Directors and Officers'Liability Insurance and Managerial Compensation

Directors and Officers'Liability Insurance and Managerial Compensation Chia-Wei Chen Tunghai University Taichung, TAIWAN Bingsheng Yi California State University-Dominguez Hills Carson, California, USA J. Barry Lin School of Management Simmons College, Boston, USA Abstract: D&O insurance has seen substantial increased adoption by companies. Although theoretically D&O insurance can enhance external monitoring and reduce the possibility of underinvestment, it can also raise incentive conflicts between managers and shareholders thus harm shareholder wealth. This paper examines the link between D&O insurance and managerial compensation. Using a recent sample of listed firms in Taiwan, we find strong evidence of higher managerial compensation for firms with D&O insurance than firms without D&O insurance. We also find average managerial compensation higher for a sample of firms after they adopted D&O insurance, relative to before the adoption of D&O insurance. Our empirical findings suggest that D&O insurance may weaken the quality of corporate governance and, therefore, increase the likelihood for firms with this insurance to pay their managers more than firms without this insurance at the expense of shareholder wealth. Our results offer alternative evidence in learning about the role of D&O insurance under different cultural and firm characteristics. Keywords: D&O insurance, Managerial compensation 1

I. Introduction According to a recent insurance industry report 1, corporate securities suits filed had increased from a little over 700 cases in 2005 to over 1400 cases in 2011. Among the several types of corporate lawsuits, merger objection suits had increased from 21 cases in 2001 to 353 cases in 2010, highlighting the sharp increases in the number of corporate lawsuits. Moreover, this is not limited to US firms. Cases against non-us firms that end in settlement of at least $100 million increased from 60 cases in 2005 to 250 cases in 2011, more than quadrupling. It is not surprising that the increasing number of corporate lawsuits in recent years is associated with increased used of Directors and Officers' Liability (D&O) insurance. D&O insurance has gathered more and more attention from both practitioners and scholars. As key decision makers and representatives of the corporation, directors and officers are liable for their corporation s actions. Directors and officers personal assets are at risk in cases of large fines as part of the outcomes of a lawsuit against the corporation. The risk of lawsuit is in fact the greatest risk facing directors and officers. Directors and officers liability insurance contracts are purchased and owned by a corporation to protect the corporation s directors and officers and the corporation itself against legal liability. D&O insurance policy covers all expenses and losses incurred by a manager due to a lawsuit against him. The insurance company will indemnify the corporation and /or the manager only if the manager acts in good faith on behalf of the corporation. Like other standard insurance contracts, the D&O insurance contract has a policy limit and deductible. The fact that the insurers are specialized in dealing with the litigation process, the investigation, and the monitoring of the insured before and after the purchase of this insurance, not only reduces the 1 Advisen Quarterly Report: Q2 2011. 2

possibility of adverse selection but also ensures that the insured works on behalf of shareholders, follows legal and regulatory requirements, and protects shareholder wealth (Boyer (2003)). Similarly, with protection from litigation, directors and officers would be willing to take appropriate risk and therefore eliminate the potential firm value loss due to underinvestment (Bhagat, Brickley, and Coles (1987)). Gutiérrez (2003) further suggests that this insurance can be adopted as a substitute for corporate governance. O'Sullivan (1997), among others, indicates that the adoption of D&O insurance can induce independent directors, who improves the board s monitoring function and benefits shareholders, to join the board. However, while several countries have continued to encourage or force corporations to purchase this insurance in recent years, empirical evidence challenges the view of a positive role of D&O insurance. Chalmers, Dann, and Harford (2002), for example, suggest that the purchase of this insurance may lead to opportunistic behaviour by managers. In other words, insurers may not be able to detect corporate wrongdoing, and directors, given the protection of D&O insurance, might reduce their effort in monitoring managers or officers. As a result, officers face an increased incentive to pursue their own interests with a reduced litigation risk. Under the agency problem view of corporate governance, managers and directors have incentives to operate their firm in a way to optimize their own benefits, often at the expense of shareholders and other stakeholders. Such actions may result in increased litigation risk to directors and officers. But with protection of the D&O insurance, the financial consequences to mangers are greatly reduced in the event of suits against them brought about by shareholders or other stakeholders. For example, managers can enjoy financial benefits from earnings management if it is not detected. Managers in firms with D&O insurance have lower potential legal liability and financial loss than 3

managers in firms without D&O insurance. Empirical evidence in fact shows that the purchase of D&O insurance is positively associated with earnings management (Chen, Lin and Yi, 2011). Several other studies, Zou, Wong, Shum, Xiong, and Yan (2008) and Regan and Hur (2007), among others, report negative evidence on the effect of D&O insurance. These results and the associated arguments against the benefit of D&O insurance may explain the requirement to disclose information on this insurance. While academic literature offers several models to demonstrate the function of this insurance, empirical findings so far remain scant and inconclusive. In this paper, we attempt to employ the insurance data publically available in Taiwan since 2008 to explore the topic that to our knowledge has not been explored. Specifically, we try to examine the linkage between managerial compensation and D&O insurance and to offer alternative evidence in the roles of D&O insurance. With a sample of 3,566 firm-year observations, representing about 95% of listed non-financial firms in Taiwan during the period between 2008 and 2010, our empirical results indicate a positive and significant relation between D&O insurance and managerial compensation. In particular, firms protected by this insurance tend to pay their managers more than firms without this insurance. This relation remains robust when different subsamples or measures of variables are applied. We also find an increase in managerial compensation when firms move from without the D&O insurance to with D&O insurance. If the increasing of managerial compensation does not necessarily improve firm performance, the purchasing of D&O insurance potentially weaken the board function and could benefit managers at the expense of shareholder wealth. Our empirical findings are generally in line with other studies on the relationship between D&O insurance and corporate governance issues. As we are among the first to find the link between managerial compensation and D&O insurance, 4

empirical results from this paper enrich current literature related to the demand for D&O insurance and the design of compensation packages respectively. The sample, extracted from listed firms in Taiwan, in which corporations are extensively family controlled and the percentage of firms with D&O insurance is relatively small compared with Western countries reported in previous studies, also provides an opportunity in learning about the role of this insurance under different cultural and firm characteristics. The rest of this paper is organized as follows. Section II provides a brief review of related literature. Section III introduces our sample and section IV provides definition of our variables. Empirical results are reported in Section V. Section VI concludes this paper. II. Literature Review and Hypothesis Development As an instrument for improving corporate governance, D&O insurance ideally should strengthen the incentive for directors and officers to bear risk and to work hard in pursuing the maximization of shareholder wealth. However, current literature provides conflicting arguments and mixed evidence on the role of D&O insurance. 2 Several studies argue that D&O insurance is necessary in attracting and retaining competent directors and officers, thus improves the corporate governance of public companies (Priest, 1987; Daniels and Hutton, 1993; and O Sullivan, 1997, 2002). It is also suggested that D&O insurance counters managers natural tendency to be overly conservative in managing their firm (Jensen,1993). In addition, insurance companies will investigate their customers before selling them the insurance policies. 2 Boubakri, Boyer and Ghalleb (2008) and Chung and Wynn (2008) provide a good review of the literature. 5

Insurance companies will also monitor the insured to reduce the unexpected loss (Myers and Smith, 1982). Finally, the protection of D&O insurance to directors and officers is incomplete. An insured firm still bears a portion of the risk via deductibles and limited coverage (Baker and Griffth, 2006). Oppositely, other studies suggest that D&O insurance results in a negative impact in corporate governance because D&O insurance increases potential agency problem (Core 1997, 2000). The protection from D&O insurance may weaken director incentive in monitoring managers (Core, 1997; and O Sullivan, 2002). Chung and Wynn (2008) find that the higher the managerial legal liability coverage is, the less timely the news are recognized in a firm s earnings. Wynn (2008) finds that Canadian firms cross-listed in the U.S. with higher legal coverage are less likely to provide bad news forecasts and the number of bad news forecasts decreases for large cross-listed sample facing higher litigation risk. These studies suggest that D&O insurance may mitigate conservatism or make firms less likely to disclose bad news. Chalmers, Dann, and Harford (2002), with a sample of 72 firms that went public between 1992 and 1996 in the U.S., report a significant negative relation between the post-ipo performance measured by stock price and the D&O insurance purchased in conjunction with the IPO. Zou, Wong, Shum, Xiong, and Yan (2008), examining a sample in China, observe that firms controlled by local government or with severe earnings management suffer negative stock returns on the announcement of D&O insurance decisions. Potentially, seeking D&O insurance is positively related to the extent of the controlling-minority shareholder incentives. Similarly, Regan, and Hur (2007), with accounting data for 433 publicly listed non-financial firms in Korea during the period between 1990 and 2001, also indicate that members of chaebols with split ownership structures tend to demand more insurance than unaffiliated firms. 6

The recent literature reviewed above document the potential adverse selection and moral hazard problems associated with D&O insurance. In contrast, early studies, such as Romano (1991), suggest that D&O insurance offers an opportunity for corporations to shift their risk to insurers and at the same time reduce the loss of shareholder wealth and the cost of the litigation process (Core (1997) and O'Sullivan (2002)). Also, the insurers, before selling D&O insurance, investigate the purchaser and continually monitor the insured firm once the contract is made in order to reduce the unexpected loss from corporate wrongdoing (Boyer (2003)). In addition, it is suggested that D&O insurance, with its protection, creates higher incentive for independent directors to join the board (O'Sullivan (1997)).Iif these directors represent better monitoring and improved corporate governance (Rosenstein and Wyatt (1990)), then the adoption of D&O insurance may signal better firm performance. Finally, to the degree that the personal wealth of directors and officers is protected by D&O insurance coverage, the potential loss generated from conservative operation or underinvestment can be effectively reduced (Bhagat, Brickley, and Coles (1987)). Other than the arguments highlighting the benefits and costs of the D&O insurance, some scholars suggest that the role of this insurance could be neutral. In particular, the demand for D&O insurance is simply due to firm characteristics, such as type of industry, culture or business ties with countries which require this protection (Mayers and Smith (1990) and Boyer (2003)). Furthermore, as investors can simply use a portfolio strategy to diversify the risks of individual firms, the adoption of D&O insurance, therefore, may not necessarily add value to the firm. It is clear from the brief literature above, both theoretical arguments and empirical evidence in the relationship between D&O insurance and corporate 7

governance on the one hand and manager incentives and shareholder wealth on the other hand, are mixed at best. Managerial compensation, being one key factor in corporate governance, so far has not been carefully examined in the framework of D&O insurance. Core, Holthausen, and Larcker (1999) suggest that firms with greater agency problems tend to pay their executives more and they perform less well. It is likely that, for such firms, the benefits (costs) of D&O insurance, which decrease (increase) the degree of agency problems, are, therefore, associated with relatively lower (higher) compensation to managers 3. In addition, in several countries, disclosure of information on D&O insurance purchase by firms is mandatory, a positive link between D&O insurance and managerial compensation should be expected. Accordingly, our main hypothesis is that firms with D&O insurance are likely to pay their managers more than firms without this insurance. Due to the constraint of data availability, the number of empirical studies on D&O insurance is very limited, and most of the extent empirical studies on D&O insurance focus on firms in Western countries. Our study using Taiwanese data is among a small number of studies which provide an examination of the effect of D&O insurance on corporate governance using international data. III. Sample The information related to D&O insurance has been publicly available annually in Taiwan since 2008. Accordingly, our sample incorporates the annual financial results of listed firms traded on either the Taiwan Stock Exchange (TSE) or GreTai Securities Market (OTC) during the period 2008 to 2010. However, considering the differences in regulations and accounting periods, we have eliminated 3 Literature related to the link between compensation and the quality of corporate governance is also summarized in Core, Holthausen, and Larcker (1999). 8

financial, non-trading and non-december year-end firms. After excluding such firms, our final data contains 3,566 observations of 1,253 firms, around 95% of the nonfinancial listed firms in Taiwan. All variables of the observations are extracted from the Taiwan Economic Journal database. IV. Variables Table 1 reports the summary statistics of the variables employed in this paper. A dummy variable (D&O dummy) is utilized to capture whether a sample firm is protected by D&O insurance 4. It is 1 for firms with D&O insurance during the sample period and 0 otherwise. As shown in Table 1, around 50% of our sample firms are insured. This percentage is much lower than in western countries, such as U.S. and Canada. Mean managerial compensation is 3.5 million New Taiwanese dollars, with a median of only around 2.6 million, indicating a skewed distribution--that some sample firms give much higher compensation to their managers than the average (the maximum managerial compensation, not reported in the tables, is 48.7 million). To reduce the possibility that the extremely huge compensation payment may alter our empirical results, we use the nature log of managerial compensations in our main regressions. Other than the two key variables, managerial compensation and D&O dummy variable, we also follow previous literatures in using several control variables in our regressions to accurately estimate the relationship between the D&O insurance and managerial compensation. To capture firm characteristics such as firm size, performance, growth opportunities, idiosyncratic risk, and the quality of corporate 4 Although the information about officers liability insurance is not separately reported, normally firms purchase liability insurance for both directors and officers at the same time. The purchasing of directors liability insurance therefore is applied to represent the purchasing of D&O insurance. 9

governance, our control variables include: total assets, financial leverage measured by total debt divided by total assets, a cash dividend dummy, return on assets of previous year measured by net income before interests and taxes scaled by total assets, market to book ratio calculated by market value divided by total assets, standard deviation of daily returns, managerial ownership, institutional ownership, board size measured by the number of board members, and the percentage of individual directors on the board. Table 1 also indicates that variables such as total assets, managerial ownership, institutional ownership, and the number of board members exhibit some degree of skewness. Accordingly, the nature log of these variables is applied in our regressions as well. Similar methodology could also be found in Core, Holthausen, and Larcker (1999) and Baker, Jensen, and Murphy (1988). Finally, the median of the percentage of independent directors suggests that more than 50% of listed firms in Taiwan do not have independent directors on their boards. This evidence, possibly driven by regulations, is contrary to that in Western countries 5. This is also an indication of the still evolving condition of corporate governance in a newly industrialized market like Taiwan. In addition to showing the summary statistics of each variable, we also report the correlation of each variable with D&O dummy in the last column of Table 1. As all variables have significant correlation with D&O dummy, we include all these variables in our multivariate analyses. With the exception of showing the summary statistics of each variable, in the last column on Table 1 we also report the correlation of each variable with the D&O dummy. As all variables have significant correlation with the D&O dummy, the 5 Since 2007, public firms in Taiwan have been mandatorily required to have at least 2 independent directors on the board. However, in the early years, only financial firms and relatively large non-financial firms were forced to meet this requirement. 10

positive and significant relation (0.17) between managerial compensation and the D&O dummy is consistent with our hypothesis that the protection of D&O insurance could weaken the function of a board and, as a result, increase the possibility of a firm paying more to their managers at the expense of shareholder wealth. On the other hand, as documented by the literature, such as that of Core (1997), O'Sullivan (2002), and Boyer (2003), the significant relation between the D&O dummy and total assets, market to book ratio, standard deviation of daily return, institutional ownership, and the percentage of independent directors implies that the demand for this insurance could be driven by firm size, growth opportunity, risk, ownership structure, and the number of independent directors. V. Empirical Results A priori, we expect our model to capture the positive relationship between the D&O insurance dummy and managerial compensation confirming the agency problem hypothesis of D&O insurance. We apply 4 different regression models, reported in Tables 2, 3, and 4. In Table 2, we begin with an ordinary-least-square (OLS) regression including only the D&O dummy variable and industry and year dummies as the independent variables. Using the nature log of managerial compensation as the dependent variable, regression (1) shows significant positive relation between D&O dummy and managerial compensation, supporting the correlation reported in Table 1 and our hypothesis. In regression (2) and (3) of Table 2, we add 2 different groups of control variables capturing firm characteristics and the quality of corporate governance 11

separately 6. Finally, control variables are incorporated in regression (4). As the R 2 increases with the adoption of control variables, the positive relation between D&O insurance and managerial compensation remain significant at the 1% level, suggesting that the protection of D&O insurance likely weakens the function of the board and as a result increases the possibility of a firm to pay its managers more at the expense of shareholder wealth. In Table 3, we conduct robustness test of our basic results in Table 2. Utilizing the full model including all control variables, regression (1) in Table 3, for all the variables for each sample firm, uses the average value across the research period as the observations. Fixed-effect analysis is employed in regression (2) 7 to deal with potential endogeneity problem. In regression (3), we focus on only technology firms, which represent about 60% of listed firms in Taiwan. We do this to deduce potential contamination to our results due to the impact from the global financial crisis. Finally, in regression (4) we use only 2010 data to further reduce potential impact from the financial crisis. With all the adjustments in our multivariate models, the results in Table 3 confirm our hypothesis that managerial compensation is higher in firms with D&O insurance, providing empirical evidence for the agency problem view of the effect of 6 As the demand for D&O insurance can be the result of firm characteristics, our empirical findings may, accordingly, overestimate the impact of D&O insurance and managerial compensation. To deal with this concern, we first regress the D&O dummy by the natural log of total assets, total debt scaled by total assets, the standard deviation of daily stock return and the industry and year dummies. Then, the abnormal D&O dummy, calculated by subtracting the predicted D&O dummy from the original D&O dummy, is applied in regression (2) in Table 2. The coefficient of the D&O dummy (0.125), however, remains positive and significant at the 1% level. In addition, while the insurance premium is not available, we apply the natural log of insurance coverage to replace the D&O dummy and rework regression (2) in Table 2. The coefficient (0.011) remains positive and significant at the 1% level. 7 Not reported in Table 3, the results from random-effect analysis remain consistent with a positive coefficient of D&O dummy significant at the 1% level. 12

D&O insurance on corporate governance. In Table 4, we apply additional alternative measures in key variables to confirm the robustness of earlier results. In regression (1), the D&O dummy is replace by the D&O dummy of the prior year. The natural log of managerial compensation employed in previous regressions is replaced by the amount of managerial compensation scaled by total assets. In regressions (3) and (4), we separately measure managerial compensation using only the equity and non-equity based compensation respectively. Once again, relatively high managerial compensation continues to be found in firms with D&O insurance. Finally, in Table 5, we compare managerial compensation before and after the adoption of D&O insurance. We only have a relatively small sample 44 listed firms change from no D&O insurance to with D&O insurance between 2008 and 2010. When we compare total managerial compensation, while there is an increase in both mean and median compensation after the adoption of D&O insurance, the difference is not statistically significant. When we separate the equity-based and non equitybased components of managerial compensation, we find that the increases are statistically significant for both mean and median compensation on the equity-based component, while it is statistically significant for the mean difference of the non equity-based components. These somewhat weakened results, possibly due to the small sample size and the skewness, confirm our earlier basic findings. Even though the results may be weakened due to relatively few observations, the significant differences do offer additional evidence to support the hypothesis that firms with D&O insurance tend to suffer weak board function and pay more to their managers. VI. Conclusion 13

D&O insurance, by providing financial protection for directors and officers and the firm itself from litigation against them, on the one hand can strengthen a the quality of corporate governance of a firm through external monitoring, on the other hand, may reveal opportunistic behaviour by managers or officers. As the debate on how this insurance affects managerial incentives and the board function continues, in this paper we offer alternative evidence on the role of D&O insurance and on how it impacts shareholder wealth. Utilizing a recent sample of Taiwanese firms, this paper provides consistent empirical evidence that there is a positive relationship between D&O insurance and managerial compensation. Firms with D&O insurance pay their managers higher compensation. This result is true for total compensation, equity-based compensation, and non equity-based compensation. This is also found in a smaller sample of firms who change from no D&O insurance to with D&O insurance in our research period. We use a number of robustness checks, and the results remain consistently significant. Our empirical evidence is consistent with the agency problem view of D&O insurance, that the adoption of D&O insurance provides protection for directors and managers, resulting in increased managerial compensation, which is likely an indication of weakened corporate governance. Our empirical findings support Chalmers, Dann, and Harford (2002) and Core (2000) in that the purchasing of this insurance could reveal opportunistic behaviour by managers and also, on the other hand, disclose the role of this insurance in Asian countries, where culture and firm characteristics are significantly different from those of Western countries 8. As we 8 Core (2000) applied the insurance premium as a proxy of the quality of corporate governance and tested the relation between the premium and the measures of weak governance, including excess CEO compensation. While his sample is restricted to 246 Canadian firms collected by mailing, we extended the sample to almost all listed firms and focused on countries in which the information of D&O insurance is publicly 14

report that the compensation package could be altered by the D&O insurance, we also support the value of requiring disclosure on the purchase of D&O insurance. Finally, regulators or investors should be cautious in interpreting the impact of D&O insurance on managerial behaviour and shareholder wealth. With the sharply increased number of cases of corporate lawsuits, our results is profoundly meaningful for the important issue of corporate governance. It seems that while regulatory enforcement, which accounts for a large fraction of corporate lawsuits, is perceived to counteract on results of ineffective corporate governance, the availability of D&O insurance then counteracts on the weak deterrent effect of regulatory enforcement. In a more cynical view, it seems that the cat-and-mouse game continues. There are many directions and ways future research in this area can be conducted. For example, due to restricted data availability, our sample only contains firm data between 2008 and 2010, a relatively short time period. In addition, examining market reaction to the announcement of the purchase of D&O insurance can help in understanding the value of this insurance 9. The trade-off between the costs and the benefits of D&O insurance can be further studied to learn about the conditions under which the value of this insurance is maximized. Finally, as D&O insurance is linked to the quality of corporate governance, a detailed analysis of the relationship among all the corporate governance mechanisms is necessary to uncover the contagion or available, the ownership structure is different, and the percentage of firms with D&O insurance is relatively lower. 9 While our findings indicate that D&O insurance could be associated with weak corporate governance and, therefore, harm shareholder wealth, this result may not explain why almost all firms in the U.S. have this insurance. Although our evidence could be confirmed by the fact that managerial compensation does significantly increase after firms become insured, differences in culture as well as ownership structure may support our results. Perhaps, in the future, when the insurance premium is available, we can further capture the risks of the firms and accurately capture the quality of corporate governance. 15

substitution effect among them and, therefore, help in developing an appropriate corporate governance system. 16

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Table 1: Summary Statistics The sample contains 3,566 firm-year observations of listed firms in Taiwan from 2008 to 2010. Managerial compensation is the average of compensation per manager measured in thousand New Taiwanese Dollars. D&O dummy is 1 if the sample firm is covered by directors and officers liability insurance within the sample year and 0 otherwise. Total assets are measured in million of New Taiwanese Dollars. Cash dividend dummy is 1 for firms paying cash and 0 otherwise. Return on assets is measured by net income before interest and taxes scaled by total assets. Market to book ratio is the market value divided by total assets. Market value is defined as total assets minus the book value of equity and plus the market value of equity. All variables of the observations are extracted from Taiwan Economic Journal database. ***, ** and * represent the significant levels at 1%, 5% and 10% respectively. Mean 5% Median 95% Correlation with D&O Managerial compensation 3,531 918 2,641 8,681 0.17*** D&O dummy (0,1) 0.53 0 1 1 - Total assets 13,624 549 3,034 48,696 0.08*** Total debt / total assets 0.36 0.11 0.34 0.68-0.03** Cash dividend dummy (0,1) 0.65 0 1 1 0.07*** Lag (return on assets) 7.93-9.74 7.74 25.9 0.06*** Market to book ratio 1.40 0.60 1.15 2.81 0.08*** Std. of daily returns 3.07 1.67 2.87 4.45 0.04** Managerial ownership (%) 1.66 0 0.64 6.57 0.12*** Institutional ownership (%) 35.2 5.7 31.5 76.1 0.06*** Number of board members 6.81 5 7 11 0.03* Pct. of independent directors (%) 15.9 0 0 40 0.28*** 19

Table 2: D&O Insurance and Managerial Compensations The sample contains 3,566 firm-year observations of listed firms in Taiwan from 2008 to 2010. All regressions are ordinary least squares. Dependent variable in all regressions is the natural log of managerial compensation. D&O dummy is 1 if the sample firm is covered by directors and officers liability insurance within the sample year and 0 otherwise. Cash dividend dummy is 1 for firms paying cash and 0 otherwise. Return on assets is measured by net income before interest and taxes scaled by total assets. Market to book ratio is the market value divided by total assets. Market value is defined as total assets minus the book value of equity and plus the market value of equity. All variables of the observations are extracted from Taiwan Economic Journal database. ***, ** and * represent the significant levels at 1%, 5% and 10% respectively. (1) (2) (3) (4) D&O dummy (0,1) 0.286*** 0.146*** 0.229*** 0.148*** (9.33) (5.48) (7.57) (5.44) Log (total assets) 0.256*** 0.240*** (24.89) (20.57) Total debt / total assets -0.156** -0.138* (-2.03) (-1.80) Cash dividend dummy (0,1) 0.207*** 0.202*** (6.44) (6.25) Lag (return on assets) 0.012*** 0.012*** (9.22) (9.20) Market to book ratio 0.036*** 0.035*** (3.54) (3.42) Std. of daily returns 0.004 0.003 (0.57) (0.56) Log (managerial ownership) 0.056*** 0.031 (2.60) (1.56) Log (institutional ownership) 0.210*** 0.015 (11.61) (0.85) Log (number of board members) 0.519*** 0.156*** (9.74) (3.17) Pct. of independent directors -0.004*** -0.002** (-4.22) (-2.22) Industry and year dummies (0,1) Yes Yes Yes Yes R 2 0.06 0.31 0.13 0.32 20

Table 3: Robustness Tests Alternative Analyses The sample contains firm-year observations of listed firms in Taiwan from 2008 to 2010. Except regression (2) adopting fixed-effect estimation, all regressions are ordinary least squares. Dependent variable in all regressions is the natural log of managerial compensation. In regression (1), the average of each variable is applied. In regression (2), the sample includes all observations. In regression (3), only electronic firms which represent around 60% of all listed firms in Taiwan are employed. In regression (4), only observations in 2010 are applied. D&O dummy is 1 if the sample firm is covered by directors and officers liability insurance within the sample year and 0 otherwise. Cash dividend dummy is 1 for firms paying cash and 0 otherwise. Return on assets is measured by net income before interest and taxes scaled by total assets. Market to book ratio is the market value divided by total assets. Market value is defined as total assets minus the book value of equity and plus the market value of equity. All variables of the observations are extracted from Taiwan Economic Journal database. ***, ** and * represent the significant levels at 1%, 5% and 10% respectively. (1) (2) (3) (4) D&O dummy (0,1) 0.160*** 0.105* 0.187*** 0.209*** (3.91) (1.71) (5.21) (4.77) Log (total assets) 0.224*** 0.479*** 0.235*** 0.248*** (12.68) (8.57) (16.20) (13.19) Total debt / total assets -0.076-0.365** -0.108-0.145 (-0.63) (-2.54) (-1.07) (-1.16) Cash dividend dummy (0,1) 0.274*** 0.061* 0.203*** 0.219*** (4.55) (1.85) (4.64) (4.24) Lag (return on assets) 0.016*** 0.002 0.013*** 0.012*** (6.51) (1.22) (7.49) (5.15) Market to book ratio 0.045** 0.010 0.034*** 0.048* (2.38) (0.96) (2.65) (1.92) Std. of daily returns 0.003 0.003 0.004-0.002 (0.33) (0.48) (0.50) (-0.16) Log (managerial ownership) 0.008 0.064-0.017-0.008 (0.27) (1.48) (-0.70) (-0.27) Log (institutional ownership) 0.006 0.067* -0.005 0.003 (0.23) (1.90) (-0.20) (0.10) Log (number of board members) 0.167** 0.148 0.168** 0.196** (2.23) (1.28) (2.32) (2.41) Pct. of independent directors -0.003** 0.006** -0.002* -0.002* (-2.28) (2.56) (-1.94) (-1.65) Industry dummies (0,1) Yea No No Yes Year dummies (0,1) No No Yea No R 2 0.38 0.25 0.31 0.36 N 1,253 3,566 2,066 1,183 21

Table 4: Robustness Tests Alternative Measures The sample contains firm-year observations of listed firms in Taiwan from 2008 to 2010. All regressions are ordinary least squares. Dependent variable in regression (1) is the natural log of managerial compensation. Managerial compensation scaled by total assets is measures as the dependent variable in regression (2). In regression (3) and (4), the equity based and non-equity based compensations computed in natural log are applied as the dependent variables. D&O dummy is 1 if the sample firm is covered by directors and officers liability insurance within the sample year and 0 otherwise. Cash dividend dummy is 1 for firms paying cash and 0 otherwise. Return on assets is measured by net income before interest and taxes scaled by total assets. Market to book ratio is the market value divided by total assets. Market value is defined as total assets minus the book value of equity and plus the market value of equity. All variables of the observations are extracted from Taiwan Economic Journal database. ***, ** and * represent the significant levels at 1%, 5% and 10% respectively. (1) (2) (3) (4) D&O dummy (0,1) 0.126** 0.470*** 0.118*** (2.51) (4.63) (4.28) Lag (D&O dummy) 0.149*** (4.51) Log (total assets) 0.242*** -0.737*** 0.452*** 0.198*** (16.85) (-34.15) (10.36) (16.60) Total debt / total assets -0.140-0.285** -0.774*** -0.144* (-1.48) (-2.00) (-2.69) (-1.84) Cash dividend dummy (0,1) 0.205*** 0.102* 0.849*** 0.143*** (5.24) (1.70) (7.01) (4.34) Lag (return on assets) 0.012*** -0.005* 0.014*** 0.011*** (7.25) (-1.82) (2.81) (7.64) Market to book ratio 0.034*** 0.122*** -0.040 0.036*** (3.03) (6.42) (-1.04) (3.47) Std. of daily returns -0.014 0.014-0.065*** 0.003 (-0.61) (1.20) (-2.80) (0.44) Log (managerial ownership) 0.003-0.038 0.325*** 0.017 (0.12) (-1.05) (4.41) (0.86) Log (institutional ownership) 0.012 0.118*** 0.147** -0.016 (0.56) (3.68) (2.27) (-0.91) Log (number of board members) 0.166*** 0.326*** 0.473** 0.081 (2.77) (3.57) (2.56) (1.61) Pct. of independent directors -0.002** 0.004*** -0.001-0.001 (-1.96) (2.66) (-0.18) (-1.40) Industry and year dummies (0,1) Yes Yes Yes Yes R 2 0.33 0.40 0.17 0.23 N 2,348 3,566 3,566 3,536 22

Table 5: Managerial Compensation Before and After the Purchasing of D&O The sample contains 44 listed firms which change from without the purchasing of D&O insurance into with the purchasing in Taiwan during 2008 to 2010. Managerial compensation is the average of compensation per manager measured in thousand New Taiwanese Dollars. Variables of each observation are extracted from Taiwan Economic Journal database. ***, ** and * represent the significant levels at 1%, 5% and 10% respectively. Before After Difference (1) (2) (1) - (2) Panel A: Managerial Compensation Mean 2,606 2,978-372 Median 2,445 2,601-156 Panel B: Managerial Compensation Equity Based Mean 449 754-305* Median 251 356-105* Panel C: Managerial Compensation Non-equity Based Mean 1,864 2,178-314* Median 1,798 2,045-247 23