.971 10.000 5.000 24.000 4.132
BOARD_FIN Percentage of board with substantial
finance or accounting experience
29.9% 29.0% 0.0% 60.0% 14.2%
RESTATE =1 if the firm has restated its financial
statements in the past three years
+ 0.200 0.000 0.000 1.000 0.403
May 2011 Kang 80
MERGER =1 if the firm has engaged in a merger
activity in the previous or current year
+ 0.586 1.000 0.000 1.000 0.496
OFF_BS =1 if the firm has off-balance-sheet
entities for financial transactions
+ 0.343 0.000 0.000 1.000 0.478
RELATED_PARTY =1 if the firm has related party
transactions during the policy year
+ 0.514 1.000 0.000 1.000 0.503
The sample consists of 92 observations. All variables are measured at the end of the fiscal year 2009 or for the fiscal year ending prior to the year of purchase of D&O insurance.
Table 5. Correlation Matrix of D&O premium and Audit Variables
Table 6. Regressions of the Logarithm of the D&O Premium
* p<0.05, ** p<0.01, *** p<0.001 F-test 27.62 31.31 24.46 23.88 Adjusted_R-squared 0.814 0.823 0.830 0.827 (0.75) (0.64) (0.69) (0.77) Constant 7.247*** 7.557*** 7.289*** 5.498*** (0.06) LDEDUCT 0.200** (0.21) PHARMA 0.443* (0.15) MINING 0.025 (0.30) COMMEDIA 0.092 (0.22) FINANCE 0.421 (0.22) TECH 0.169 (0.39) (0.39) (0.39) INC_COMP 0.772 0.945* 0.897* (0.09) (0.09) (0.09) (0.11) Residuals 0.977*** 0.979*** 0.923*** 0.683*** (0.20) (0.20) (0.20) (0.20) US_OPS -0.500* -0.468* -0.467* -0.093 (0.16) (0.16) (0.16) (0.18) PRIOR_LIT 0.266 0.324* 0.262 0.312 (0.05) (0.04) (0.05) (0.04) ROE -0.065 -0.072 -0.044 -0.069 (0.03) (0.03) (0.03) (0.03) SIZE 0.253*** 0.235*** 0.250*** 0.206*** (0.08) (0.07) (0.07) (0.07) CEO_EXP 0.160* 0.152* 0.162* 0.145* (0.15) (0.15) (0.15) (0.16) POIS_PILL 0.160 0.197 0.293 0.055 (0.15) (0.15) (0.15) (0.16) GOLD_PAR 0.360* 0.350* 0.381* 0.197 (0.17) CONTRACT 0.146 (0.16) (0.15) (0.16) (0.15) CEO_COB -0.201 -0.213 -0.242 -0.070 (0.22) (0.21) (0.21) (0.21) DIR_APP -0.717** -0.696** -0.662** -0.467* (0.41) (0.39) (0.40) (0.38) DIR_OUT 0.407 0.437 0.101 0.342 (0.12) OUT_BLOCK -0.054 (1.10) (1.05) (1.08) (1.11) INS_VALUE -3.924*** -4.018*** -4.309*** -3.792** (0.47) (0.45) (0.45) (0.49) INS_VOTE 2.097*** 2.095*** 2.239*** 1.804*** b/se b/se b/se b/se Model 1 Model 2 Model 3 Model 4
May 2011 Kang 83
Table 7. Partial F-test that βgovernance structure = 0
Model 1 Model 2 Model 3 Model 4
Industry effects NO NO YES1 NO
F-test for the
restriction that the
coefficients on all
of the governance
structure variables
are 0
6.24*** 7.74*** 8.38*** 4.34***
*** significant at the 0.001 level (two-tailed) 1
The high-risk industries are technology, finance, communication and media, mining, and pharmaceuticals.
Table 8. Factor Analysis of Independent Variables
Table 9. Regressions of the Logarithm of the D&O Premium and the Logarithm of the Limit
inc_comp -0.0056 0.4184 0.5267 0.3276 0.4402 pois_pill 0.1177 0.0943 -0.7134 0.2215 0.4192 gold_par -0.0463 0.7161 -0.1857 0.0717 0.4454 contract 0.1403 0.6990 0.1916 -0.0848 0.4478 ceo_cob 0.2786 0.0024 0.6681 -0.0156 0.4758 dir_app 0.5469 -0.2831 0.1674 0.0821 0.5860 dir_out -0.1128 0.2067 -0.1991 0.7943 0.2740 out_block 0.1862 0.3433 -0.1335 -0.7066 0.3304 ins_value 0.8798 0.0896 0.0070 -0.1219 0.2031 ins_vote 0.8142 0.0170 0.0202 -0.1304 0.3194 Variable Factor1 Factor2 Factor3 Factor4 Uniqueness
Rotated factor loadings (pattern matrix) and unique variances
* p<0.05, ** p<0.01, *** p<0.001 F-test 68.31 60.15 28.64 Adjusted_R-squared 0.838 0.820 0.646 (0.48) (1.09) (0.66) Constant 7.877*** -2.548* 11.605*** (0.08) LOG_LIMIT 0.898*** (0.08) RES_LIMIT 0.979*** (0.18) (0.19) (0.24) US_OPS -0.468** -0.275 -0.215 (0.14) (0.15) (0.19) PRIOR_LIT 0.324* 0.112 0.236 (0.04) (0.04) (0.06) ROE -0.072 -0.038 -0.038 (0.02) (0.03) (0.03) SIZE 0.235*** -0.013 0.276*** (0.06) (0.06) (0.08) CEO_EXP 0.152* 0.001 0.167* (0.05) (0.06) (0.07) GOVERNANCE_QUALITY -0.446*** -0.155* -0.322*** b/se b/se b/se Log(premium) Log(premium) log(limit)
May 2011 Kang 84
Figure 4: Plot of Log(premium) on Governance Quality
Table 10: Confirmatory Evidence Using CEO Compensation
* p<0.05, ** p<0.01, *** p<0.001 F-test 41.49 44.23 Adjusted_R-squared 0.727 0.740 (0.72) (0.70) Constant 6.020*** 5.974*** (0.15) PREMIUM_RES 0.306* (0.26) (0.26) US_OPS -0.394 -0.404 (0.06) (0.06) RETURN -0.130* -0.122* (0.07) (0.07) ROE 0.107 0.109 (0.03) (0.03) GROWTH 0.007 0.010 (0.03) (0.03) SIZE 0.413*** 0.415*** (0.08) GOVERNANCE_QUALITY -0.031 b/se b/se Model(1) Model (2)
May 2011 Kang 85
Table 11: Regressions of the Logarithm of the D&O Premium and Audit Variables
* p<0.10, ** p<0.05, *** p<0.01 squared 3.88 6.49 5.31 Adjusted_R 0.400 0.417 0.448 (1.39) (1.24) (1.33) Constant 8.206*** 7.561*** 8.889*** (0.64) OTHER -1.105* (0.38) KPMG -0.895** (.) ERNSTY 0.000 (0.39) DELOITTE -1.007** (0.40) PRICEWC -0.917** (0.40) (0.39) (0.38) US_OPS -0.769* -0.707* -0.795** (0.37) (0.35) (0.34) PRIOR_LIT 0.374 0.447 0.514 (0.10) (0.09) (0.09) ROE -0.056 -0.070 -0.078 (0.07) (0.06) (0.06) SIZE 0.172** 0.231*** 0.208*** (0.23) RELATED_PARTY -0.070 (0.30) OFF_BS 0.475 (0.25) (0.23) (0.24) MERGER 0.256 0.303 0.362 (0.31) (0.28) (0.28) RESTATE -0.166 -0.180 -0.137 (0.96) (0.92) (0.91) BOARD_FIN 1.830* 1.725* 1.853** (0.02) AUDITOR_YRS -0.004 (0.03) BOARD_MEET 0.019 (0.04) CFO_EXP 0.021 (0.03) CEO_EXP -0.015 (0.59) (0.53) (0.53) AUDIT_EXP -0.037 -0.068 -0.226 (0.06) AUDIT_MEET 0.047 (0.00) (0.00) (0.00) AUDIT_CONSULT 0.000 -0.000 -0.000 b/se b/se b/se Model 1 Model 2 Model 3
May 2011 Kang 86
Figure 5a. Normality of residuals
Figure 5b. Normality of residuals
May 2011 Kang 87
REFERENCES
Asaro, Catherine A. 2005. Beecher and Carlson. ―Will a Financial Restatement Cause Your
D&O Coverage to Disappear into Thin Air?‖ pp.1-5.
Baker, Tom, and Sean J. Griffith. 2007. ―Predicting Corporate Governance Risk: Evidence from
the Directors’ & Officers’ Liability Insurance Market,‖ Chicago Law Review, Vol. 74, pp.
487-544.
Baker, Tom, and Sean J. Griffith. 2007. ―The Missing Monitor in Corporate Governance: The
Directors' & Officers' Liability Insurer,‖ Georgetown Law Journal, Vol. 95, pp. 1795-
1842.
Bhagat, Sanjai, James A. Brickley, and Jeffrey L. Coles. 1987. ―Managerial Indemnification and
Liability Insurance: The Effect on Shareholder Wealth,‖ Journal of Risk and Insurance,
Vol. 54, pp. 721-736.
Bebchuk, L. A., and A. Hamdani, 2009. ―The Elusive Quest for Global Governance Standards,‖
University of Pennsylvania Law Review, Vol. 157, Issue 4, pp. 1263‐1317.
Bebchuk, Lucian A., Alma Cohen, and Allen Ferrell. 2009. ―What Matters in Corporate
Governance?‖ The Review of Financial Studies, Vol. 22, No. 2, pp. 783-827.
Black, Bernard S., Brian R. Cheffins, and Michael Klausner. 2006. ―Outside Director Liability:
A Policy Analysis,‖ Journal of Institutional and Theoretical Economics, Vol. 162, No. 1,
pp. 5-20.
Borokhovich, Kenneth A., Kelly R. Brunarski, and Robert Parrino. 1997. ―CEO Contracting and
Antitakeover Amendments,‖ Journal of Finance, Vol. 52, pp. 1495-1517.
Boubakri, Narjess, and Nabil Ghalleb. 2008. ―Does Mandatory Disclosure of Directors’ and
Officers’ Liability Insurance Curb Managerial Opportunism? Evidence from the
Canadian Secondary Market,‖ HEC Montreal Department of Finance and King Fahad
University Department of Finance & Economics. Working Paper, December.
Boyer, M. Martin. 2003. ―Is the Demand for Corporate Insurance a Habit? Evidence of
Organizational Inertia from Directors’ and Officers’ Insurance,‖ Cirano. Working Paper
No. 2004s-33, May.
Boyer, M. Martin. 2007. ―Three Insights from the Canadian D&O Insurance Market: Inertia,
Information and Insiders‖ Connecticut Insurance Law Journal, Vol. 14, No. 1, pp.75-106.
Boyer, M. Martin, and Lea H. Stern. 2010. ―Is Corporate Governance Risk Valued? Evidence
from Directors’ and Officers’ Insurance,‖ Cirano and Ohio State University Fisher
School of Business. Working Paper, February.
Brickley, James A., Jeffrey L. Coles, and Gregg Jarrell. 1997. ―Leadership Structure: Separating
May 2011 Kang 88
the CEO and Chairman of the Board,‖ Journal of Corporate Finance, Vol. 3, p. 189-220.
Cao, Zhiyan, and Ganapathi Narayanamoorthy. 2005. ―Accounting and Litigation Risk,‖ Yale
School of Management. Working Paper No. 47, November.
Core, John E. 1997. ―On the Corporate Demand for Directors’ and Officers’ Insurance,‖ The
Journal of Risk and Insurance, Vol. 64, No. 1, pp. 63-87.
Core, John E. 2000. ―The Directors' and Officers' Insurance Premium: An Outside Assessment of
the Quality of Corporate Governance,‖ The Journal of Law, Economics, and
Organization. Vol. 16, No. 2, pp. 449-477.
Core, John E., Holthausen, Robert W., and David F. Larcker. 1999. ―Corporate
Governance, Chief Executive Officer Compensation, and Firm Performance,‖ Journal of
Financial Economics, Vol. 51, No. 3, pp. 371-406.
Cornerstone Research, Securities Class Action Filings: 2005, A Year in Review 4 (2006).
http://securities.stanford.edu/clearinghouse_research/2005_YIR/2006012302.pdf,
accessed September 8, 2010.
Dechow, Patricia M., Richard G. Sloan, and Amy P. Sweeney. 1996. ―Causes and Consequences
of Earnings Manipulations: An Analysis of Firms Subject to Enforcement Actions by the
SEC,‖ Contemporary Accounting Research, Vol. 13, pp. 1-36.
Directors and Boards. Spring 2007. ―Boardroom Briefing: D&O Insurance.‖ Directors and
Boards and GRID Media LLC, Vol. 4, No. 1, pp. 4-36.
―Directors and Officers Insurance Cleans up Executive Messes.‖ Last updated June 7, 2010.
http://www.insure.com/articles/businessinsurance/directors-officers-insurance.html,
accessed September 8, 2010.
Fitzpatrick, Sean M. 2004. ―Fear is the Key: A Behavioral Guide to Underwriting Cycles,‖
Connecticut Insurance Law Journal, Vol. 10, No. 2, pp. 255-275.
Foley & Lardner LLP. 2007. ―Director and Officer Liability Trends and D&O Insurance—
Advanced Issues.‖ 2007 National Directors Institute. http://www.foley.com/files/
tbl_s31Publications%5CFileUpload137%5C4087%5CDOLiability.pdf, accessed June 1,
2010.
Garen, John E. 1994. ―Executive Compensation and Principal-Agent Theory,‖ Journal of
Political Economy, Vol. 102, No. 6, pp. 1175-1199.
Gaughan, Patrick A. 2007. Mergers, Acquisitions, and Corporate Restructurings, 4th
ed. New
Jersey: John Wiley & Sons.
Gillan, Stuart L. 2005. ―Recent Developments in Corporate Governance: An Overview,‖ Journal
of Corporate Finance, Vol. 12, pp. 381– 402.
May 2011 Kang 89
Gische, David. 2000. ―Directors and Officers Liability Insurance.‖ Last updated 2000.
http://library.findlaw.com/2000/Jan/1/241472.html, accessed April 21, 2010.
Gompers, Paul A., Joy L. Ishii, and Andrew Metrick. 2003. ―Corporate Governance and Equity
Prices,‖ Quarterly Journal of Economics, Vol. 118, No. 1, pp. 107-155.
Green, Meg. 2010. ―Executives: Competition Driving Down Prices in the D&O Market.‖ Last
updated 2010. http://insurancenewsnet.com/article.aspx?id=158711&type= property
casualty, accessed May 13, 2010.
Griffith, Sean J. 2006. ―Uncovering a Gatekeeper: Why the SEC Should Mandate Disclosure of
Details Concerning Directors' & Officers' Liability Insurance Policies,‖ University of
Pennsylvania Law Review, Vol. 154, pp. 1147-1208.
Gutierrez, Maria. 2003. ―An Economic Analysis of Corporate Directors’ Fiduciary Duties,‖ The
RAND Journal of Economics, Vol. 34, No. 3, (Autumn 03), pp. 516-535.
Hart, Oliver, 1995. ―Corporate Governance: Some Theory and Implications,‖ The Economic
Journal, Vol. 105, No. 430, pp. 678-689.
Her, Young-Won, Lim, Jane, and Myungsoo Son. 2010. ―The Impact on Financial Restatements
on Audit Fees: Consideration of Restatement Severity,‖ International Review of
Accounting, Banking and Finance, Vol. 2, No. 4, pp. 1-22.
Holderness, Clifford G. 1990. ―Liability Insurers as Corporate Monitors,‖ International Review
of Law and Economics, Vol. 10, pp. 115-129.
Jensen, Michael C., and William H. Meckling. 1976. ―Theory of the Firm: Managerial Behavior,
Agency Costs, and Ownership Structure,‖ Journal of Financial Economics, Vol. 3, Issue
4, pp. 305-360.
Kaltchev, George D. 2008. ―The Demand for Directors’ and Officers’ Liability Insurance by US
Public Companies,‖ Southern Methodist University. Working Paper, December.
Kuchta, James. 2001. ―Rates Head Skyward for Corporate D&O Insurance,‖ American Agent &
Broker, May 1: p.1.
Nelson, James. 2005. ―Corporate governance practices, CEO characteristics and firm
performance,‖ Journal of Corporate Finance, Vol. 11, pp. 197-228.
O’Sullivan, Noel. 1997. ―Insuring the Agents: The Role of Directors’ and Officers’ Insurance in
Corporate Governance,‖ The Journal of Risk and Insurance, Vol. 64, No. 3, pp. 545-556. Phillips, Zack. 2010. ―Glut of Capacity Expected to Keep D&O Market Soft,‖ Business
Insurance, January 11: p. 1.
May 2011 Kang 90
Redington, William C. 2006. ―An Underwriter’s Perspective on Audit Committee Expertise,‖
International Journal of Disclosure and Governance, Vol. 3, No. 2, pp. 107-114.
Shleifer, Andrei, and Robert W. Vishny. 1986. ―Large Shareholders and Corporate Control,‖
Journal of Political Economy, Vol. 94, pp. 461-488.
Shleifer, Andrei, and Robert W. Vishny. 1997. ―A Survey of Corporate Governance,‖ Journal of
Finance, Vol. 52, pp. 737-783.
Tillinghast Towers Perrin, 2002. ―Directors and Officers Liability Survey: US and Canadian
Results.‖ http://www.towersperrin.com/tp/getwebcachedoc?webc=TILL/USA/2003/
200304/DO_summary002a.pdf, accessed May 10, 2010.
Tillinghast Towers Perrin, 2005. ―Directors and Officers Liability Survey.‖
http://www.towersperrin.com/tillinghast/publications/reports/2005_DO/DO_2005_Exec_
Sum.pdf, accessed September 9, 2010.
Towers Perrin. 2007. ―Directors and Officers Liability: 2007 Survey of Insurance Purchasing and
Claim Trends.‖ http://www.towersperrin.com/tp/getwebcachedoc?webc=REIN/USA/
2008/200806/do_survey_report_061008.pdf, accessed June 1, 2010.
Turner, Lynn E., and Thomas R. Weirich. 2006. ―A Closer Look at Financial Statement
Restatements.‖ The CPA Journal, December, Vol. LXXVI, No. 12.
Wyatt Company. 1993. Directors and Officers Liability Survey. Chicago: Wyatt Company