By M. Martin Boyer HEC Montréal, Université de Montréal. and. Sharon Tennyson Cornell University. Current Draft December 2011

Transcription

1 Directors and Officers Liability Insurance, Corporate Risk and Risk Taking: New Panel Data Evidence on the Role of Directors and Officers Liability Insurance* By M. Martin Boyer HEC Montréal, Université de Montréal and Sharon Tennyson Cornell University First Draft July 2008 Current Draft December 2011 Abstract. In this paper, we develop and estimate models of the determinants of firms demand for directors and officers liability insurance. We add to and validate the existing empirical literature by testing hypotheses regarding the relationship between D&O insurance purchase and firm size, governance characteristics and business risk. Our data set allows us to test both purchase decisions and limits choices. We present separate estimates of these decisions along with estimates that allow for their joint determination and recognize the potential for selection bias in the estimates of coverage limits models. To shed additional light on the role and consequences of D&O insurance we make additional use of the panel structure of our data to examine the effects of D&O insurance purchase on corporate governance. * Comments and suggestions are welcomed. Please do not distribute, cite or quote without the authors permission. Copyright 2008 and 2011 by M. Martin Boyer and Sharon Tennyson.

2 Directors and Officers Liability Insurance, Corporate Risk and Risk Taking: New Panel Data Evidence on the Role of Directors and Officers Liability Insurance 1. Introduction Members of the boards of directors of publicly traded corporations in many countries around the world face personal liability for breach of the duties of care and loyalty to the company s shareholders (Romano, 1991). Imposing liability is thought to aid in aligning managers incentives with the interests of shareholders, by providing shareholders with a mechanism for recouping losses brought about by director malfeasance. Permitting shareholder suits is also a means to deal with the classic agency problem, acting as a disciplinary force on managers and directors (see Becht et al, 2003, and Bauer et al, 2008). 1 The latest Towers-Watson (2011) survey finds that 29% of public companies reported having a D&O claim in the previous 10 years; with two-thirds of public companies reporting at least one direct shareholder or investor lawsuit (the same for derivative lawsuits). Surveys of U.S. and Canadian firms find that the most common reasons for D&O suits brought against public companies are inadequate or inaccurate disclosure (42%), stock or other public offerings (20%) and general breach of fiduciary duty (13%); and that the majority of suits (53%) are brought by shareholders (Towers-Watson, 2007). This pattern has remained relatively stable over the last decade. For example, the 2002 edition of the same survey of D&O trends (Towers-Watson, 2002) highlights that 46% of complaints arose from disclosure related issues or stock offerings. Shareholders remained the largest source of complaints against public companies (58%) in that year. 2 One puzzle is that the strength of this shareholder liability threat is often mitigated by the corporation s purchase of directors and officers liability insurance (D&O insurance hereafter) on 1 For example, DuCharme et al. (2004) argue that discovered false earning signals have important reputational consequences that result in a higher difficulty of raising capital in the future. The threat of a shareholder suit may reduce earnings restatements and thus increase the value of the firm. McTier and Wald (2011) present an alternative view that shareholder suits arise from legal rent-seeking by opportunistic plaintiffs' attorneys who sue firms that experience large stock price drops in order to expropriate a settlement from the firm's D&O insurance policies (see also Beck and Bhagat, 1997). 2 Prior to 1996, mergers and acquisitions activity was the greatest source of shareholder complaints against public companies, representing as much as 40% of all complaints against public companies in 1990 (Towers-Watson, 2002). 1

3 the board s behalf. 3 D&O insurance provides indemnity for damages and legal fees awarded to claimants who bring suits for losses stemming from negligent actions on the part of directors and officers. 4 D&O insurance policies exclude losses arising from deliberate fraud or dishonesty, however (Ross et al, 2000). As such, D&O insurance provides coverage to a company s officers and directors against risks arising from day-to-day management. Thus, on the one hand corporate owners threaten directors with liability but on the other hand they provide insurance to indemnify them for court costs and judgments. The purchase of D&O insurance raises the obvious concern that lowering directors liability risk will increase agency problems within the firm, and will decrease board effectiveness (see Barrese and Scordis, 2007, and Bradley and Chen, 2011). 5 Under this point of view D&O insurance may lead to inefficiencies and is more likely to be purchased by entrenched management. Others theories suggest that purchase of D&O insurance enhances board efficiency. For example, liability exposure may induce managers to be overly conservative and may cause them to forego risky positive-npv projects (an under-investment problem). D&O 3 It used to be that D&O insurance was only available to organizations incorporated in common law countries such as England, Canada, the United States, and Australia. The globalization of markets seems to have generated a demand for protection by corporate directors in civil law countries. This is a relatively new turn of events. Gutiérrez (2003) reported that D&O insurance was rarely used in continental Europe because it reduces director accountability; she wrote that D&O insurance was forbidden in Germany, where the legislature considers that its use would both reduce the levels of diligence of directors and increase the compensatory demands of plaintiffs (p.517). However, the German Corporate Governance Code of 2002 now allows directors to have such insurance (see Werder et al, 2005, and Talaulicar and Werder, 2008). Recently, LaCroix (2009) posted the following: Most large European companies carry some amount of D&O insurance, although the perceived level of D&O insurance coverage need varies among countries. Many small to mid-sized European public companies do not purchase D&O insurance at all In Japan, the usefulness of D&O insurance is limited because the concept of punitive damages is regarded as incompatible with the public order. In France, the action sociale limits the scope of derivative lawsuits. D&O insurance protection is now the norm for directors in Taiwan (see Chen and Li, 2010). Interestingly, Towers-Watson (2011) reports that 47 percent of for-profit organizations with international operations purchased a local D&O policy in a foreign jurisdiction in Two years before, only 2 percent of respondents with international operations had purchased a local policy in a foreign jurisdiction. 4 D&O insurance policies offer three different types of coverage, which are called sides in the insurance business (Gustafson, 2006). Side A (or, individual) coverage ensures direct reimbursement for directors and officers when a company is unable (for legal reasons or because of bankruptcy) or does not wish to reimburse them. Side B (or, corporate) coverage is the most common type of D&O coverage, and ensures that a company will be reimbursed for any amounts paid to claimants on behalf of the directors and officers. The third form of coverage is Side C (or, entity) which provides for direct reimbursement of costs that the company itself may incur from D&O related suits. Most D&O insurance policies consist of a mix of all three types of coverage (Towers-Watson, 2011). 5 D&O insurance policies are not the only means of protection available to directors and officers. There are several other contracts that ensure peace of mind to directors and officers in their day-to-day decision-making. For example, in Canada and in most U.S. states corporations are allowed to indemnify directors for legal expenses associated with lawsuits in which they are not found negligent; in these cases D&O insurance may increase moral hazard by increasing directors certainty of being indemnified and increases the extent of indemnification offered (Romano, 1991, 2006). 2

4 insurance may also help to attract higher quality risk-averse outside directors (Priest, 1987). It has also been suggested that D&O insurance may substitute for direct shareholder monitoring by relying on the insurer s screening mechanisms (Holderness, 1990). 6 These arguments suggest that D&O insurance will benefit shareholders by encouraging optimal risk taking, and that D&O insurance is part of an efficient contract between shareholders and directors. Although theoretical discussions of the demand for and the effects of D&O insurance have developed significantly, relatively fewer empirical studies have been conducted. This is likely due to the fact that data on D&O insurance purchases are not readily available. Beginning in the 1990s several countries including England and Canada require publicly traded companies to report D&O insurance purchases to shareholders; but obtaining this information often entails hand-collection of data from annual reports (Core, 1997, 2000, Park-Wynn, 2008; O Sullivan, 1997, 2002). Other research has taken advantage of voluntary D&O insurance disclosures (Bhagat et al, 1987), proprietary data from insurance brokers (Holderness, 1990; Chalmers et al, 2002; Kaltchev, 2004; Kim, 2005), or survey data from Tillinghast Towers-Perrin or Towers- Watson (Cao and Narayanamoothy, 2010). 7 One consequence of the difficulties of obtaining data is that the sample sizes used in empirical work have been small, and are generally confined to a cross-section of firms. 8 To allow for a more rigorous empirical testing of the different theories we construct a unique panel dataset of firm level data. Our original sample consists of data from over 200 publicly traded Canadian corporations listed on the Toronto Stock Exchange (excluding financial and mining firms). The sample period covers the years 1996 through 2005 and includes firms from seven sectors of the economy. We include in our sample both newly listed firms and firms that disappear from the data during the period, to avoid problems of survivor bias. A key advantage 6 A related idea is that D&O insurance enhances efficiency by providing a commitment device to induce shareholders to sue negligent directors (Bhagat et alii, 1987; Sarath, 1991; Gutierrez, 2003; Chang and Yeh, 2011). Gutierrez (2003) develops a formal theoretical model of this view which is based on the assumptions that director negligence is unobservable, that potential shareholder losses are greater than directors wealth, and that lawsuits are costly for shareholders. In these circumstances the model shows that D&O insurance can serve to commit shareholders to bring costly litigation against directors in the event of losses or disappointing returns (see also Boyer, 2005, and Kremslehner, 2011, for similar arguments). 7 The 2010 Directors and Officers (D&O) Liability survey is the 32 nd in a series that was initiated by Wyatt in 1992 (previously it was titled Health care organization directors and officers liability survey), continued by Watson-Wyatt, then by Tillinghast Towers-Perrin and Towers-Perrin. The survey is now conducted by Towers-Watson and no longer covers Canada independently from the United States. 8 One exception is Kaltchev (2004) who analyzes a panel dataset of U.S. firms that purchase D&O insurance from one insurance broker. 3

5 of the dataset for our purposes is that the purchase of D&O insurance is less prevalent in Canada than in the U.S. during the period of our study. Moreover, our data include both firms that purchase D&O insurance and firms that do not, as well as firms that change their insurance status over the sample period. In addition, many firms change their D&O insurance limits over the period, which provides an additional source of variation for empirical testing. Using the extant theoretical literature on D&O insurance purchase, coupled with the literature on corporate insurance purchases, we develop and estimate models of the determinants of firms demand for D&O liability insurance. We add to and validate the existing empirical literature by testing hypotheses regarding the relationship between D&O insurance purchase and firm size, governance characteristics and business risk. Our analysis differs from previous research in recognizing that D&O litigation risk depends on the affected shareholders exposure and not on all shareholders exposure. Also, while previous studies have assumed that purchase decisions and limits choices depend on the same variables, this is not strictly true and we can separately analyze these two decisions. Our dataset allows us to test both purchase decisions and limits choices. We first present separate estimates of these decisions. We then present estimates that allow for their joint determination, and that recognize the potential for selection bias in the estimates of insurance coverage limits choices if the purchase decision is not accounted for (Heckman selection corrected estimates). To shed additional light on the role and consequences of D&O insurance we make further use of the panel structure of our data to examine the effects of D&O insurance purchase on corporate governance measures. 2. Existing Empirical Literature Support for the hypothesis that providing D&O insurance is part of an efficient contract with a firms directors and officers is provided by several event studies which find a positive or insignificant share price reaction to events that reduce directors personal liability. Bhagat et al (1987) find suggestive evidence of positive share price effects (and no significant negative share-price effects) of firms announcements of the purchase of D&O insurance. Similarly, Brook and Rao (1994) find no significant stock price reactions to firms adoption of director indemnification plans. Changes in the legal regime regarding director liability also appear to have had no negative effects on firm value. Bhagat et al (1987) find that a New York law broadening director indemnification had no significant effects on share prices, results that are 4

6 echoed in Janjigain and Bolster s (1990) study of Delaware rule changes regarding director liability. Other research has focused on the moral hazard effects of D&O insurance, and these results must be seen to temper the conclusions of the event studies. The first such study, by Chalmers et al (2002), examines the purchase of D&O insurance around initial public offerings of 72 U.S. firms. The study finds that firms long-run stock performance is negatively related to the amount of D&O insurance purchased. Kim (2005) uses proprietary data to construct a matched sample of 93 U.S. firms and finds that firms which purchase greater-than-predicted amounts of D&O insurance are significantly more likely to engage in earnings restatements. Boubakri et al (2008) use data from a sample of 138 Canadian seasoned equity offerings to examine the relationship between D&O insurance and earnings management. 9 Similar to Kim, these authors find that excessive D&O insurance coverage is associated with more aggressive earnings management. They also find that firms appear to purchase D&O insurance coverage in anticipation of opportunistic behavior, but that this likelihood is reflected in a higher insurance premium. A small empirical literature has emerged to test hypotheses regarding the relationship between firm characteristics and the demand for D&O insurance. Using cross-section data on Canadian and British firms respectively, Core (1997, 2000) and O Sullivan (1997) provide the first such analysis. O Sullivan relates the D&O insurance purchase decisions of 366 firms in the United Kingdom to their corporate governance characteristics, and concludes in favor of Holderness (1990) view that D&O insurance serves as a form of monitoring of directors and officers. Specifically, O Sullivan finds that the purchase of D&O insurance is positively related to firm size and, and negatively related to insider ownership of shares. These corporate features are predicted to increase the demand for monitoring or to increase the cost of monitoring alternatives to D&O insurance. Core (1997) analyzes D&O insurance purchase and coverage limits using a cross-sectional sample of 222 Canadian firms, using data on board characteristics, insurance purchase and financial conditions of each firm. Results are generally consistent with theories of corporate insurance purchase as firms with higher risk are more likely to purchase insurance and choose higher coverage limits, although few explanatory variables are statistically significant at conventionally accepted levels. Specifically, the estimates show that firms with prior D&O 9 For more on the relationship between the risk of lawsuits, D&O insurance and earnings management, see Cao and Narayanamoorthy (2010), DuCharme et al. (2004) and Boyer and Hanon (2009). 5

7 litigation, higher insider voting control and lower insider ownership percent are more likely to purchase insurance and also purchase higher coverage limits. Greater risk of financial distress is also associated with higher coverage limits, as is firm size. Core (2000) uses the same sample to analyze D&O insurance premiums and finds that premiums are higher for firms that have weaker corporate governance and higher litigation risk. The importance of corporate governance for insurer underwriting and premium determination is verified by Baker and Griffith (2007), who report results of an intensive interview-based study of the D&O insurance underwriting process. Although these studies provide important first steps in understanding the characteristics of D&O insurance market participants, the use of panel data on firms that are drawn from stock market listings is important if our interest lies in understanding the demand for and effects of D&O insurance. The only panel data study of D&O insurance demand in the United States uses a sample of 337 firm-year observations on 113 firms for the period (Kaltchev, 2004). The data are proprietary and are obtained from an insurance broker; thus all firms purchase insurance in each year and firms appear in the sample in a year only if they purchase insurance through the broker. These features limit the set of decisions that can be analyzed using the sample, and may introduce selection bias if decisions to purchase insurance or to purchase through the broker are systematically related to firm characteristics that affect purchase limits. 3. Empirical Framework This research analyzes the demand for and effects of D&O insurance among publicly traded companies. First, we examine the characteristics of firms that are associated with the acquisition of D&O insurance as compared to firms that do not purchase insurance. Second, we measure the factors that are associated with the choice of the policy limit for an insurance contract. For those firms that purchase D&O insurance, we examine whether the price of insurance reflects corporate governance quality, and whether the purchase of insurance appears to influence board structure and compensation. Insurance purchase decisions of corporations are determined by a wide variety of factors including the financial position of the firm in relation to the potential loss severity and probability distribution of loss; risk tolerance of the board (if directors are risk averse); insurance service benefits demanded by the firm (and in this context we must include monitoring of the board); and opportunism by an entrenched board (who get insurance benefits but do not pay the full 6

8 cost of insurance). This implies that the decision to purchase insurance should be determined by a large set of firm characteristics including the corporate board structure; firm size and growth opportunities; and the risk of litigation. The price of insurance will also matter, but the price at which insurance is offered will be affected by many of these same firm characteristics. 3.1 Litigation Risk Measuring differences in firms litigation risk exposure is the most challenging, but one can proxy for the risk based on characteristics of the legal and institutional environment. We know from our previous discussion that shareholders represent the most important (and costly) group of possible plaintiffs (see the different surveys of Towers-Watson). Yet it is important to realize that not all shareholders have the right to sue for managerial incompetence or misinformation. Shareholders need to show the amount of damages they suffered by providing evidence of the difference between the price at which the stock was purchased and the estimated market price of the stock if no false statement had been made (perhaps some model market price). 10 Suppose that managers reported misleading accounting results on June 1 st 2003 (on which day the share price increased from P 0 to P 1 ) and that these false results are acknowledged on June 30 th 2003 (on which day the share price falls from P 1 to P 2 ). The shareholders who may have a claim are not those who purchased the stock prior to June 1 st (they were buying on correct information), nor those who purchased and sold prior to June 30 th (their information set is the same). The shareholders that can claim to have lost money because of managerial misinformation are those who purchased on or after June 1st (after the false news) and held on to the shares until June 30 th (after the correction). Their loss, per share, is P 1 -P Assuming there are N shares of stock on the market and a proportion ρ of shareholders that can claim a loss, the potential lawsuit is equal to S N this as S P 1 P 2. In terms of returns, we can write NP 1 1 r 2, with r 2 P2 P1 0. We therefore see that the potential loss is a function of the proportion of shareholders who purchased on wrong information and held on to the stock (ρ), the current market value of equity of the company (NP 1 ) and some measure of the 10 Another possible formula for damages could be to have them equal to the average stock market price for one month before the date on which the false statement was publicly announced, minus the average stock market price during the month after the public announcement. 11 If we assume continuously compounded return r, the loss per share between date t 1 and date t 2 r t2 t1 r t2 t1 becomes P Pe P 1 e

9 return that will befall the stock when the real information is revealed (1+r 2 ). Of course, assuming that insurance is purchased on June 1 st, the only unknowns are ρ and r 2 since the firm's market value of equity is known at the time the insurance is purchased. 12 Because we are dealing with very different firms in terms of size, it is appropriate to use the log of the potential loss instead of the expected loss per se. This means that E ln S ln NP E ln E ln r (1) Because the purchase of insurance and the insurance policy limit should be positively related to the expected loss from shareholder suits E[ln(S)], we observe that insurance purchase and policy limits should be positively related to the log of the firm's market value of equity, ln(np 1 ), 13 the importance of small shareholders E[ln(ρ)], and the expected downward return of the stock E[ln(1+r 2 )]. The log of a firm s market value of equity can be directly measured using stock market data. The two other components of the potential loss, ρ and r 2, are more difficult to measure. The proportion of shareholders that have a claim (ρ) depends on the number of new shareholders that purchase the stock on date t=1 and keep it until date t=2. We may proxy for the percent of shareholders who potentially suffer a loss due to managerial misbehavior by examining the frequency with which the firm s stock has traded in recent time periods. More frequent trades will increase the percent of shareholders with standing in a suit, and will therefore be positively related to the firm s demand for insurance. We may also expect that ρ is a function of the importance of minority shareholders, or an inverse function of the presence of important block holders and insider shareholders. Thus the presence of large block holders should have a negative impact on the demand for D&O insurance. We thus hypothesize that ρ is a positive function of the float (the proportion of shares that are available to the public) and a negative function of the presence of block holders and managerial shareholding. As a proxy for the presence of large block holders in the ownership structure of Canadian corporations, we shall use the shareholding of large financial institution (calculated as the percentage of the shares held by financial institutions, provided they own 12 The proportion of shareholders that will be able to claim a loss (ρ) will depend on the number of new shareholders that purchase the stock on date t=1 and keep it until date t=2. 13 Put differently, given that the most damaging lawsuits originate from shareholders so that the more shareholders have to lose because of the managers' incompetence, the more protection the firm will purchase. 8

10 more than 10% of the stock). Similarly, we calculate the extent of managerial shareholding, the percentage of the firm s shares held by insiders (corporate officers or employees) on the board. We expect these measures of concentrated ownership to have a negative impact on the demand for insurance. The expected downside risk of managerial wrongdoing, ln 1 r E, will be positively related to D&O insurance ownership and may be related to several observable variables. The first is the stock's annual volatility of compounded daily returns. The more volatile the stock price is to any type of information, the greater should be the price jumps following the revelation of managerial wrongdoing. We also expect a positive relationship between financial distress and the expected downside return since a firm in financial distress is more likely to observe a very bad return (bankruptcy represents a return of -100%) than a firm that is financially healthy. Finally, the firm s return on assets (ROA) measures the solidity of the firm s earnings, with ROA negatively related to the expected downside return of the stock. Stock volatility and risk of financial distress should be positively related to D&O insurance demand, while ROA should be negatively related to demand Firm size and growth opportunities Traditional insurance theory (Mayers and Smith, 1982) implies that larger firms should be less likely to purchase insurance, predicting a negative relationship between asset size and purchase decisions. On the other hand, the shareholder protection strategy implies that the purchase decision should be positively related to firms market capitalization (MVE). It is also true that stakeholders other than shareholders are allowed to sue a firm s directors and officers. These lawsuits are usually related to the firm s operations (employees, clients, suppliers) so that directors in larger firms are more likely to be sued. For these reasons larger firms, measured both in terms of operations and shareholder equity, will have a stronger demand for owning D&O insurance. The aggregate (annual) limit of a policy must take into account both the expected frequency and the expected severity of claims. Of primary importance in the coverage limits calculation is the potential severity of the loss. Moreover, the more frequent are claims the higher should be the aggregate limit, which must account for the sum of all claims. A policy s aggregate limit may be measured as Limit f n * S n, where n is the number of possible claims, f n is the frequency n 9

11 distribution of claim n and S n is the severity distribution of claim n. The choice of coverage limit will depend on those factors that affect the decision to purchase insurance, plus a few additional characteristics. There are two primary sources of exposure to a D&O insurance claim: financing and operations. Lawsuits originate from the shareholders or from individuals who have a close relationship with the firm s operations (mostly employees, but suppliers, clients and governments too). Financingrelated claims are likely due to significant decreases in share price, which is why these types of claims are very infrequent 14 for not-for-profit organizations. Operations-related claims are linked to the size of the firm s operations: The larger the operations, the more likely and severe will be the claims. Although financing-related and operations-related claims will both funnel into the general D&O insurance policy, the determinants of each will be different. Taken together, however, these factors imply that coverage limits will depend importantly on firm size and future growth opportunities. 3.3 Board structure and governance As with other insurance, economic theory predicts that the provision of D&O insurance protection to directors and officers will reduce their incentives to monitor managers activities and to provide energetic oversight of the financial condition of the firm. This was the main reason why D&O insurance was not allowed in many continental European countries until very recently (see Gutierrez, 2003, Werder et al, 2005, and LaCroix, 2009). Recognizing this problem, insurers engage in substantial amounts of pre-sale monitoring of potential purchasers of D&O insurance (Baker and Griffith, 2009). Holderness (1990) states that insurers may negotiate changes in a firm s corporate governance as a condition for obtaining insurance, including diluting the power of the Chairman of the Board and increasing the number of outsiders on the audit committee. 15 As discussed previously, these relationships imply that board structure and governance may affect both the demand for D&O insurance and D&O insurance prices, and previous empirical 14 Only 7% of not-for-profit organizations report having had a D&O insurance claim related to a derivative lawsuit the most costly types of lawsuits in the previous 10 years, compared to 65% of public organizations (Towers-Watson, 2008) and 7% of private organizations. 15 On the other hand, Romano (1991) finds that corporations change their governance structures in reaction to D&O litigation suggesting that D&O insurers may not provide sufficient monitoring of corporate governance (see also Baker and Griffith, 2006). 10

12 literature has found some support for these effects (O Sullivan, 1997; Core 2000). Our empirical models therefore consider board characteristics for inclusion as explanatory variables. However, we must first explore the extent to which board characteristics may themselves be determined by the purchase of D&O insurance. We take advantage of our firm level panel dataset in which some firms purchase D&O insurance for only some of the years in which they appear in the sample, to examine whether the (new) purchase of D&O insurance affects board structure or governance. 3.4 Exogenous factors affecting price We must also consider the supply side of the market. There is always the possibility that the firm applies for and is turned down for insurance by an underwriting decision. Under conditions of symmetric information insurance applications should never be denied in an unregulated environment. Insurance denials and the resulting shrinking of insurance market size arise from problems of information asymmetry which lead to adverse selection. In cases where insurance applicants know their risk better than the insurer and the insurer does not have a perfect means to sort applicants or to force self-revelation of risk, applications may be denied. However, Knepper and Bailey (1998) argue that information asymmetry is not an important issue for D&O insurance. Insurers verify the quality of the managerial team, and the flexibility of the D&O policy allows the insurer to deny payment in the event that the insured hid relevant information. Indeed, when underwriting or renewing insurance, insurers require that companies provide them with complete detailed questionnaires, and any omitted or incorrect information might eventually lead to a claim denial (Baker and Griffith, 2007). Consequently in such cases, the quality of financial data reporting, which is a primary cause of complaints, would enable insurance companies to correctly price the litigation risk faced by firms who seek to purchase D&O insurance. Based on this evidence, we may model the demand for insurance ownership without strong consideration of the possibility of insurance denial. 16 The price of insurance should nonetheless be an important aspect of the coverage limit chosen, and the coverage limit and total premium amount will be jointly determined. Insurance theory tells us that the amount of coverage chosen will depend upon the unit price of insurance -- the price per dollar of expected loss. It is this price that is appropriately included as an element of the coverage limits decision. The unit price will reflect the insurer s mark-up of the total premium 16 Because we cannot observe whether firms in our sample who do not purchase D&O insurance sought to purchase it and were denied, we cannot directly examine this relationship. 11

13 relative to the coverage limit and will be determined by cost and market conditions. In the absence of data that would allow us to construct expected losses, we proxy the unit price of insurance as the price per dollar of insurance limits, that is the total premium divided by the aggregate policy limits. As in other insurance markets, insurance market cycles are partly responsible for premium levels and premium evolution over time. Figure 1 plots the mean, median, first quartile and third quartile of D&O annual premiums for years 1990 through 2006 to provide some indication of these trends during our sample period. The data are plotted using the mean for 1990 as an index base (set equal to 100). Cyclical trends over the subsequent years are apparent, but in most years the variations are small; a notable exception is the sharp rise in premiums in the 2001 to 2003 period. This may be due to the passage of the Sarbanes Oxley Act (SOX) in the U.S. in 2002, or more directly to the corporate governance scandals that led to its passage. The 2005 D&O report by Towers-Watson revealed that the American market saw an 8% decline in premiums in 2004 and a 10% decline in At the same time there was a 30% increase in claim frequency, and policy limits increased by 9% in Premiums in Canada doubled or tripled for some companies between 2001 and The subsequent softening of the insurance market in 2006 led to premium declines of 14% in Canada and 18% in the U.S., with policy limits remaining stable (Tillinghast Towers-Perrin, 2007). [Figure 1 here] D&O insurance prices may also be affected by insurance market structure. Although the market faces little in the way of regulatory barriers to entry, it remains a highly concentrated insurance line of business. In 2006 for example, the Towers-Watson survey reports that two primary insurers (Chubb and American Insurance Group) accounted for 60% of the D&O insurance premium volume. D&O insurance is one of the most concentrated insurance markets in the United States with a (countrywide) Herfindahl index of approximately By comparison, the countrywide Herfindahl index for homeowners insurance is 700 and that for private passenger automobile insurance is 600. The only line of insurance business that exhibits concentration levels similar to that of D&O insurance is the mortgage guarantee line, with a Herfindahl index of This suggests that insurance prices may be less sensitive to individual firm risk (the marginal cost of providing insurance) than in a competitive market environment. 12

14 4. Data and Sample Characteristics We construct a panel dataset of firms using publicly available data from stock-exchange traded Canadian companies. The companies in our sample are traded on the Toronto Stock Exchange, Canada s main stock exchange, but are not limited to being in the index. The dataset includes information on D&O insurance purchases, coverage limits, and premium charges, along with extensive information on the financial and governance characteristics of each firm. Information regarding D&O coverage and board composition and compensation is collected from the firms annual management proxy and information circular. Firms financial data are obtained from Compustat; stock prices and total returns are drawn from the Toronto Stock Exchange data retrieval services. The firms are drawn from seven economic sectors (the mining, public services and financial services sectors are omitted). The sample period encompasses years 1996 through 2005, with the ending date 2005 chosen due to important securities reforms being passed in Canada that year. 4.1 Characteristics of sample firms We obtain data on a total of 328 firms and 2,192 firm-year observations over the 1996 through 2005 sample period. Because of missing information in Compustat about Canadian companies, the number of firm-year observations available for statistical analysis that includes firms financial characteristics is smaller than the number of observations on board characteristics and D&O insurance ownership. As we can see in Table 1, we lose a total of 611 firm-year observations over the 10 years of data due to some Canadians companies not being included in the Compustat database. The remaining sample for analysis consists of 1,581 firm-year observations on 198 firms. We also see from the table that approximately one third of our data comes from the Industrial Products sector, but there is a broad distribution of the remaining firms across the other six sectors. This is true in both the original sample and the Compustat sample, so it appears that firms in specific sectors are not noticeably more likely to be dropped from the sample. Our data are distributed relatively evenly over the years, and this is especially true in the Compustat sample relative to the original sample. This suggests that we are less successful in matching earlier firm observations to Compustat. [Table 1 here] 13

15 Table 2 presents summary statistics for our (Compustat) sample of key firm characteristics of interest in our study. Firms average $160 million in assets and sales, and close to a zero rate of return on assets. Boards have an average of just under 9 members, of which 62 percent are outsiders. Insiders own an average of 24.3 percent of shares, and 32 percent of firms in the sample have a financial institution as a block holder (owning more than 10 percent of shares). Nearly 74 percent of our sample firms carry D&O insurance. This represents a total of 1,170 firm-year observations. On average, the typical D&O insurance policy has a policy limit of 24.8 million dollars (in US 2006 constant dollars). 17 This compares to an average market value of equity of approximately 170 million dollars so that the D&O insurance limit represents about 14.6% of the market capitalization of a given firm. Premium data are available for only about two-thirds of the sample of firms. The average premium paid by corporations to obtain D&O insurance is just under $186,000, which represents 0.6% of the policy limit amount. [Table 2 here] The dynamics of D&O insurance purchase among firms in our sample are illustrated in Figure 2 which shows the percentage of firm-year observations in the sample for which D&O insurance is purchased by year. The figure shows some slight upward trending over time in D&O insurance purchase, but the percent in each year does not differ dramatically from the overall sample mean of 74 percent. [Figure 2 here] Figure 3 summarizes the dynamics over the sample period of D&O insurance purchases for each firm. Of the 198 firms in our sample for analysis, 109 (55%) purchase D&O insurance in every year that they appear in our database; 33 (17%) never purchase D&O insurance, and 56 (28%) change their purchase behavior during the years which we observe them. [Figure 3 here] 5. D&O Insurance as a Monitoring Device One hypothesis for the purchase of D&O insurance is that the insurer may act as a monitor on behalf of shareholders. Indeed, Holderness (1990) argues that D&O insurance may substitute 17 Canadian dollar values are translated into US dollars using the year-end exchange rate. 14

16 for shareholder monitoring of managers, hypothesizing that companies in which the cost of monitoring is high will be more likely to purchase D&O insurance. O Sullivan notes, however, that in many firms D&O insurance may be used as a complement to other monitoring mechanisms. This may be especially true in large corporations and when boards appoint outside directors to improve monitoring. A related hypothesis is that the insurer monitoring function operates to require good corporate governance as a condition of insurance. If this form of the monitoring hypothesis is correct, we should expect to observe stronger governance characteristics when the firm s managers are protected under a D&O insurance policy. The distinction between these alternative views of insurer monitoring is important in its own right, and will also have implications for the treatment of variables measuring board structure and governance in our models of insurance demand. To explore these relationships we compare a variety of board characteristics across firms with D&O insurance and those without. Because the analysis does not use Compustat data, these comparisons are undertaken using the original sample of firms. The board characteristics examined are: whether the CEO is also the chairman of the board (CEO-COB); the overall size of the board; the percentage of outsiders on the board; the percentage of outsiders on the audit committee; the percent of voting shares owned by insiders; and the percent of board compensation received in options rather than cash. We first conduct the analysis using the full sample of firms, comparing all firm-years in which D&O insurance is present to all firms-years in which it is not. We then restrict the analysis to firms which changed D&O ownership status during the years that we observe them, comparing firm-years in which D&O insurance is owned to those in which it is not. This latter comparison provides a stronger test of whether board differences are likely to be a consequence of D&O insurance ownership. Table 3 presents means and t-test statistics for these comparisons, along with the predicted relationships between board characteristics and D&O insurance if D&O insurance is complementary results in boards with stronger governance characteristics. The table also reports the sign and statistical significance of the coefficient estimate for an indicator of D&O insurance ownership obtained from regressing each variable on the D&O insurance indicator, industry dummies, and year dummies. This regression approach accounts for the fact that D&O insurance purchase rates differ across industries and increase over time. If board characteristics 15

17 also vary across industry and time, comparison of means may mistakenly ascribe these differences to D&O insurance ownership. 18 [Table 3 here] The top panel of the table presents results for the full sample of observations. Both the comparison of means and the regression estimates reveal substantial differences in governance structures among firms with D&O insurance and those without. Firms with D&O insurance are significantly less likely to have a single person act as both CEO and COB, have significantly larger boards, have a higher fraction of outsiders on the board, a higher fraction of outsiders on the audit committee, and a higher percentage of voting shares controlled by insiders. Thus, D&O insurance appears to be complementary to other shareholder monitoring mechanisms. Comparisons of board structures across the insurance and no-insurance regimes for firms that change insurance status during the time that we observe them are reported in the bottom panel of Table 3. Here we observe relatively few significant differences in board structure. In the comparisons of means, statistically significant differences are observed in the prevalence of a combined CEO-COB, the size of the board, and the percent of outside directors. The CEO-COB and board size variables have the expected sign if D&O insurers require board changes to strengthen monitoring. Results from the regressions controlling for industry and year, however, are not statistically significant for the CEO-COB variable and the board size difference is only marginally statistically significant. Moreover, the percentage of outsiders on the board is significantly lower when firms have D&O insurance, which runs counter to the monitoring hypothesis. Also unexpectedly, the percent of outsiders on the audit committee is lower and the voting share of insiders is higher under the insurance regimes, although these differences are not statistically significant. Results overall provide little support for the idea that the insurance underwriting process changes board structure to strengthen oversight of management. 6. Estimating Insurance Demand As described previously, we estimate models of two alternative measures of D&O insurance demand: ownership of insurance and insurance policy limits. We model the likelihood that a firm purchases D&O insurance in a year as depending on the market valuation of the firm, the percent ownership of large block holders and board insiders, measures of the trading volume of 18 Full results are available from the authors. 16

18 the firm s stock and stock price volatility, firm financial distress and profitability. To reflect the timing of the insurance purchase decision, lagged values of financial variables are used in the models. All monetary values are converted to US 2006 constant dollars. The construction of regression variables is described in the Appendix table A1, which also reports summary statistics. Appendix table A2 reports the correlation matrix for the regression variables. The empirical models include measures of the firm s market valuation at the end of the previous year (lag_lnmve). The percent of shares owned by insiders (inside_own), and the percent ownership of large financial institution block holders (fin_blockshr), where block holders are defined as owning at least 10 percent of shares, are included as measures of the importance of large block holders. The models include stock price volatility over the previous three years (volatility), a measure of the risk of financial distress (distress), and the previous year s profitability (lag_roa). A measure of financial leverage is included to account for the possible role of creditors in supervising the firm s managers (debtratio). Variables to account for board characteristics, board monitoring tools, and board entrenchment are the number of board members (n_board), the percent of outside board members (pct_outside), the percent of board compensation received in options (board_opt), and the power of the CEO as measured by whether the CEO is also the board chairman (ceocob). Several additional variables are included in the models of insurance coverage limits. Firm size is measured as the log of the firm s sales (lag_lnsales). 19 A proxy for the proportion of investors that are mostly affected by false or misleading accounting is the trading volume of the firm s stock in the previous year (pcttrade). We also include measures of the recent growth of the firm, measured as changes in total assets over the previous three years (growth). The unit price of insurance (unitp) is included, measured as the premium per dollar of coverage limit. The models treat the unit price as jointly determined with the coverage limit, due both to the predicted relationship between price and quantity demanded and due to the construction of the variable. The excluded instrument in the instrumental variables estimates is the average unit price of D&O insurance for the industry and year. Because we observe the choice of policy limit only for those firms that choose to purchase insurance, these estimates rely on a smaller sample of firm-year observations than are used in the insurance ownership estimates. 19 We do not use firm assets as the size variable since assets are used to calculate other independent variables (return on assets, debt ratio, and asset growth). 17

19 6.1 Demand for insurance ownership The first set of estimates we present are those related to firms D&O insurance purchase decisions. Although the purchase decision is a dichotomous (0-1) choice, we present both linear probability estimates and probit estimates. Alternative estimates including industry fixed effects, firm-specific fixed effects and firm-specific random effects are reported for the linear specification, and alternative estimates including industry fixed effects and firm-specific random effects are reported for the probit estimates. The estimation results are displayed in Table 4. [Table 4 here] As we can from the table of results, it is relatively difficult to explain the ownership of D&O insurance with the available variables. Although the models are statistically significant the R- squared values are low and relatively few variables are statistically significant. Board characteristics show the most significant role. D&O ownership is negatively associated with board compensation through options, reflecting either a trade-off in compensation forms or the use of options as an incentive alignment tool for board members (and reducing the need for monitoring by an insurer). The percent of outsiders on the board is positively associated with D&O ownership in some models, in line with theoretical predictions. Most of the financial characteristics are not significantly related to insurance ownership. Contrary to expectations past accounting profitability as measured by the firm s ROA is unexpectedly associated with an increased likelihood of owning D&O insurance. 6.2 Insurance policy limit A second set of regressions examines the D&O policy limit chosen by a firm in a year. We first present models of the coverage limit choice for firms that choose to purchase insurance. We then present Heckman selection-corrected estimates of the policy limit, which take into account the fact that the endogenous choice to purchase insurance determines whether we observe the policy limit. Table 5 provides the first set of estimation results for the policy limit. Just as in the previous estimates, we report alternative specifications that include industry fixed effects, firm-specific fixed effects and firm-specific random effects. For comparison purposes we report OLS estimates which treat unit price as an exogenous variable, in addition to IV estimates, 18

20 [Table 5 here] As can be seen from the table, these models of the demand for D&O insurance achieve more explanatory power than those reported previously, and the OLS and IV estimates are similar. In all specifications, firm size and market valuation are positively related to coverage limits, as expected. The unit price is negative as expected, and statistically significant. We also observe the expected negative sign on lagged accounting profitability. The risk of financial distress is positive and significant in some models, as is the percent of outsiders on the board. Similarly, the expected positive sign on the percent of firm shares traded is observed, and this is statistically significant in models with industry fixed effects. The same is true of the leverage variable. One unexpected result is that growth opportunities, as measured by recent asset growth, are negatively related to the policy limit. Several alternative specifications, not reported here, were estimated to try to account for the fact that the coverage limit and our measure of the unit price may be affected by the deductible amount chosen. 20 In our sample of firms, this further reduces the sample size since some firms do not report the deductibles on their policies. Among those firms that report deductible amounts, these tend to be small relative to the policy limits. All estimation approaches yielded results that are similar to those reported in Table 5, with no effects on the signs and significance of variables in the model. The regressions results we presented thus far in terms of the determinants of the policy limit do not take into account the fact that firms that opt to have no D&O liability insurance are possibly not similar to the firms that did opt to have D&O insurance coverage. To correct for this we use a Heckman selection correction. The Heckman selection corrected estimation takes account of the joint decisions regarding the insurance coverage limit and the purchase of insurance. The Heckman approach is appropriate since the coverage limit (and price) is observed only if the insurance is purchased, leading to a classic Heckman-type 21 model. In our setting, we want to examine the effects of the premium and risk variables on the policy limit, but we must account 20 One approach includes the deductible as an explanatory variable in the policy limit model. Other approaches involve constructing a composite coverage amount (limit deductible) and/or a composite unit price (premium/(limit deductible) and using these as dependent variables in appropriately modified regression models. 21 For example, the classic Heckman-selection problem arises when we examine the effects of schooling on wages since we must account for the self-selection into working. 19