Directors and Officers liability insurance: Analysis of disclosure effects and other implications
Directors and Officers liability (D&O) insurance is used extensively in top management compensation. This insurance reduces the financial liability of top management arising from lawsuits, especially shareholder lawsuits. According to a survey by Towers Perrin, 99% of their surveyed U.S. firms buy D&O insurance for their officers and directors. Surprisingly, only a handful of firms listed in the US disclose their D&O insurance practices (based on my extensive search of publicly available databases on corporate disclosure). In addition, there is ample evidence that a large number of firms provide coverage beyond the level justified by the economic theory on normal corporate insurance (Kim, 2005). Such corporate practices raise at least two important questions. First, what factors determine the disclosure of D&O insurance? Second, why do some firms insure their officers and directors for amounts that exceed the level justified by the economic theory on corporate insurance?
This study provides insights into both questions. Using a sample of firms from 2004 to 2008, I focus on level of competition, threat of increase in lawsuit costs, firm's ability to pay damages, internal governance, and level of external monitoring to examine the discrepancies in disclosure. Consistent with the hypothesis, the results show that firms in competitive industries, firms with a high probability of lawsuits, big firms, firms with weak internal governance, and firms with high institutional holdings are less likely to disclose D&O insurance. In addition, I examine the implications of the purchase of abnormal D&O insurance on firm performance. For this aspect of the analysis, I draw from the literature on optimal contracting and examine the relation between abnormal D&O insurance and aggressive firm reporting, aggressive project selection, and firm's profitability. The results show that abnormal D&O insurance is positively associated with aggressive reporting, aggressive investment activity, and abnormal profit performance.