Directors’ and Officers’ Insurance: Ordinary Corporate Expense or Valuable

Signaling Device?

May 11, 2011

Christine Kang*1

Department of Economics

Stanford University

Stanford, CA 94305

cakang@stanford.edu

Under the direction of

Professor Michael Klausner

ABSTRACT

After many years in which directors have used directors’ and officers’ (D&O) coverage to shield

themselves from personal responsibility for corporate failure, directors at Enron and WorldCom

have been forced to pay $31 million out of their own pockets to settle securities class action

lawsuits stemming from two of the largest corporate governance scandals in U.S. history. These

settlements have brought the question of director's liability to the foreground, generating interest

in the extent to which a firm’s D&O liability coverage reveals valuable information regarding its

quality of corporate governance. Since insurers are expected to perform a thorough examination

of the directors for whom insurance protection is sought, there is reason to believe that poor

governance increases litigation risk and thus the size of the insurance premium. Using a sample

of D&O premiums gathered from the proxy statements of firms cross-listed in the U.S. and

Canada, I find a significant negative relationship between D&O premiums and variables that

proxy for the quality of firms’ governance structures. This association is robust to a number of

alternate specifications. As further evidence that the D&O premium reflects the quality of a

firm’s corporate governance, the proxies for weak governance are positively related to excess

CEO compensation. Overall, these results suggest that the D&O premium can be a useful

measure of the quality of a firm’s governance.

Keywords: corporate governance, D&O insurance, premium, litigation risk

*I would like to thank Professor Klausner for his guidance, support, and encouragement through

every step of the research and writing process. Without his help, the task of writing a thesis

would have seemed immensely difficult. I am grateful to Professor Geoffrey Rothwell, Professor

John Shoven, and Nipun Kant for their continuous advice and helpful discussions since the early

stages. Alex Gould was also instrumental in motivating my interest in this topic. Finally, I would

like to thank my family and friends for their intellectual and emotional support, which have

rendered this a rewarding process.

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CONTENTS

1 Introduction 3

2 Primer on D&O Insurance 9

2.1 D&O Policy Coverage. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

2.2 D&O Insurance and Shareholder Litigation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

2.3 Market for D&O Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

2.4 What Matters in D&O Underwriting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

3 Literature Review 20

4 The Model 28

5 Empirical Model 32

6 Data 38

6.1 Proxies for Governance Structure Quality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

6.2 Proxies for Business Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

7 Results 45

7.1 Analysis of the Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45

7.2 Sensitivity Tests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53

7.3 Direct and Indirect Effects of Governance Structure Quality . . . . . . . . . . . . . . . . . . . . 54

7.4 Confirmatory Analysis Using Excess CEO Compensation . . . . . . . . . . . . . . . . . . . . . . 56

7.5 Secondary Analysis Using Audit Committee and Finance Variables . . . . . . . . . . . . . . 58

8 Conclusion 66

9 Appendix 71

References 87

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1. INTRODUCTION

“What you’re really underwriting when you underwrite D&O is you’re underwriting the people. You’re

underwriting the senior management, the quality of the management team.”

― D&O broker, Baker and Griffith (2007)

As representatives of the corporation, directors and officers are liable for the

corporation’s actions. More importantly, the directors and officers are personally responsible for

those actions, and accordingly their personal assets are at risk in the event of a lawsuit against the

corporation and its management. Following the recent loss of confidence in corporate

governance resulting from the debacle of corporate giants like Enron, Worldcom, Adelphia, and

Anderson, corporate managers are facing greater risk of lawsuits originating from angry

shareholders who feel they were kept in the dark regarding the company's operations. These

lawsuits are not only reserved for large, high-profile companies. According to a 2002 survey by

insurance consulting firm Tillinghast-Towers Perrin, 19% of firms had at least one lawsuit

brought against their directors in the previous ten years (Tillinghast 2002). One way for a

corporate director to protect his personal wealth in the event of a lawsuit is to have the

corporation buy insurance on his behalf. This insurance is known as Directors’ and Officers’

(D&O) insurance.

In recent years, D&O insurance has become a core component of corporate insurance.

Given that it has become a commonplace of the financial world that disappointed investors will

charge corporations and their directors and officers with securities fraud when a company’s stock

drops significantly in price, it is not surprising that as many as 95% of Fortune 500 companies

maintain directors’ and officers’ liability insurance (Gische 2000). Walter Wriston, former chief

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executive of Citicorp and director of nine companies highlights the importance of D&O

insurance to board members when he asserts, ―I don’t know of anybody who would join a board

without [liability] insurance‖ (Boyer 2003). Wriston so claims because directors and officers can

be held personally liable for corporate missteps. For instance, shareholders can sue managers for

violating their fiduciary duty to the shareholders. The most common reason that shareholders sue

is related to corporate disclosure, though there are a host of other reasons, such as derivatives

suits, for which shareholders will take action. Without D&O insurance, directors and officers put

their personal assets, which are often substantial, at risk when they agree to serve. In order to

attract and retain capable and skilled directors and officers, then, D&O insurance has become a

practical necessity in today’s litigious corporate environment.

In terms of coverage, D&O insurance covers the financial loss of managers from

settlements, judgments, and defense costs in the case of lawsuits. There are typically three parts

to a D&O policy. Part A refers to personal liability and pays the non-indemnifiable expenses

directly to the directors and officers, given that they have acted in good faith. Parts B and C refer

to corporate liability. Part B reimburses the corporation for the expenses they pay on behalf of

directors and officers, and Part C, entity coverage, provides the corporation itself insurance in the

case of lawsuits.

It is important to note that the insurance company only indemnifies the corporation and

manager if the manager acted in good faith on behalf of the company. The purpose of D&O

insurance is to protect the innocent director who is held liable for undesirable business

occurrences beyond his immediate control. Fraudulent actions are thus not covered. In fact, this

issue is presently very sensitive with insurers, since some have alleged such fraud in regards to

the managers of Enron and other recent scandals. In the case of Worldcom, for instance, the

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insurance companies rescinded their policies. D&O insurers must consistently and accurately

decide what is covered, for what reason, and for how much on a case-by-case basis.

Yet it is precisely this case-by-case nature that makes D&O insurance a rich testing

ground for economic theories of behavior under risk and insurance contracting. D&O insurers

customize policies for each company, taking into account its specific risk characteristics.

Consequently, when placed properly, D&O policy is one of the most specialized types of

business insurance and requires a high degree of detail and special handling on the part of the

insurance broker, who acts as the insured’s consultant and adviser (Kuchta 2001). The types of

coverage required and the price vary widely and, unlike auto collision insurance, no two policies

are the same. This provides an opportunity to explore what corporate insurers perceive as risky

and how they price it. Griffith (2007) provides a comprehensive account of the detailed and

thorough process through which insurers price their policies. Only after multiple written

applications, extensive interviews with management, and detailed examination of the firm’s

financial statements, legal documentations, and litigation history, does the D&O insurer decide

whether and how to provide a firm coverage.

Griffith, among others, have suggested that because D&O insurers must correctly assess a

company’s and management’s risk to protect their bottom line, D&O insurance premiums may

be a reflection not only of a firm’s business risk but also of its quality of corporate governance.

Good governance, then, ought to lead to less litigation. The argument proceeds as follows:

corporate governance constraints are designed to control mangers, who may otherwise act

opportunistically. By preventing defections from shareholder interests that lead to lawsuits,

better corporate governance should result in less shareholder litigation (Griffith 2006). Less

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litigation means less likelihood that the insurer would have to pay out, and thus a lower premium

for the firm.

This theory that quality of corporate governance is negatively related to the size of D&O

premium has generated significant interest because, if true, it means the D&O premium could

provide investors a better measure of governance quality than existing alternatives. While

several governance indices have emerged to fulfill the need for governance risk assessment,

these indices are themselves criticized by academics and practitioners. As underlined in Bebchuk

and Hamdani (2009), governance indices suffer from many different methodological

shortcomings. And because some governance factors are neither adequately specified nor

publicly available, one has to wonder how much remains unknown (Baker and Griffith 2007). A

superior alternative to using ad hoc corporate governance indices would be to use the third-party

assessment made when a D&O underwriter provides liability insurance for a company’s directors

and officers. This measure of corporate governance quality would be a valuable piece of

information for investors when assessing potential investments between companies since

shareholders arguably want managers who will act in their best interests. Managerial agency

costs needlessly destroy firm value. Thus, careful monitoring of managers who act on behalf of

shareholders is necessary, especially given the asymmetric information problems generated by

the financial crisis of 2008. Should D&O insurers provide such monitoring by capturing

corporate governance quality in the premiums that they charge firms, there is reason for the SEC

to mandate public disclosure of U.S. D&O insurance policies.

While the theory underlying the relationship between corporate governance quality and

D&O premiums has generated substantial interest, it has not received much empirical attention,

especially in the U.S., where such information on D&O insurance is not publicly available. Core

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(2000) performed the leading study examining Canadian data to determine whether D&O

premiums can be related to corporate governance variables. Hypothesizing that D&O premiums

are a function both of business-specific risk factors and governance-related risk factors, Core

separated proxy variables relating to each. Grouping measures of ownership structure, board

independence, and management entrenchment together as indicators of ―governance quality,‖ on

the one hand, and firm size, financial performance, and U.S. exchange listing as proxies for

―business risk,‖ on the other, Core regressed each variable against D&O premiums. The D&O

premium regressions test whether there is information in the governance structure variables

incremental to the business risk control variables, and whether the coefficients on the governance

structure variables are consistent with the interpretation that weaker governance increases

litigation risk. He found five of the nine governance quality variables to be individually

statistically significant and all of them to be collectively significant and with the predicted

coefficient signs (Core 2000). Significant governance quality variables—including insider stock

ownership and voting control, director independence, and executive employment contracts

enabled Core ultimately to conclude that Canadian data supports a negative association between

D&O premiums and governance quality.

One of the variables Core found to be most significant, however, underscores the study’s

inherent limitations. If a Canadian firm is also listed on a U.S. exchange, exposing it to U.S.

securities litigation, the firm has significantly higher D&O premiums. This emphasizes the

difference between U.S. and Canadian liability risks. At least with regards to shareholder

litigation, and perhaps representative litigation generally, the legal systems between the two

countries are different enough to make cross-country comparisons somewhat tenuous. As a result,

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although Core’s study ultimately supports a link between corporate governance and D&O

insurance, U.S. data are needed to confirm the results.

Given the importance to investors and regulators regarding whether D&O premiums can

explain factors such as quality of corporate governance and litigation risk, this paper builds upon

Core (2000) to address this question. My paper’s contribution is three-fold. First, I test the

robustness of Core’s model using a sample of U.S. cross-listed firms and verify that the negative

relationship between governance quality and size of premium holds for firms exposed to U.S.

securities litigation. My results have potential policy implications for disclosure of information

regarding D&O insurance in the U.S. Second, my recent data allow me to explore the relative

importance of corporate governance in a ―soft‖ insurance market. Baker and Griffith (2007) find

that some questions are less substantial now than they were in a harder market when premiums

were higher and capacity was lower. I test their conclusion that D&O brokers seek to price

―culture‖ and ―character‖ by using variables such as executive compensation to proxy for these

underlying governance values. I also include variables that Bebchuk, Cohen, and Ferrell (2009)

find indicate management entrenchment and limits on shareholder power. Finally, as the

corporate governance literature is premised on Jensen and Meckling’s (1976) agency theory and

the principal-agent problem, I discuss how certain governance structures can mitigate agency

costs. I then empirically test for such a relationship. The ensuing analysis reveals that D&O

insurance can serve as a valuable signaling device of corporate governance quality, thereby

enriching the relatively small applied literature on these important issues.

The rest of the paper is organized as follows: Section 2 describes unique features of D&O

insurance. Section 3 discusses the key literature related to D&O insurance. It will look at

proposed theories of what D&O insurance decisions can tell us about a company’s corporate

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governance, monitoring, and vulnerability to managerial opportunism. Section 4 presents

comparative statics on an illustrative principal-agent model. Section 5 develops the hypothesis

and econometric model. Section 6 explains the data and presents descriptive statistics. Section 7

discusses the empirical results and Section 8 concludes.

2. PRIMER ON DIRECTORS’ AND OFFICERS’ INSURANCE

Navigating today’s corporate environment can be extremely difficult. While corporations

can be held liable for their behavior, they are not the only ones. Directors and officers of

companies face the possibility that, even if they diligently discharge their duties to their

stockholders, their stockholders may still sue them. Recognizing that the risk of personal liability

makes being a director or officer of a public company unattractive, most companies purchase

directors’ and officers’ (D&O) insurance to protect their representatives. In addition to

mitigating the risk of incurring personal liability, a principal purpose of this insurance is to help

companies recruit and retain good directors and officers.

In addition to protecting current directors and officers and recruiting quality new ones,

D&O insurance provides coverage when indemnification is not available. Most companies have

indemnification policies in which they agree to protect directors and officers who act in good

faith. However, certain claims by law may not be indemnified, such as shareholder derivative

suits in which shareholders sue directors and officers on behalf of the firm (Core 2000). The firm

might also be willing but financially unable to provide monetary protection, such as in the case

of bankruptcy. A secondary purpose, then, of D&O insurance is to protect directors and officers

when indemnification is not possible.

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Understanding the general structure of D&O insurance, in addition to its purpose, will

help inform the model relating D&O premiums to corporate governance quality. Thus, in the

follow sections, I discuss D&O insurance as follows: First, I explain the key elements of D&O

coverage. Second, I examine the preponderance of D&O claims triggered by shareholder

litigation. Next, I discuss the market for D&O insurance and then conclude with an explanation

of the D&O underwriting process.

2.1 D&O Policy Coverage

As previously mentioned, a typical D&O policy sold to a publicly traded corporation

contains three different types of coverage, known as Side A, B, and C. ―Side A‖ coverage

protects individual managers from the risk of shareholder litigation and is what most non-

specialists think of as D&O insurance. However, D&O policies also contain two other, less

widely known types of coverage. The second type, known within the industry as ―Side B‖

coverage, reimburses the corporation for indemnification payments to officers and directors. And

the third type, ―Side C‖ coverage, protects the corporation itself from shareholder litigation in the

case in which the corporate entity itself is sued.

All D&O policies have the effect of shifting the risk of shareholder litigation from

individual directors and officers and their corporations to a third-party insurer, such as Chubb or

AIG. When shareholders sue their officers or directors, the insurer almost always pays (Black,

Cheffins, and Klausner, 2006). Covered losses include legal fees incurred in defense of claims,

compensatory damages, and settlement amounts, which are substantial, though admittedly

skewed due to a handful of very large and high-profile settlements. The average settlement value

for the years 2002-2005 was $22.3 million, significantly higher than the average settlement value

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of $13.3 million for the years 1996-2001 (Baker and Griffith 2007). Given these large figures, it

is not surprising that D&O insurance has become a practical necessity for public firms since its

rise in popularity in the mid-1960s.

2.2 D&O Insurance and Shareholder Litigation

Directors and officers most often seek protection against shareholder claims. Thus, most

economists estimate litigation risk using shareholder litigation risk. According to Tillinghast-

Towers Perrin’s (2003) Directors and Officers Liability Survey, about one-half of D&O

insurance claims against public companies in Canada and the U.S. are brought by shareholders.

The remainder is filed by other stakeholders of the company, such as employees and customers,

or even competitors and government regulatory agencies. A myriad of reasons may trigger

lawsuits: illegal acts, violations of security laws, self-dealing, imprudent or negligent

management, bankruptcy, executive compensation, and violations of fiduciary duty to

shareholders (Boubakri and Galleb 2008). Of these reasons, the most common is inadequate

corporate disclosure; other frequent reasons are shareholder suits related to stock or public

offerings and unnecessary takeover defenses in the face of a merger or acquisition. While the

possible grounds for complaints are many, the basic concern underlying these types of claims is a

divergence between managerial conduct and shareholder welfare—the problem, in other words,

of agency costs (Baker and Griffith 2007). Whether the claim is that managers looted the

company or negligently managed it or lied to investors in order to inflate their own compensation

packages, the basic concern is that management has sought to serve its own interests rather than

the interests of its investors.

However, apart from shareholder suits, directors and boards foresee new risks for

triggering a company’s D&O coverage in the year ahead. New compensation disclosure rules

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and recent high profile exit packages may lead to increased litigation in the area of executive

compensation and severance packages (Directors 2010). With the increasing importance attached

to corporate social responsibility, directors’ due diligence on environmental issues is another

potential source of litigation. More broadly, new risks could be embedded in any changes made

in Congress or in the enforcement mentality of the Department of Justice and other enforcement

agencies on insider trading, salary disclosure, and the failure to report suspicious activity

centering on Currency Transaction Reports and Suspicious Activity Reports (Directors and

Boards 2007). So while the usual suspects—activist shareholders and M&A activity—continue

to create opportunities for a claim, directors and officers are always vulnerable to new

accusations of wrongdoing.

2.3 The Market for D&O Insurance

The D&O insurance market has three key participants: corporate buyers, insurance

brokers, and insurance company sellers. The corporate buyers are typically the ―risk management‖

officers of companies. They purchase D&O policies from specialized insurance brokers, expert

intermediaries who facilitate the transaction and act as the insured’s consultants and advisers.

After having carefully accessed all relevant financial and business risks associated with the

applying company, these brokers negotiate with insurance companies on behalf of the insured.

Attributes of the sale of D&O coverage relevant to my study are discreteness of limits

and correlation of limits with market size. Insurance brokers sell coverage limits by layers of

$1,000,000, although the most important steps are $5,000,000 (Boyer 2004). This step-wise

characteristic of the D&O insurance limit is known as ―sticky points‖ and becomes relevant

when trying to precisely measure the amount of coverage demanded by corporations.

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Moreover, the amount of D&O insurance corporate buyers purchase correlates with their

company’s market capitalization. According to Tillinghast, in 2005, small-cap companies with

market capitalizations between $400 million and $1 billion purchased an average of $28.25

million in D&O coverage limits compared to large-cap companies with market capitalizations in

excess of $10 billion, who purchased an average of $157.69 million in D&O coverage

(Tillinghast Towers Perrin 2005). The positive correlation between size and coverage makes

sense since the largest companies are more likely to attract lawsuits—not only are they more

visible in the press but also they offer higher potential payoffs for plaintiffs’ lawyers. D&O

brokers assemble towers of coverage for their clients according to these two principles.

On the opposite spectrum from the buyers and brokers are the insurance company sellers,

or carriers, that actually provide the coverage and cover expenses in the case of litigation. D&O

liability insurers are what Baker and Griffith (2007) call the ―financiers of shareholder litigation

in the American legal system,‖ paying on behalf of the corporation and its directors and officers

when shareholders sue. Chubb supplies the majority of D&O coverage in Canada while Chubb

and AIG together dominate the U.S. market. While these two market leaders hold approximately

50% market share in premium terms, the U.S. D&O insurance market is becoming increasing

competitive, with 53 suppliers offering policyholders expanded options (Green 2010).

Soft pricing has been driven mostly by new insurers entering the D&O liability market

during the past two years, many sparked by revelations last fall of financial troubles at American

International Group Inc., XL Capital Ltd., and Hartford Financial Services Group Inc. The three

companies fared better than some had anticipated, though, leaving more insurers than ever

offering D&O liability coverage. Increased supply has consequently driven down rates (Phillips

1). This is a classic illustration of the cyclicality of insurance underwriting—―hard markets‖ in

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which underwriters become more selective and less willing to offer high limits are followed by

―soft markets‖ in which underwriters loosen standards in an attempt to salvage profits. While the

recent shift in the D&O market to the ―soft‖ phase is good news for companies seeking insurance,

it signals tighter profit margins for D&O liability underwriters.

2.4 What Matters in D&O Underwriting

Underwriting is the process that insurers use to decide whether or not to offer coverage to

prospective insureds, and if so, at what amounts and at what price. Since the process of

underwriting D&O insurance is considered highly personal (as compared to fire insurance, for

example), legal scholars and economists have taken steps to determine the key criteria that

determine pricing. Professors Tom Baker of the University of Connecticut and Sean Griffith of

Fordham have reported on their empirical effort to understand what makes D&O underwriters

comfortable and influences their pricing decisions. They conducted detailed interviews with over

forty well-respected D&O professionals between 2004 and 2006 and uncovered two ―pillars‖ of

D&O underwriting: one, the financial health of the company and, two, the quality of that

company’s governance. Using this framework, the authors analyzed responses to the following

questions, which directly pertain to my study: What information do underwriters ask for during

this process? What information do they value most? And finally, what do they believe best

predicts shareholder litigation risk?

a. Financial Analysis

According to their survey study, underwriters believe they can ―out-select‖ their peers.

To do so, underwriters first look to financial and objective data: information from public filings,

private databases or analysis services, claims history, company knowledge of pending litigation,

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and especially any intent to acquire other companies or issue securities. Underwriters and

investors, however, analyze risk in fundamentally different ways. Baker and Griffith explain:

Insurers, unlike investors, do not look favorably upon high-growth companies. Insurers

focus more on downside risk because they have a fixed return (the policy premium) that

is modest in relation to their exposure to loss (the policy limits), while equity investors

have a fixed exposure to loss (their initial investment) and a potentially unlimited upside

(their share of the business’s growth). (30)

In other words, when assessing the risk a company brings to the table and pricing policies,

insurers prefer the stability of mature companies to the volatility of new ones. Insurers demand

higher premiums from riskier companies. For instance, Tony Galban, senior vice president and

underwriting manager for directors’ and officers’ liability insurance at Chubb, states that a start-

up company with nebulous business plans is likely to face closer scrutiny from D&O

underwriters and pay $10,000 annually for $2 million in D&O coverage (Directors 2010). This

substantial payment is necessary to compensate D&O insurers for the increased likelihood of

litigation from company failure and stock volatility. Thus, a company’s growth stage is an

important input into underwriters’ assessment of litigation risk.

Equally important to insurers is a company’s market capitalization, which signals the

potential magnitude of payout. Paul Rauner, president of Chicago Risk Services, an insurance

brokerage in the Midwest, explains that small, established private companies are considered low-

risk by underwriters and could pay as little as $500 per million in annual premiums. Large public

companies, on the other hand, are typically considered high-risk and pay anywhere from $10,000

to $30,000 per million in annual premiums (Directors 1). The reason for this discrepancy is that

underwriters use market capitalization as a gauge of both litigation frequency and severity.

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Larger companies are sued more often and for greater amounts so therefore must pay higher

premiums.

In addition to considering a potential insured’s market capitalization, insurers note the

company’s industry affiliation. Insurers associate industry with litigation frequency—some

industries are sued more often than others. While the industries sued most often fluctuate

somewhat from year to year, in 2005, the three industrial sectors receiving the most securities

class action filings were consumer noncyclical, consumer cyclical, and financials. The year

before, however, the top three industries in terms of filings were consumer noncyclical,

technology, and communications (Cornerstone Research 2006). Despite the ever-shifting

categorizations of highest-risk industries, these findings point to which industries D&O

underwriters classify as high-risk.

b. Governance Factors

While business intelligence informs the basic modeling of policy premiums, Baker and

Griffith argue that corporate culture and governance practices differentiate one risk from another

and, in turn, determine underwriters’ willingness to negotiate. But before further discussion, I

pause to define corporate governance, a ubiquitous but nebulous term. Some, such as Shleifer

and Vishny (1997) define corporate governance as the ways in which suppliers of finance to

corporations assure themselves of getting a return on their investment. This paper, however,

takes a broader view on these issues and subscribes to Gillan and Starks’ (1998) view of

corporate governance as the system of laws, rules, and factors that control operations at a

company. Irrespective of the particular definition used, corporate governance is an important

component of the insurer’s pricing equation, because without taking this into account, insurers

would be unable to differentiate between firms with otherwise identical business characteristics.

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Economists agree that corporate governance enters into the insurer’s pricing matrix

because insurers stake their own capital on their risk assessments and therefore have optimal

incentive to carefully analyze governance risk. Other third-party evaluators of corporate

governance, such as equity analysts, Institutional Shareholder Services (ISS), and ratings

agencies, including Moody’s and Standard & Poor’s, operate on a fee-for-services model and

therefore do not suffer when a rating is incorrect (Baker and Griffith 2007). D&O insurers, on

the other hand, stake their own capital on their governance assessments and suffer directly from

any error in evaluating risk.

In addition, Baker and Griffith point out that, unlike mutual funds, pension funds, and

other diversified equity investors, insurance companies cannot eliminate the nonsystemic risk of

firm-specific governance. Mutual funds are able to eliminate nonsystemic risk by building

diversified portfolios, but insurance underwriting occurs in a competitive market in which not

every insurer receives a portion of every risk. This means that each insurer’s portfolio is different,

with insurers that are skilled at distinguishing good and bad risks predictably building better

portfolios than those who are not. Since institutional equity investors can diversify away this

type of risk, they have less incentive to develop expertise in distinguishing good and bad risks.

Similarly, bondholders can control their downside risk by a system of priority and security

interest. In contrast, insurers have no such mechanisms to protect against faulty risk assessments.

Given this particular structure of incentives, one expects insurers to develop expertise in

distinguishing good and bad governance risks and to build these assessments into their pricing

models for D&O insurance.

However, financial motivation is in itself insufficient to claim that D&O insurers can

accurately price policies. But insurers have an added advantage: they can assess the prospective

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insured’s corporate governance on the basis of information beyond that which is publicly

available in the company’s securities filings or other public documents. The first piece of

nonpublic information that insurers possess comes in the form of a written application and

questionnaire that prospective clients submit for initial review. The application requests

information directly related to the quality of a firm’s corporate governance. For instance,

questions pertain to earnings management and related-party transactions because these actions

frequently trigger securities litigation and derivatives lawsuits. The application also asks for the

board’s takeover planning, which can indicate entrenchment and the possibility that shareholder

suits will result from acquisition-related activity.

Perhaps most importantly, underwriters interview management, during which they delve

into deeper ―governance issues‖ than the board’s structure and upcoming plans. Baker and

Griffith (2007) report that, in these meetings, underwriters are keen to know how company

policy determines incentives for executive action, such as executive compensation formulas, the

strength of internal controls, and the compliance culture, especially the vigor of insider-trading

prohibition. Baker and Griffith’s study further reveals that underwriters consider process and

controls when contemplating business acquisitions just as important as the M&A activity itself.

If dissatisfied with corporate officials’ responses in these interviews, underwriters can request

sensitive information or confidential documents to enable the underwriters to complete their

evaluation. Such disclosures are typically made pursuant to non-disclosure agreements (NDAs).

Since the insurer is not an equity analyst or rating agency, the company has no obligation to

disclose the information to the market. Because underwriters can commit to confidentiality, they

can base their pricing on non-public information not already reflected in a company’s share price.

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Essentially, it is possible that the D&O underwriting process successfully delves into both

conventional and ―deep governance‖ issues and incorporates this information into the premium.

c. Summary and significance

As economists and legal scholars have pointed out, insurance companies that write D&O

insurance will presumably use all available information as to a company's financial condition and

the efficiency of its governance procedures. Baker and Griffith’s paper offers insight into how

D&O underwriting works and what type of information is embedded in the premium. Rather

than simply reflecting the business risk of a firm, such as the size and industry in which it

operates, the premium should reveal underwriters’ subjective assessment of governance and

internal controls. The underwriters’ detailed inquiries include questions of ethics, morality, and

humility in both personal conduct and in conduct of the business. Arrogance and excessive risk

taking are markers for bad risks. (Even the number of speeding tickets by the CEO was taken to

be an indicator of D&O risk.) Overcommitment to growth, excessive risk taking, and aggressive

earnings-per-shares targets may create a culture where individuals may be tempted to act

opportunistically at the expense of shareholders.

After collecting a comprehensive set of public information and non-public information,

insurers enter their assessment of the firm’s risk into a ratemaking matrix (Baker and Griffith

2007). As this matrix yields only a premium given the amount of coverage demanded, we would

like to know if governance quality is embedded in the premium. Or, as Boyer (2004) puts it to

financial economists, would it be possible to design a profitable investment strategy based on the

D&O information contained in management proxies? Many would agree that D&O insurance

information is a better signal than the CEO's age and could be construed as part of the

compensation package of the directors and officers of the corporation. With detailed information

May 2011 Kang 20

available regarding the compensation of top executives and the structure of the board, it appears

almost paradoxical that information as easy to present as the D&O insurance policy limit,

deductible and premium, and so informative as to the governance health of a firm does not find

its way to U.S. proxy statements. A major goal of this study is to determine whether empirical

evidence supports this call for public disclosure.

3. LITERATURE REVIEW

In this section, I discuss the three main hypotheses surrounding D&O insurance: the

relationship between D&O premiums and corporate governance, the determinants of D&O

insurance demand, and the presence of moral hazard in insured firms. I also briefly discuss

agency theory, which forms the basis of any study on corporate governance.

The empirical literature on D&O insurance is relatively recent, as the majority of studies

occurred within the past decade. While economists increasingly conduct studies with newer data

and data from different countries, few have studied issues unique to D&O insurance. This is

mainly due to the lack of public information prior to 1990. The Cadbury report in the United

Kingdom and the Dey report in Canada changed that by mandating their respective securities

commissions to make available information on the risks publicly traded corporations face and the

tools they use to manage those risks. Following the 1992 Dey Report, disclosure of basic

information regarding D&O insurance (i.e. policy limit, premium and deductible) in firms’

financial statements became the norm in Canada. This allowed a handful of academics to analyze

the determinants of the purchase of D&O insurance, as well as the factors affecting premiums.

Core (1997) conducted the pioneer study, using publicly available Canadian data on 222

firms whose fiscal year ended in 1994 to test for the main determinants of the D&O insurance

policy limit and deductible. Perhaps unsurprisingly, he found that litigation risk and the cost of

May 2011 Kang 21

financial distress are the main determinants related to D&O purchase decisions. In his 2000

study, however, Core posed a more interesting question: if insurers can price litigation risk, and

corporate governance is a component of litigation risk, does this mean that insurers can

accurately assess the quality of corporate governance? Using variables that proxy for quality of

corporate governance, Core (2000) conducted a F-test and found the corporate governance

variables to be statistically significant determinants of the premium, even after controlling for

business risk, such as firm size, financial performance, and U.S. exchange listing. The combined

evidence that all the coefficients had the predicted signs, that five of nine proxy variables were

individually significant, and that the corporate governance proxy variables were collectively

significant led Core to conclude that the information contained in the D&O premium is a useful

summary measure of the quality of a firm’s governance. His study verified his hypothesis: D&O

premiums are higher for firms with weaker governance structures.

This result has important implications. In a world in which we do not have reliable

measures of corporate governance quality, Core’s (2000) findings suggest that capital market

participants might consider using D&O insurance premiums as indicators of governance quality.

Griffith (2006) argues that the type of insurance package purchased by a particular firm may

convey information concerning the firm’s likely motives in purchasing it and, by extension,

provide some gauge of the extent of agency costs within the organization. Furthermore, should

insurers successfully separate good governance risks from the bad, the price of a firm’s D&O

policy represents the insurer’s assessment of the quality of the firm’s corporate governance.

Equipped with this information, investors may adjust their reservation values, thereby creating a

discount on the share price of firms whose D&O policies reveal high agency costs or low-quality

corporate governance. This discount might even incentivize firms to improve their corporate

May 2011 Kang 22

governance (Griffith 2006). The essence of the argument for disclosure, then, is that the

information contained in D&O policies is potentially valuable for investors and can even

encourage better governance practices within firms.

One of the variables Core found to be most significant, however, underscores the study’s

inherent limitations. If a Canadian firm is also listed on a U.S. exchange, exposing it to U.S.

securities litigation, the firm has significantly higher D&O premiums. This emphasizes the

difference between U.S. and Canadian liability risks. Litigation is so common in the U.S that

some firms consider it a normal business expense, in contrast to the Canadian market where

litigation is less common (Kaltchev 2004). The Canadian legal system is less conducive to

nuisance suits over stock price declines because it is less favorable to entrepreneurial plaintiffs’

lawyers (Baker and Griffith 2007). These cross-border differences suggest that, while Core’s

study supports a link between corporate governance and D&O insurance, ultimately data from

my study are needed to confirm the result.

One reason why D&O insurance has not been studied more empirically in the U.S. is that

D&O insurance data are not publicly available. As a result, most past studies rely on U.K. and

Canadian data. So far, the existing D&O insurance studies focus primarily on the demand for

insurance. After Core (1997) showed that litigation and distress risks are the major determinants

of D&O insurance purchases in Canada, O’Sullivan (2002) investigated the determinants of

D&O insurance demand in the U.K. He used probit analysis and found that insured companies

are larger and are more exposed to U.S. litigation. Insured companies also experience greater

share price variability, exhibit lower levels of managerial ownership, and possess greater non-

executive representation on their boards than their uninsured counterparts. O’Sullivan

May 2011 Kang 23

contributed to the literature by uncovering U.K. firms’ revealed preferences in purchasing D&O

insurance and by providing a detailed profile of the types of companies who buy D&O insurance.

Also seeking to understand which factors explain the corporate demand for insurance,

Boyer (2003) used a recent sample of 318 Canadian firms, regressing the demand for D&O

insurance on corporation size, return characteristics, credit worthiness, litigation environment,

and corporate governance. He found none of these to be determinants of the demand for D&O

insurance. Even corporate governance, which Tufano (1996) found to be an important

determinant, played no role. The most important factor that determined the amount of D&O

insurance coverage purchased was last year’s purchase. Boyer (2003) interpreted this as evidence

of managerial habit; that is, managers make an optimal decision this period before waiting to see

future results. Since results may take years to materialize, in the interim, they make the same

D&O purchase decisions. This ―persistence‖ theory is Boyer’s (2003) most notable contribution

to the literature on Canadian D&O insurance.

While Boyer (2003) interprets the significance of the lagged limit as solid evidence that

habit is the main driver of D&O insurance demand, other authors take issue with that. They

argue that its significance may mean that the risk exposure of companies may remain unchanged

from year to year, explaining why companies purchase the same limit year after year. Habit

would not be the true reason in this case. To resolve this debate, Kaltchev (2008) used

proprietary U.S. panel data from 1997-2003, consisting of 113 public companies. Kaltchev found

support for Boyer (2003) by verifying the significance of the lagged limit. However, the result

that inertia plays an important role in the structure of the D&O insurance policy is not as

important in Kaltchev’s study as in Boyer’s. In analyzing Kaltchev’s results, Boyer (2003)

attributed the difference in results to four factors. First, U.S. corporations do not behave in the

May 2011 Kang 24

same way as Canadian corporations do. Second, Kaltchev uses information from a unique

insurance broker whereas he uses publicly available information. Third, the period under study is

different, as Kaltchev (2008) uses more recent data. Finally, Boyer’s data includes a wider range

of years, which allows him to better test the organizational inertia hypothesis. No matter whose

results are more robust, the persistence theory has important implications for my study. By

positing that firms’ D&O insurance decisions are explained not by corporate governance or

likelihood of financial distress but by mere inertia, it raises the question of how much D&O

insurance can really reveal about corporate governance.

My study contributes to the literature by using recent data and testing Core’s (2000)

model on a sample of firms cross-listed on the Toronto Stock Exchange and a U.S. stock

exchange. Like Core (2000), I study the relationship between D&O premiums and corporate

governance. In doing so, I adopt a view on corporate governance consistent with a

straightforward agency perspective. The agency problem is an important element of the

contractual view of the firm, developed by Coase (1937), Jensen and Meckling (1976), and Fama

and Jensen (1983). The essence of the agency problem is the separation of ownership and

control—shareholders, the owners of the firm, find it difficult to ensure that the managers, who

act as their agents, do not expropriate or waste their funds on unattractive projects.

One theoretical framework often used in the corporate governance debate to address

agency problems is principal-agent theory. Unlike neoclassical theory, which assumes that effort

choices and costs are observable, principal-agent theory supposes that some costs are private

information. In a typical principal-agent problem, an owner hires a manager to run his firm for

him. The firms’ performance, represented by gross profit, Π, depends on the manager’s effort e

and also a chance variable ε, determined after e is chosen:

May 2011 Kang 25

Π = ƒ(e, ε)

The model assumes that the manager’s effort choice is observed only by him. Thus, for a

contract in which the manager’s compensation is I, a direct function of e cannot be enforced

(Hart 1995). The optimal contract is second-best in that the manager’s compensation must be

based on realized profit, Π: I = I (Π), rather than effort e.

Principal-agent theory is useful for explaining why managers are often given

performance-related pay in the form of shares or stock options. By making I sensitive to Π,

incentive contracts motivate managers to act in the interest of the owners. However, Hart (1995)

argues that the theory itself does not provide a role for governance structure. The reason is that,

despite being second-best in the sense that I depends on Π as opposed to e, optimal principal-

agent contracts are comprehensive. A contract specifies all parties’ obligations in all future states

of the world whereas governance structure exists to provide a way to decide on future actions not

specified in an initial contract.

Nonetheless, principal-agent theory has been applied to D&O insurance by construing

D&O insurance to be part of the directors’ and officers’ compensation package. Maria Gutierrez

(2003) presents a model in which D&O insurance is used as a commitment device for

stockholders to monitor the behavior of corporate directors. The paper follows in the steps of

Sarath (1991) but innovates by having an uniformed principal purchase insurance on behalf of an

informed agent because the insurer cannot observe ex post the agent’s true effort. While

Gutierrez presents a detailed game-theoretic model of the optimal contract between managers

and shareholders, her model has limited empirical applications. Thus, in Section 5, I develop a

testable model based on the broader agency cost theory to study the relationship between D&O

premiums and corporate governance.

May 2011 Kang 26

Although I primarily focus on testing whether D&O insurance premiums reflect

corporate governance quality, an important part of the literature focuses on the theory of

managerial opportunism. Managerial opportunism, as defined by Chalmers, Dann, and Harford

(2002) is the use of superior information by rational managers to sell shares when the public

valuation of the company’s shares exceeds management’s valuation estimate. The idea of

corporate insiders taking advantage of external shareholders has often been studied in the context

of insider trades, as evidenced by Seyhun (1986), Lee (1997), and Kahle (2000). However,

Chalmers, Dann, and Harford (2002) creatively examine the hypothesis of managerial

opportunism from the context of directors’ and officers’ liability insurance. According to their

hypothesis, the amount of D&O insurance bought by an IPO firm is inversely related to the

firm’s ex post stock price performance. That indicates that managers use their superior

information to assess the probability of exposure to legal liability. The authors use similar

characteristics as in Core (2000) to find factors normally influencing D&O insurance demand.

They run cross-sectional regressions of D&O purchase amount to IPO size, leverage, average

revenue, standard deviation of these revenues, average operating income, standard deviation of

the operating income, age of the firm, percentage of outside directors, among others. The

variable of interest, long-run stock performance, appears to be negatively related to the amount

of insurance purchased (Chalmers, Dann, and Harford 2002). The relationship holds for each of

raw returns, book-to-market, and size-adjusted returns. They interpret these results to be

consistent with the managerial opportunism hypothesis, provided we treat the three-year future

returns as a proxy for managers’ private information.

Chalmers, Dann, and Harford’s (2002) paper draws on previous work by Bhagat,

Brickley, and Coles (1987), Holderness (1990), and Core (1997, 2000). It fits squarely among

May 2011 Kang 27

the subset of literature studying the effects of D&O insurance purchase decisions on shareholder

wealth. Many opponents of D&O insurance believe that shielding managers from personal

liability creates a moral hazard problem and increases the likelihood that they will violate their

duty of loyalty. Chalmers, Dann, and Harford’s (2002) results certainly justify these concerns.

In response to Chalmers, Dann, and Harford’s (2002) argument that mandatory disclosure

of D&O insurance details limits potential opportunism, Boubakri and Ghalleb (2008) recently

tested the managerial opportunism hypothesis in a new context: the purchase of D&O insurance

around the time when Canadian firms are getting ready to proceed with their seasoned equity

offerings (SEOs).The authors claim that the Canadian context is interesting mainly because the

reporting of D&O insurance details is mandatory. They examine whether informed managers

modify their behavior regarding the purchase of D&O insurance when their firm are about to sell

SEOs. After controlling for other cross-sectional determinants of D&O insurance coverage, they

find a significant negative relation between the amount of D&O insurance purchased and

subsequent firm performance. This result is surprising because the imposition of a public

disclosure is supposed to make the D&O insurance purchases a useless tool for extracting private

benefits from private information. This result is also perplexing because one would presume that

incentives and opportunities to act opportunistically are more limited for SEOs than for IPOs.

Thus, any evidence of predictable post-issue returns for SEO issuers based on available D&O

insurance information poses an even stronger challenge to the efficient markets theory than the

evidence on IPOs (Boubakri and Ghalleb 2008). Using univariate tests, they document that

managers do significantly change their D&O insurance purchase around the equity offering dates.

This suggests that managers time their purchase of insurance to coincide with their equity-

offering surge. This makes sense only when there is opportunistic behavior. The major

May 2011 Kang 28

implication of this study is that the imposition of a mandatory reporting may not alleviate the

opportunistic behavior of managers through the purchase of D&O insurance despite economic

theory to the contrary.

Overall, the D&O insurance literature mostly revolves around these central ideas: the

corporate governance hypothesis proposed by Core (2000), the corporate inertia hypothesis

introduced by Boyer (2003), and the managerial opportunism hypothesis presented by Chalmers,

Dann, and Harford (2002). The existing D&O insurance studies focus primarily on the demand

of insurance. Few studies focus on D&O insurance premiums and whether the insurance

premium is sensitive to firms’ corporate governance practices, which is the subject of my study.

Select studies use data from the U.K., China, and Taiwan to test various hypotheses, though

those results are not directly comparable to the U.S. There is much more to be studied in regards

to the U.S., especially because the only two other U.S. studies, Kaltchev (2008) and Chalmers,

Dann, and Harford (2002), use small data sets in concentrated time periods. The inability to

seamlessly apply foreign results to the U.S. means that we can greatly benefit from a careful

study of whether D&O insurers translate their assessment of governance risk into the premium.

Should this be the case, there is considerable motivation to argue that the disclosure of details

regarding D&O insurance decisions, as is required by some countries, is valuable.

4. THE MODEL

This section presents a basic principal-agent model that is used to derive predictions as to

how the parameters of the D&O insurance premium change with various exogenous influences.

The basic model of Garen (1994) is utilized, with adaptations for the case at hand. Garen’s model

is used to study the CEO’s relative performance pay. In this paper, however, I construe D&O

May 2011 Kang 29

insurance to be part of the salary portion of the CEO’s compensation package as Boyer (2003)

does. This allows me to compute comparative statics for how the D&O premium should change

with variables, such as market capitalization and volatility.

In this model, the CEO is the risk averse agent. Stockholders are the principals. It is

assumed that stockholders hold a diversified portfolio and thus are subject only to the firm’s

systematic risk.

Let the CEO’s utility function be given by2

, ( )-

where Y is CEO income, µ is CEO effort, ρ is the coefficient of absolute risk aversion, and .5kµ2

is the cost of effort.3 The CEO’s income is modeled as a linear function of the firm’s net revenue,

R, as .

The firm’s rate of return is defined as net revenue over market capitalization. It is given

by ⁄ , where V is market capitalization and represents unobserved, random

influences on the firm’s return. Assume that is normally distributed with mean zero and

variance . It follows that the net revenue of the firm is .

I assume that each CEO allocates part of his salary to the risk-free asset, which earns

and part to the market portfolio, which earns . Given this setup and substituting in the

expression for R, CEO income is:

( ) ( )

where and is the random part of the market return assumed to be

normally distributed with mean zero and variance .

2 This specific functional form is adopted to ease the derivation of comparative statics.

3 In this model, k is equal to the ratio of incentive pay to effort over the elasticity of effort with respect to b1,

following Jensen and Murphy (1990).

May 2011 Kang 30

Given the discussion above, expected utility can be written as

( ) * [ ( )

]+

where

,

and is the covariance of the firm and the market return. The CEO maximizes expected utility

subject to effort and the portfolio mix, M.

Owners of the firm are assumed to be diversified stockholders. The capital asset pricing

model implies that the minimum return necessary to attract investors is , where is

the covariance of market and shareholder returns and q is ( )

Shareholders seek to maximize

expected returns net of the required return, .

Since we defined as the return to stockholders, its expectation is given by

( ) ,( ) - . The covariance of the market and stockholder returns is

( ) Since shareholders maximize expected returns net of ( ) , they

wish to choose to maximize

( )

( )

subject to the constraint that the CEO acts to maximize expected utility.

The solution for is given by

( )

Recall that is the pay performance sensitivity. An increase in the variance of the firm’s

return lowers . An increase in the firm’s market capitalization also tends to lower . These

May 2011 Kang 31

two effects reinforce one another, since variance enters into CEO income as a multiple of and

Consider now the effects of the exogenous variables on the salary portion of executive

compensation, of which the D&O insurance premium is a component. This is given by . It

must be set to meet the CEO’s reservation utility constraint. Therefore, differentiating with

respect to the exogenous variables yields the desired expressions. They are

and

(

)

where

is the slope of the CEO’s indifference curve between and . Because

< 0,

the D&O premium rises with as long as the CEO’s indifference curve slopes downward. A

similar result holds for total market capitalization, V.

Garen (1994) notes that the general intuition for these findings is as expected from

principal-agent theory. The specific breakdown of executive pay involves a trade-off between

incentives and insurance. As the output the agent produces becomes inherently riskier (volatility

increases), the insurance component of pay is increased and the incentive component is reduced.

Although the model is defined for CEO compensation because that data is readily available, the

predictions of the model apply to director and executive compensation in general. Specifically,

as is discussed in Section 7, Analysis of Results, market capitalization and volatility do indeed

significantly and positively affect the D&O premium.

May 2011 Kang 32

5. EMPIRICAL MODEL\

This paper determines whether D&O insurers value corporate governance risk by testing

whether variables that proxy for corporate governance can explain the D&O insurance premium.

The underlying premise is that D&O insurers price litigation risk, which has two components:

business risk and governance structure quality. Business risk refers to objective risk factors that

insurers initially consider, such as market capitalization, industry, jurisdiction, assets, revenue,

and credit rating. After analyzing these business risks, the insurer considers subjective factors,

such as corporate governance quality, that distinguish otherwise identical firms.

The econometric model I use builds on that of Core (2000) with the null hypothesis that

the D&O insurance premium reflects only the firm’s business risk. A proponent of this view

might claim that D&O underwriters use increasingly objective criteria to evaluate litigation risk

because they have access to a large stock of detailed information. The alternative hypothesis is

that the premium also reflects the insurer’s assessment of the quality of the firm’s governance

structure. Under the alternative hypothesis, D&O insurance can reveal valuable, otherwise not

measurable, information about the strength of a corporation’s management.

Corporate governance enters the D&O premium through its effect on litigation risk. D&O

insurers seek to price litigation risk and choose a premium equal to the expected value of

litigation costs. This cost can be approximated by (risk of lawsuit × size of lawsuit). As

discussed in Section 2.2, shareholder risk is the most important type of litigation risk that public

corporations face. Shareholders, it can be said, sue for bad behavior. Thus, firms with good

governance structures that keep shareholder value high face lower litigation risk and are

considered less risky by D&O insurers. These governance structures keep shareholder value high

by reducing agency costs, as described in Jensen and Meckling’s agency cost model (Jensen and

Meckling 1976). The objective of this study, then, is to find management arrangements that

May 2011 Kang 33

reduce agency costs and thus litigation risk. These arrangements are hypothesized to be

positively associated with management diligence and negatively associated with management

entrenchment and opportunism.

Core (2000) states that a sufficient condition for the quality of corporate governance to be

priced in the D&O premium is that the quality of governance structures varies in cross section

for otherwise identical firms and that it is too costly for the insurer to just exclude all claims

arising from weak corporate governance. To adopt Core’s definition, corporate governance is

characterized as strong (weak) if it allows shareholders to impose tight (loose) constraints on

managers’ actions. Presumably, a firm with weaker governance has greater litigation risk

because the manager of such a firm is more likely to take actions inconsistent with shareholders’

interests. Because business risk (firm size, profitability, etc.) also increases litigation risk, a

firm’s D&O premium is hypothesized to be a function of the quality of corporate governance and

its business risk:

D&O premium= ƒ (governance structure quality, business risk) (1)

Key Assumptions

This function is an expression of the alternative hypothesis from which Core derives an

econometric model that assumes (1) the firm and insurers have symmetric beliefs about the

probability and distribution of D&O losses, and (2) the D&O insurance market is perfectly

competitive. The first assumption about symmetric beliefs is reasonable since the D&O

insurance application process is structured to enable the insurer to obtain complete information

about the applicant’s risk factors. When a firm initially applies for D&O insurance, it must

submit an extensive written application that details the firm’s past litigation experience, its past

May 2011 Kang 34

and future business activities, biographical data on its directors and officers, and its ownership

structure (Baker and Griffith 2007). The firm must truthfully reveal any information pertaining to

its litigation risk or else risk being denied coverage in the event of a claim. In addition to

reviewing the application, which is renewed yearly, the D&O insurer conducts background

checks on the firm’s management and often requests interviews with management. The

comprehensive application and renewal process suggests minimal asymmetric information—the

insurer and the firm share similar beliefs about the firm’s litigation risk at the time the insurance

is priced.

The second assumption of perfect competition is reasonable given the current economic

environment in 2009. Core asserts that perfect competition holds for the Canadian D&O

insurance market, though it applies to the U.S. as well. According to speakers at the Professional

Liability Underwriting Society’s D&O Symposium in February 2010, tough competition

continues to put pressure on prices. When top insurers such as AIG and XL Capital Ltd. faced

troubles during the financial crisis of 2007-2008, barriers to entry fell. New players are emerging

in the U.S.—53 companies are currently underwriting D&O coverage and offering policyholders

coverage options heretofore unavailable (Green 2010).

Assuming symmetric information and competitive markets, we can further specify how

a firm purchases D&O insurance. It chooses the limit it desires and is charged a premium equal

to its litigation risk plus a mark-up. After the firm completes the application process and chooses

a limit and deductible, the insurer sets a premium by adjusting the ratebook premium for that

chosen limit and deductible to reflect the difference in that firm’s risk from the average risk. The

firm’s premium can be modeled as a product of the insurer’s overhead and profit factor, the

idiosyncratic litigation risk of the firm, and the conditional expected loss, which is a function of

May 2011 Kang 35

the limit and deductible. Since the premium is a product of these terms, the logarithm of the

premium is linear in the firm’s litgation risk, the unconditional loss, and a constant:

log(premium) = β0 + β1 litigation risk + β 3 log (E[ratebook loss | limit, deductible] ) + ε1 (2a)

or, equivalently:

premium = ( ℮ β0

) (℮ β1risk

) (℮ β3 log (limit)

) (2b)

As the conditional expected loss is unobservable, Core uses log (limit) as its proxy because the

limit a firm desires closely reflects the losses it expects it will incur. In this model, the dependent

variable is log (premium) and independent variables are the proxies for governance structure

quality and business risk:

log(premium) = β0 + β1 litigation risk + β 3 log(limit) + ε1 (3)

Assuming litigation risk is determined by governance structure quality and business risk, we

obtain:

log (premium) = β0 + β1 governance structure quality + β 2 business risk + β 3 log(limit) + ε1 (4)

To define log(limit), which is the amount of insurance a firm decides to purchase, note that high

risk and highly levered firms have greater expected losses so would purchase greater limits (Core

1997). Figure 1 in the Appendix shows that firms with larger market capitalizations do indeed

purchase greater coverage. Thus, business risk is part of the D&O purchase decision. O’Sullivan

(1997) and Kaltchev (2008) find evidence that corporate governance also influences firms’ D&O

May 2011 Kang 36

purchase decisions. Like the premium, then, the limit is a function of governance quality and

business risk:

log (limit) = γ0 + γ1 governance structure quality + γ2 business risk + ε1 (5)

And substituting in the expression for log (limit), the reduced form of the model is:

log (premium) = δ0 + δ1 governance structure quality + δ2 business risk + β3 ε2 + ε1 (6)

where the total effect is δi = βi + β3 γi, the sum of the direct effect, βi, of the variable on log

(premium) and its indirect effect by increasing log(limit), β3 γi,. This is the model I estimate.

Consistent estimates for this reduced-form model are obtained under the standard assumption

that the governance structure and business risk variables are uncorrelated with ε1 and ε2. The

reasoning for E (ε1 ε2 ) = 0 is discussed in the next section. A final assumption is that the

governance structure and the risk variables are exogenous or predetermined at the time of

insurance pricing decision. This assumption is consistent with the assumption of symmetric

contracting in which the firm decides what limit it wants to purchase and the insurance company

charges it a premium adjusted for its conditional expected loss.

Statistical methodology

To examine the association between the level of D&O premium and governance structure

quality and business risk, I use the reduced form specified in Equation (6). In this regression

equation, the dependent variable is log (premium) and the independent variables are the proxies

for governance structure quality and business risk defined in Table 1. In order to estimate

May 2011 Kang 37

Equation (6), I must first include ε2 as an independent variable. This is the error term from

Equation (5), which expresses log (limit) as a function of governance structure quality and

business risk. Thus, ε2 represents information in the limit that is orthogonal to the proxy variables.

As Core (2000) notes, one reason this information arises is because limits are sold in ―sticky

points.‖ As discussed in Section 1, insurance brokers sell coverage limits in discrete multiples of

$1,000,000, although the most important steps appear to be $5,000,000. Thus, even if the firm’s

desired limit were completely determined by the proxies for litigation risk, because of the

discreteness in the actual limit, there will be information in the residual limit that will be

associated with the premium.

To estimate ε2, I conduct a first-stage regression of log (limit) on the proxies for

governance structure quality and business risk to obtain ε 2, the residual of log (limit). I then

estimate the following second-stage regression:

log (premium) = δ0 + δ1 governance structure quality

+ δ2 business risk + β3 residual of log(limit) + ε1 (7)

The residual of log (limit) controls for information in log (limit) that is associated with the

premium. The total effect δ 1 is the sum of the variable’s direct effect on log (premium) and its

indirect effect on log(premium) through its effect on the amount of coverage purchased,

log(limit).

To test the joint hypothesis of the governance variables, I conduct a partial F-test (p=0.05)

that all the corporate governance variables are equal to zero. Rejecting the null hypothesis means

that the variables significantly explain the model for log (premium). To test the robustness of my

specification, I perform a number of sensitivity tests to ensure that omitted variables are not

influencing the effects I measure for the governance structure variables of interest. Overall, if the

May 2011 Kang 38

results show that all the coefficients have the predicted signs, that the majority of the variables

are individually significant, and that the variables are collectively significant, then they would be

consistent with the hypothesis that the information contained in the D&O premium is a useful

summary measure of the quality of a firm’s governance.

6. DATA

The initial sample consists of a cross section of the 1,498 publicly traded companies

listed on the Toronto Stock Exchange (TSX), which is the largest stock exchange in Canada. The

Toronto Stock Exchange represents a broad range of businesses from Canada, the United States,

and Europe. Of this initial sample, 176 firms that have fiscal years ending between June 1, 2009,

and May 31, 2010, are cross-listed on a U.S. Exchange (NYSE, AMEX, or NASDAQ). I use

cross-listed firms because exposure to the more litigious U.S. legal environment has been found

to be a significant determinant of the D&O premium (Core 2000). Exposure to U.S. securities

litigation risk makes the sample firms close proxies for U.S. firms. Since D&O insurance

information is not publicly available in the U.S., the best alternative is to use cross-listed firms

that both abide by U.S. securities law and disclose their D&O policy details. Due to their dual

listings in Canada and the United States, these firms have also adopted governance structures

consistent with the best practice guidelines of the Canadian securities regulatory authorities, the

rules of the SEC, and the Sarbanes-Oxley Act of 2002. Observance of U.S. corporate governance

listing standards further strengthens the comparability between my sample and U.S. firms.

Excluded from the sample of 176 cross-listed firms are Exchange Traded Funds, split

share corporations, investment funds, limited partnerships, and other special purpose issuers. I

also eliminated income trusts because they exist only in Canada, are not incorporated like

May 2011 Kang 39

traditional companies, and have more byzantine corporate structure that Boyer (2004) found to

be priced into the D&O premium. From this sample of 176 cross-listed firms, a subsample of 92

firms are used in the analysis of D&O premiums. This subsample of 92 firms was obtained by

eliminating 84 firms for the following reasons: (1) the firm does not carry D&O insurance (66

firms); (2) either premium or limit data are not disclosed or disclosed for only part of the D&O

coverage (14 firms)4; (3) missing proxy statement (3 firms); and (4) new company with an IPO

in the previous year (1 firm).5 Eleven of the 92 firms are U.S.-incorporated firms and so are

subject to U.S. state law rather than U.S. securities law. These U.S.-incorporated firms are

identified with a dummy variable, as described in Table 1.

This 92-firm subsample represents ten different industry sectors. In order of decreasing

proportion they are: mining, diversified industries, life sciences, technology, financial services,

oil and gas, clean technology, communication and media, utilities and pipelines, and real estate.

My sample consists of a relatively large percentage of mining companies (38%), though this

feature simply reflects the broader Toronto Stock Exchange, which is a world leader in mining

and oil and gas. Figure 3 in the Appendix shows a detailed industry composition of the sample.

Canadian D&O insurance data is publicly available— the Ontario Business Corporations

Act required firms to disclose the aggregate premium, total amount of insurance, and deductible

or co-insurance in regards to D&O insurance purchased in the previous year. As such, I use a

cross section of the most recent D&O insurance data available, which is disclosed in the online

4 Some firms disclosed only the premium paid for coverage or the annual limit. As both amounts are needed in the

empirical analysis, those firms were excluded from the sample. Also, firms that disclosed only the premium paid for

the corporate coverage or the personal coverage portion of their D&O policy were dropped because this partial

premium is not comparable to a premium paid for the aggregate D&O policy.

5 I exclude firms that offered an IPO in the previous year to reduce the incidence of any information asymmetry

between the insurance carrier and the company as documented by Chalmers et al. (2002), who report that typically

there are huge increases in insurance limits (or coverage is initiated) and premiums around the time a company

makes an IPO.

May 2011 Kang 40

database SEDAR (www.sedar.com). SEDAR contains the documents and securities filings of all

publicly traded Canadian companies. I hand collect the D&O insurance data, which include

details on D&O insurance coverage amounts, premiums paid, and corporate deductible, from the

proxy statements and annual reports of each firm. Following the methodology employed by Core

(2000), Boyer (2004), and Bourbakri (2008), if there is no mention of the existence of D&O

insurance policy in these filings, I consider the firm uninsured. According to responses I received

from Canadian business lawyers and D&O brokers, uninsured firms are usually small and

venture companies in Canada that have not yet secured coverage or find it prohibitively

expensive.

After gathering information on the logarithm of D&O insurance premium and limits, I

create proxy variables for governance structure quality and business risk. The next subsection

discusses nine characteristics of corporate governance that agency theory literature has found to

affect agency costs. These governance structure variables were collected from the proxy

statements of each firm. The second subsection discusses a set of control variables for business

risk. These business risk variables were created using the company’s annual report and stock

price data from Compustat and Capital IQ. Following Core (2000), all independent variables are

measured as of the end of the fiscal year 2009, prior to the purchase of D&O insurance, under the

assumption that the D&O policy was purchased at the beginning of the most recent fiscal year.

Table 1 in the Appendix presents the definitions, predicted effect on the premium, and

descriptive statistics of the two sets of explanatory variables. All figures are in U.S. dollars.

6.1 Proxies for Governance Structure Quality

Firms with weaker governance are hypothesized to have higher D&O insurance

premiums. To proxy for the firm’s governance quality, I use three measures of ownership

May 2011 Kang 41

structure, three measures of board independence, and three measures of management

entrenchment as in Core (2000). These measures are based on prior research, which supports that

corporate governance is stronger when insiders own more stock, when insiders have less voting

control, and when there is monitoring by outside blockholders. The corresponding variables for

ownership structure are:

INS_VALUE, the percentage of share value owned by inside directors

INS_VOTE, the percent of share votes controlled by inside directors

OUT_BLOCK, a dummy variable equal to one if an outside blockholder owns 10% of

the firm, and zero otherwise

It is well-known that insider control of shares has competing aligning and entrenching

effects on management. INS_VALUE intends to captures the incentive alignment effect, while

the insider voting variable (INS_VOTE) captures the entrenchment effect and works in the

opposite direction. INS_VALUE should have a negative relationship with the D&O premium

because, as insiders hold more of the value of the firm, their incentives are better aligned with

those of shareholders. I predict a positive coefficient for INS_VOTE, as this would be consistent

with an entrenchment effect from insider voting control (Morck, Shleifer, and Vishny, 1988;

Stulz, 1988). INS_VALUE and INS_VOTE are empirically distinct for firms with dual class

structures (18.5% of the firms in the sample). Finally, OUT_BLOCK is predicted to have a

negative coefficient because concentrated ownership of shares by outside shareholders increases

the incentive to monitor and mitigates free-rider problems (Shleifer and Vishny, 1986).

Core (2000) also observes that corporate governance is stronger when the board is

independent of the CEO. This is the case because a board may fail to exercise the necessary

May 2011 Kang 42

oversight if its CEO is also chair of the board and significantly influences both the selection of

directors and the board’s agenda. The following variables measure board independence:

DIR_OUT, the number of outside directors as a percentage of total directors

DIR_APP, the percentage of outside directors appointed by the CEO

CEO_COB, a dummy variable equal to one if the CEO is also the board chair, and zero

otherwise

Corporate governance is expected to be strong when the board is independent of the CEO, where

board independence is positively related to the percent of outside directors appointed by the CEO

and negatively related to whether the CEO is chair of the board. For instance, Dechow, Sloan,

and Sweeney (1996) find that firms accused by the SEC of fraudulent reporting have fewer

outside directors and are more likely to have a CEO who is also board chair. Outside directors

are thought to provide monitoring benefits to shareholders because they are more objective. In

my sample, the mean of the dummy variable CEO_COB is 0.163, lower than Core’s mean of

0.536. This difference reflects the increased adoption of separate CEO and board chairman

positions as a corporate governance best practice.

Finally, to measure management entrenchment, I use:

CONTRACT, a dummy variable equal to one if top executives have employment

contracts, and zero otherwise

GOLD_PAR, a dummy variable equal to one if top executives have golden parachutes,

and zero otherwise

May 2011 Kang 43

POIS_PILL, a dummy variable equal to one if the firm has a poison pill, staggered board,

or other takeover deterrents, and zero otherwise

Top executive employment contracts are expected to weaken corporate governance by

entrenching managers, though this effect is lower when golden parachutes are part of the contract.

Golden parachutes are clauses in executive employment contracts that provide executives with

lucrative severance packages in the event of their termination. Golden parachutes, when attached

to employment contracts, are expected to weaken this entrenchment effect by aligning managers’

incentives so that they are less likely to resist takeovers. Hence, the predicted coefficient on the

dummy variable CONTRACT is positive but on golden parachutes (GOLD_PAR) is negative.

POIS_PILL is expected to be positively associated with the D&O premium. Since the

takeover market provides a mechanism for controlling agency problems, takeover deterrents,

such as poison pills, staggered boards, and other tactics close down this mechanism and increase

entrenchment. One example of entrenchment is that managers may resist takeovers in order to

preserve their jobs. Consistent with takeover deterrents increasing entrenchment, Borokhovich,

Brunarski, and Parrino (1997) find that firms adopting antitakeover charter amendments receive

fewer takeover bids and pay higher CEO compensation. Nelson (2005) finds that firms that

adopt poison pills and other takeover deterrents underperform benchmark portfolios.

Underperformance matters because many D&O claims originate from shareholder challenges to

takeover defenses. Thus, takeover defenses may lead to higher D&O premiums because they

proxy for an increased risk of litigation by shareholders seeking to remove these deterrents.

May 2011 Kang 44

6.2 Proxies for Business Risk

While the joint coefficients of interest are the proxies for corporate governance quality, I

must control for business risk because firms with higher business risk are expected to have

higher premiums. Five variables proxy for business risk:

CEO_EXP, the logarithm of the number of years that the CEO has served on the board of

directors, where a low CEO_EXP increases litigation risk

ROE, a proxy for financial performance expected to be negatively related to the D&O

premium

SIZE, firm size measured as the logarithm of market value of equity, predictably

positively related to premium

PRIOR_LIT, equals one for companies that have disclosed pending or prior litigation,

and zero otherwise

US_OPS, equals one for firms with U.S. operations, and zero otherwise

CEO_EXP intends to measure the benefits of having an experienced CEO net of any

entrenchment effect and should be associated with lower litigation risk. The firm’s annual return

on equity (ROE) proxies for financial performance and is expected to be negatively related to the

D&O premium. Return on equity is an important variable because D&O claims often arise

because of poor financial performance (Wyatt Company 1993). Moreover, the variable SIZE,

which is the logarithm of market capitalization, is included as a control variable because larger

firms are expected to have higher litigation risk and thus pay higher premiums. Figures 1a and b

in the Appendix show the positive relationship between the D&O premium and limit and market

May 2011 Kang 45

capitalization. Financial variables ROE and SIZE, as of fiscal year-end 2009, were collected

using Computstat and Capital IQ.

In addition to return on equity and size, litigation history (PRIOR_LIT) is a factor that all

D&O insurers examine. Firms with pending or past litigation pose a higher risk to insurers and

must be charged a correspondingly higher, experience-rated premium. In accordance with

economic intuition, SIZE and PRIOR_LIT are expected to bear large positive coefficients.

Litigation data was collected using the Stanford Securities Class Action Clearinghouse database.

The last variable, US_OPS is included because of the differences in the Canadian legal system.

Canadian D&O premiums are lower than those in the U.S. because of the more litigious legal

environment in the U.S. Thus, I control for the fact that 12% of my firms are incorporated in the

U.S. and thus subject to U.S. state law. Table 2 in the Appendix presents the correlation matrix

between the dependent variable, log (premium), and the independent variables.

7. RESULTS

7.1. Analysis of Results

The association between the D&O premium, governance structure quality, and business

risk is examined using Equation 7, which is developed in Section 5. This regression equation

includes as the dependent variable log(premium) and as the independent variables the proxies for

governance structure quality and business risk defined in Table 1, ―Descriptive Statistics.‖ Also

included as an independent variable is ε2, the error term from Equation 5, which expresses

log(limit) as a function of governance structure quality and business risk. The residual of

May 2011 Kang 46

log(limit) controls for information in log(limit) orthogonal to the other regressors, which may

arise due to discreteness in coverage limits.

To estimate the model specified in Equation 6, I first regress log(limit) on the proxies for

governance structure quality and business risk to obtain ε 2, the residual of log(limit). I then

estimate the second stage regression of log(premium) on the same proxies and the residual of

log(limit):

log (premium) = δ0 + δ1 governance structure quality

+ δ2 business risk + β3 residual of log(limit) + ε1

In order to test the robustness of Core’s (2000) findings, I adopt his governance structure

variables. The regression model in column 1 of Table 3 shows that Core’s results are robust—the

governance structure variables add significant explanatory power to the model for log(premium).

The model has significant explanatory power (adjusted R2 = 81.4%), and with the exception of

the proxies for CEO independence, the governance structure variables and business risk variables

have the predicted signs. Four of the nine governance structure variables are significant. A partial

F-test (p=0.001) rejects the hypothesis that the coefficients on all the governance structure

variables are equal to zero, which means that the variables add a significant amount of

explanatory power to the model for log(premium). The combined evidence that the majority of

the governance structure variables have the predicted signs, that four of the variables are

individually significant, and that the variables are collectively significant is consistent with the

hypothesis that the D&O premium reflects the quality of the firm’s corporate governance.

Comparing my results to those of Core (2000), I draw three main conclusions. First,

Core’s results are robust over time. He used a cross section of firms with fiscal year ends

May 2011 Kang 47

between June 1, 1993 and May 30, 1994 whereas I use a very recent sample of firms with fiscal

year ends between June 1, 2009 and May 30, 2010. Given that we both hand-collect samples

from public proxy statements and have similar sample sizes (Core used 110 firms and I, 92

firms), our similar results suggest that the ability of corporate governance structure variables to

explain the D&O premium is persistent over time. Second, Core’s results are robust to firms

exposed to U.S. securities litigation. Whereas Core used an all-Canadian sample, I use a sample

of firms cross-listed on the Toronto Stock Exchange (TSX) and a U.S. Exchange (NYSE,

NASDAQ, AMEX). Previous research and interviews with D&O brokers find the U.S. securities

litigation environment to be more litigious than that of Canada. Thus, I use cross-listed firms as

proxies for U.S firms. These firms are suitable proxies because they are exposed to SEC laws

and subject to U.S. corporate governance standards yet are still required by the TSX to disclose

their D&O details. My sample yielded more significant values and better fit (adjusted R2 = 81.4%

compared to 76.3%) than Core’s, suggesting that corporate governance quality matters even

more for U.S. firms. As D&O details are not currently publicly disclosed in the U.S., my results

provide empirical support for D&O disclosure as a way to provide investors and institutions with

a measure of corporate governance quality superior to ad hoc governance indices.

Finally, my results deviate from Core’s only in the predicted sign on the proxies for CEO

independence: DIR_OUT, DIR_APP, and CEO_COB. Core found a significant negative

relationship between the D&O premium and DIR_OUT and a positive relationship between the

D&O premium and DIR_APP and CEO_COB. His results suggest that good corporate

governance and lower premiums are associated with boards independent of CEOs; that is, firms

have lower premiums if they have more outside directors, fewer outside directors appointed by

the CEO, and separate CEO and board chairman positions. Core’s findings are generally

May 2011 Kang 48

consistent with prior governance literature, which espouses the merits of CEO independence.

However, my sample yields a significant negative relationship between the D&O premium and

DIR_APP and CEO_COB and a positive relationship between the premium and DIR_OUT, even

after controlling for CEO experience. One possibility for the opposite signs on these

―independence‖ proxy variables is that D&O underwriters do not consider CEO influence on the

board to be an indication of bad governance. Baker and Griffith (2007) discovered in their

interviews with forty D&O professionals that D&O underwriters put more of an emphasis on

their ―feel‖ of the board dynamics than on standard notions of board independence. While years

of experience attempts to control for CEO skill, it is possible that D&O underwriters are in fact

assessing CEO skill in DIR_APP. A significant and negative coefficient on DIR_APP would be

consistent with underwriters charging a lower premium to firms with more outside directors

appointed by the CEO—those firms have CEOs with longer tenures and thus possibly more skill.

Overall, D&O underwriters are concerned with pricing litigation risk. Having a more skilled

CEO with considerable experience with the board can lower such risk such that, ceteris paribus,

that firm would pay a lower D&O premium.

While Core’s governance structure variables are significant determinants of the D&O

premium, I use factor analysis to improve on his model. Note that INS_VOTE and INS_VALUE

in Table 8 seem to explain factor 1, which Core calls ―ownership.‖ The results of the improved

model are shown in column 2 of Table 6. The positive and significant coefficient on INS_VOTE

is consistent with an entrenchment effect from insider voting control, and the negative and

significant coefficient on INS_VALUE is consistent with an incentive alignment effect that

occurs when insiders own more of the firm. This result complements Shleifer, and Vishny (1988)

and Stulz (1988) by highlighting the importance of the dual role of stock ownership in

May 2011 Kang 49

entrenching and motivating managers. Both variables are significant at the 1% level and specify

that for a 1% increase in insider voting control (insider ownership value), the D&O premium

increases by 8.125% (decreases by 0.018%).

Improving on Core’s regression specification, I drop OUT_BLOCK for lack of

explanatory power and CONTRACT for its high correlation with GOLD_PAR. OUT_BLOCK

has been found in previous studies to be insignificant, consistent with the offsetting effects of

outside shareholders: they simultaneously increase governance structure quality and litigation

risk because they use lawsuits as a substitute monitoring device (Romano, 1991). Like Core, I

find that inference is unaffected when OUT_BLOCK is dropped from the regression.

I replace the two dropped variables with a new variable INC_COMP, which is the

percent of total CEO compensation that consists of short-term incentive payments. Short-term

incentives consist primarily of year-end cash bonuses and exclude incentive-aligning long-term

stock compensation. I include INC_COMP as a proxy for intrafirm incentives. Through

extensive interviews with over forty D&O professionals, Baker and Griffith (2007) find that

D&O underwriters pay attention to executive compensation, not because it creates liability risk

in and of itself, but because it suggests something about the culture of incentives and constraints

within a firm. A CEO whose total compensation consists almost entirely of year-end cash bonus

as opposed to salary or vested options is incentivized to take larger than normal risks to

maximize share price, which is the most commonly used measure of firm and CEO performance.

In fact, incentive pay has been proven to significantly increase the probability of a shareholder

class action lawsuit. One study suggests that the fast-vesting options representing a substantial

component of current executive pay may give managers incentives to self-deal by, for example,

May 2011 Kang 50

manipulating earnings, and that such misbehavior ultimately triggers class action lawsuits (Asaro

2005).

Replacing OUT_BLOCK and CONTRACT with INC_COMP improves the fit of the

model (adjusted R2=82.3%). A 10% increase in INC_COMP increases the D&O premium by

21.64%, or by about a factor of two. This is a considerable increase in the premium from the

short-term incentive component of CEO compensation. INC_COMP is individually significant,

and an F-test of Model 1 versus Model 2 rejects the hypothesis that INC_COMP is irrelevant.

The coefficient on POIS_PILL is positive but insignificant, and its insignificance is

consistent with the aforementioned finding that U.S. D&O underwriters are more concerned with

firm constraints and incentives than with specific legal defenses. For instance, Baker and Griffith

(2007) note that staggered boards and poison pills are not key determinants of D&O pricing.

Only if directly questioned do the D&O underwriters address takeover defenses, such as poison

pills. Instead of takeover defenses, D&O underwriters try to assess whether top management is

―riskier than the norm‖ (Baker and Griffith 2007). Thus, my findings in column 2 that

INC_COMP is positive and significant (p=0.05) and that POIS_PILL is positive but insignificant

support qualitative evidence presented in Baker and Griffith (2007).

In addition to INS_VOTE, INS_VALUE, DIR_APP, and INC_COMP, GOLD_PAR is

positive and statistically significant at the 5% level. This provides evidence for the hypothesis

that governance structure quality decreases when managers entrench themselves by obtaining

lucrative exit options. The exponentiated coefficient of GOLD_PAR is the ratio of the geometric

mean for the firms with golden parachutes to that of those without golden parachutes. In terms of

percent change, adding a golden parachute provision increases the D&O premium by about

41.9%, holding all other variables constant, since ℮(0.350)

= 1.419. Although GOLD_PAR is

May 2011 Kang 51

intended to proxy for management entrenchment, factor analysis presented in Table 8 shows that

it and INC_COMP explain much of factor 2. Factor 2 reflects ―excess compensation,‖ which

signals to the D&O insurer management’s risk attitude and the firm’s internal constraints. A

board that pays its CEO excess amounts for short-term stock performance and a change of

control is more likely to be overly optimistic of firm growth forecasts and potential deals.

Overall, the alternate specification in column 2 improves on Core’s model, as shown in

column 1. A partial F-test rejects the null hypothesis that the coefficients on all the governance

variables are 0 (F=31.31, p = 0.001) and increases the fit of the model due to additional

explanatory power from INC_COMP and reduced correlation between variables in Core’s

original specification (see correlation matrix in Table 2).

As expected, all of the business risk variables are significant and, thus, effective control

variables. Each is significant at the 10% level, and all but one is significant at the 5% level. The

significant positive coefficients on SIZE and PRIOR_LIT support my hypothesis and economic

intuition. Larger firms are more likely to be the subject of litigation and must pay a higher

premium due to higher frequency and severity of claims. As both SIZE and the premium are

logarithmic, the coefficient on SIZE takes on the interpretation of an elasticity. For a 1% increase

in market capitalization, the D&O premium increases by 0.235%. This large and positive effect

is as predicted by the model developed in Section 4. The positive coefficient on PRIOR_LIT is

consistent with the findings of Romano (1991), and with the explanation that D&O insurers are

concerned about spillover effects of pending litigation, that prior litigation has a negative

reputational effect, and that prior litigation may itself be a manifestation of weak governance. A

firm that has prior or pending litigation pays a D&O premium about 38.3% higher than that of an

equivalent firm with no litigation, since ℮ (0.324)

= 1.383. The magnitude of the effect of

May 2011 Kang 52

PRIOR_LIT on the premium is very close to that of GOLD_PAR (38.3% versus 41.9%). This

suggests that the effect on the premium of prior litigation is comparable to the effect of adding a

golden parachute to the executive compensation package.

ROE is negative as expected, indicating that firms with better operating performance

have lower litigation risk because the majority of claims are securities suits for unexpected drops

in stock price. US_OPS is negative and significant, which is particularly interesting given my

sample. This means that firms that are incorporated in the U.S. but not listed on a U.S. exchange

pay lower D&O premiums, confirmatory evidence that it is exposure to the more litigious U.S.

securities environment and not U.S. state law that matters for D&O insurance.

Finally, the coefficient on the residual of log(limit) is highly significant and positive,

which indicates that information in the limit that is orthogonal to the governance structure and

business risk variables is significantly associated with log(premium).

In sum, columns 1 and 2 of Table 6 lend support to the idea that a firm’s D&O premium

varies inversely with its governance quality. This is the basic prediction of agency theory.

Among particular findings to note is that dual class stock is a governance red flag to D&O

insurers. The presence of dual class stock (in 18.5% of the sample) causes INS_VALUE to differ

from INS_VOTE because certain classes of stock have more voting rights than others but all

shares have equal value. Both INS_VALUE and INS_VOTE as significant at the 0.001% level

and have opposite signs. Higher INS_VOTE is associated with higher D&O premiums because

dual class structures raise suspicion of management entrenchment. Another interesting finding is

that it is U.S. securities law, rather than U.S. state law, that leads to greater shareholder litigation

risk. The coefficient on US_OPS is negative and significant in all panels of Table 6. Lastly, the

May 2011 Kang 53

unexpectedly negative coefficient on DIR_APP reflects the difficulty in identifying ―good‖

CEOs using objective criteria. A CEO who appoints a majority of the directors could exhibit

undue influence on the board; however, that CEO may also have appointed many directors

because of his long tenure and success in his position. Ultimately, there are limits to what a

CEO’s years of experience can tell us about his intelligence and his integrity. This is essentially

what DIR_APP is suggesting—there is a range of how much of a good CEO is too much.

Despite this last point, the results in Table 6 reveal valuable insights that can be applied to future

research concerning D&O insurance and governance quality.

7.2 Sensitivity Tests

The remaining panels of Table 6 present the results of sensitivity tests of the main model

presented in column 2 (column 1 is included to provide an immediate comparison to Core). I

perform a number of sensitivity tests to ensure that omitted variables are not inducing spurious

inference with respect to the governance structure variables. First, in column 3, I include the five

indicators for high-risk industries. Interviews with D&O underwriters and prior research (e.g.

Cornerstone Research 2008) suggest that the following industries experienced higher litigation

risk in Canada and the United States during the sample period: technology, finance,

communication and media, and pharmaceuticals/biotech. I include mining as the fifth industry

indicator variable. My sample is about one-third mining companies due to their high

representation on the broader TSX. Despite the individual significance of PHARMA and the

common presumption that industry membership is associated with shareholder suits, an F-test

(p=0.16) does not reject the restriction that the coefficients on the five risky industry indicators

are all zero. As shown in column 3, including these variables has no effect on inference with

respect to the governance structure variables besides increasing the significance of INC_COMP.

May 2011 Kang 54

In column 4, I include the logarithm of the corporate deductible as an additional regressor.

Although the inclusion of the variable tends to reduce the magnitudes of the coefficient estimates

(particularly INS_VOTE, GOLD_PAR, and US_OPS), inference on the governance structure

variables is unaffected. In results not presented in Table 6, I introduce STOCK_COMP, the

percentage of the CEO’s total compensation that consists of stock-based pay from stock and

option grants. The variable is highly correlated with INC_COMP and increases multicollinearity

problems in the regression without improving explanatory power, and its coefficient is not

significant. In order to assess whether board composition is relevant, I introduce LAWYER, a

dummy variable equal to 1 if the company’s lawyer serves on the board and WOMEN, the

percentage of the board that is female. However, LAWYER and WOMEN are neither

individually nor jointly significant. Hence, this measure of board diversity does not seem to

matter for D&O insurance. As predicted by the principal-agent model, VOLATILITY positively

affects the D&O premium but is not significant. If dummy variables indicating board interlocks,

majority voting policy for the board, and say on pay (a newly introduced shareholder advisory

vote on executive compensation) are included either separately or together in the regression, the

variables are not significant, the governance structure variables are collectively significant, and

the coefficients estimates on the other independent variables are similar to those in column 2.

7.3 Direct and Indirect Effects of Governance Structure Quality

Following Core (2000), I define the variable GOVERANCE_QUALITY as the sum of

the governance structure variables weighted by their estimated coefficients, δ i, shown in column

2 of Table 6, multiplied by negative one:

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GOVERNANCE_QUALITY (δ i INS_VOTE + . . .+ δ 8POIS_PILL) (8)

This variable is standardized to mean zero and unit variance. Column 1 of Table 9

presents OLS regression results for Equation (7) when this variable is substituted for the eight

variables that comprise it. The linear composite of governance quality provides a clearer

magnitude of the effect of governance quality on the D&O premium. The coefficient -0.446

indicates that a firm with corporate governance one standard deviation weaker than average pays

a D&O premium roughly 45% more than an otherwise similar firm. This total effect of

GOVERNANCE_QUALITY on the D&O premium is depicted in Figure 4, recognizing though

that other variables are not controlled for in the graph.

Column 1 of Table 9 shows the total effect of GOVERNANCE_QUALITY and the

business risk variables on log(premium). The total effect is estimated from the reduced-form of

Equation (7). Recall that the total effect from Equation (7) is δi = βi + β3 γi, the sum of the direct

effect, βi, of the variable on log (premium) and its indirect effect by increasing log(limit), β3 γi.

Thus, the estimated total effect of GOVERNANCE_QUALITY on log(premium) shown in

column 1 (-0.446) can be decomposed into the sum of its direct effect on log(premium), shown

in column 2 (-0.155), and its indirect effect on log(premium) through its effect on log(limit),

shown in column 3 (0.979×-0.322). Column 2 shows the direct effect of a variable on

log(premium) in excess of that variable’s indirect effect through log(limit). The significant

coefficient on GOVERNANCE_QUALITY in column 2 indicates that weaker governance is

associated with significantly higher premiums even after controlling for the indirect effect that

weaker governance has on increasing the limits.

May 2011 Kang 56

7.4 Confirmatory Evidence Using Excess CEO Compensation

The preceding tests indicate that proxies for governance structure quality add

significant explanatory power to regression models for the D&O premium. While these results

suggest that these proxies for governance quality are associated with increased litigation risk, it

remains to be shown that these weaker governance structures make shareholders worse off. It

could be that certain firms are well-managed yet have governance structures that are considered

risky from the standpoint of the D&O insurer. To separate this effect and derive the link between

higher litigation risk and lower shareholder value, in this section I provide confirmatory evidence

that weak governance implied by the D&O premium have a statistically positive relation with

excess CEO compensation.

Core, Holthausen, and Larcker (1999), Hallock (1997), and other recent studies find that

CEO compensation in excess of its standard economic determinants is a proxy for weak

corporate governance that makes shareholders worse off. When corporate governance is weak,

CEOs can extract additional compensation from the firm. This often the case when the board of

directors is not independent of the CEO. Friendships arise out of board longevity, and with the

majority of the board sitting together for over a decade and managers who can remove directors

that they dislike, lack of dissention within the board room on matters such as executive

compensation is common. If the measure of weak governance implied by the D&O premium is

positively associated with excess CEO compensation, then this results suggests that the increase

in the D&O premium results from an assessment of weaker governance that makes shareholders

worse off and is not, as Core (2000) explains, simply an assessment of the increased litigation

risk of governance structures that allow for more managerial discretion.

May 2011 Kang 57

To test this hypothesis, I use a linear regression model in which the logarithm of total CEO

compensation is the dependent variable and GOVERNANCE_QUALITY, as defined by

Equation (8), is the variable of interest. The control variables for the economic determinants of

CEO compensation are SIZE, GROWTH (the market to book equity ratio as a proxy for growth

opportunities), firm performance (annual return, RETURN, and return on equity, ROE), and the

expected difference in CEO compensation for CEOs more exposed to the U.S. labor market

(US_OPS). With the exception of GROWTH and US_OPS, these are the same variables that

Core (2000) uses in this model. Table 3 contains definitions and descriptive statistics for the

compensation and governance variables.

The sample used in this analysis consists of the same 92 firms used in the analysis of the

D&O premium, and total CEO compensation is that as defined in the firms’ proxy statements.

Total CEO compensation is the sum of base salary, annual short term incentive awards, long

term equity award incentives, stock options, restricted stock units, and the value of any benefits

and perquisites. Compensation figures are collected from individual firms’ proxy statements for

fiscal year end 2009. Financial data for SIZE, GROWTH, RETURN, and ROE are collected

from Compustat and Capital IQ.

Model 1 of Table 10 shows that GOVERNANCE_QUALITY has the predicted negative

coefficient, indicating that excess pay is higher when governance is weaker. While the variable is

not significant at standard significant levels, the result provides evidence that the governance

structure variables underlying GOVERNANCE_QUALITY in fact proxy for the quality of the

firm’s governance structure. With the exception of RETURN, all the coefficients on the control

variables have the predicted signs consistent with research on the association between firm size,

growth opportunities, financial performance, and CEO compensation. As expected, SIZE is the

May 2011 Kang 58

most highly significant variable in both specifications in Table 7, as CEOs of larger companies

are compensated more highly.

Though GOVERNANCE_QUALITY does not yield a statistically significant relationship

with excess CEO compensation, we can conduct a more direct test of the hypothesis that D&O

premiums reflect weaker governance by using as a proxy for weak governance the residual

premium unexplained by the business risk variables and log(limit). PREMIUM_RESIDUAL is

obtained by excluding all the governance variables from Equation (7), which is equivalent to:

log (premium) = β0 + β2 business risk + β3 log(limit) + ε3 (9)

Because the governance variables have been omitted from the regression, PREMIUM

RESIDUAL captures any amount of the premium related to the firm’s governance structure. This

variable, as show in column 2 of Table 10, has a significant positive association with excess

CEO pay and provides additional confirmatory evidence that the D&O premium is higher when

corporate governance is weaker. This shows that in addition to measuring litigation risk, the

D&O premium captures a measure of weak governance that has been shown in the CEO

compensation literature to make shareholders worse off.

7.5 Secondary Analysis Using Audit Committee and Finance Variables

While this paper studies the effect of governance quality on litigation risk, it is worth

asking whether there are even more direct predictors of litigation risk. Since D&O litigation risk

primarily derives from stock price drops following earnings misstatements, I will look at factors

that affect financial restatements.

May 2011 Kang 59

A financial restatement revises public information previously filed with the SEC and

often leads to loss of investor confidence, SEC investigations, shareholder lawsuits, or rescission

of D&O coverage. Restatements occur for a number of reasons. The most frequent ones are

improper revenue recognition (either non-reported or misreported revenue), reporting of costs

and expenses, restructuring assets or inventory, accounting for mergers or acquisitions, and

securities transactions. According to Huron’s Annual Review of Financial Reporting Matters, the

three leading causes in 2008 were revenue recognition (16.4%), equity accounting (16%), and

reserves, accruals, and contingencies (14.1%). While the consequence of restatements depend on

their severity, in general, restatements call into question the company’s accounting methods,

internal control systems, and quality of leadership. As is relevant to this study, a financial

restatement is an almost certain precursor of a D&O suit. This is because restatements often

indicate broader corporate negligence or intentional misdeeds that could generate many more

claims.

Because restatements can result from either intentional or unintentional mistakes, for the

purpose of this analysis, I define two main causes of restatements: 1) audit committee and board

experience and 2) merger activity. Shareholders seek attentive and expert boards that will

exercise adequate oversight of the financials. They also want audit committees that have

financial expertise. A firm’s audit committee meets on a regular basis with management and the

external and internal auditors to discuss internal controls over the financial reporting process.

Since it is responsible for appointing the external auditors and reviewing and approving all

financial disclosure contained in the company’s public documents, the Audit Committee’s

diligence determines the likelihood of financial restatements, and consequently, shareholder suits.

The second cause of restatements, merger activity, is well-documented. Industries and companies

May 2011 Kang 60

that undertake many mergers or acquisitions expose themselves to litigation risk, whether from

violations of fiduciary duty, erroneous purchase accounting, or lucrative executive severance

packages. Thus, Audit Committee experience and merger activity are the main contributors to

D&O litigation risk from restatements. I next detail the variables and methodology for the

ensuing analysis.

To study the effect of audit committee and board experience and merger activity on D&O

litigation risk, I replace the governance structure variables in Equation (7) with the finance

variables shown in Table 4. Table 4 contains definitions and descriptive statistics. The variables

include:

CEO_EXP, the logarithm of the number of years the CEO has served in his position

CFO_EXP, the logarithm of the number of years the CFO has served in his position

CEO_EXP is predicted to have a negative coefficient, consistent with the finding that

CEOs with longer tenures having more skill and thus lower litigation risk. CFO_EXP, on the

other hand, is expected to have a positive relationship with the D&O premium, since longer-

tenured CFOs may be less vigilant about screening the financial statements for inaccuracies.

Other variables measure the board’s attentiveness to the financial statements and ability

to analyze them:

BOARD_MEET, the number of board meetings per year

BOARD_FIN, the percentage of the board with substantial finance or accounting

experience

The variable BOARD_FIN measures the collective financial expertise of the board. A

director is considered to have financial expertise if he has prior experience as a Chief Financial

Officer of a large public company, as a Certified Public Accountant or partner of a leading

May 2011 Kang 61

accounting firm, or senior positions in investment banking, private equity, or financial services.

The mean and medium for BOARD_FIN is about 30%, as shown in Table 4.

The next group of variables measures the length and scope of the company’s relationship

with its outside auditor and the extent of experience of the company’s Audit Committee:

AUDIT_TOTAL, the percentage of total audit fees attributed to audit and audit-related

fees

AUDIT_CONSULT, the ratio of audit to non-audit fees

AUDIT_MEET, the number of audit meetings per year

AUDIT_EXP, the percentage of the audit committee with substantial finance or

accounting experience

AUDITOR_YRS, the number of years the outside auditors have served in their position

The above variables correspond to D&O underwriters’ perspective on audit committee

expertise. Baker and Griffith (2007) interviewed over forty D&O professionals on the most

important information they consider when pricing policies. The interviewees’ responses include,

―How often does the Audit Committee meet? What is the length and scope of the company’s

relationship with outside auditors? What percentage of fees is paid for auditing versus consulting

fees? Has the company changed auditors or restated its financials in the past three years?‖ I

include these five variables to proxy for these issues, with a lower D&O premium associated

with a higher percentage of audit fees, more frequent audit committee meetings, and more

experienced audit committee members. The percentage of Audit Committee members with

financial expertise is as defined in BOARD_FIN. Since 2002, however, the provisions of the

Sarbanes–Oxley Act have required that at least one ―audit committee financial expert‖ is a

May 2011 Kang 62

member of the registrant’s audit committee (Redington 2006). The median of 33.3% reflects that

most audit committees consist of three members, one of which is a designated financial expert.

Finally, I include four dummy variables that are expected to increase the D&O premium:

RESTATE, equal to one if the firm has restated its financial statements in the past three

years

MERGER, equal to one if the firm has engaged in merger activity in the previous or

current year

OFF_BS, equal to one if the firm has off-balance-sheet entities for financial transactions

RELATED_PARTY, equal to one if the firm has related party transactions during the

policy year

Baker and Griffith (2007) and Redington (2006) report that D&O underwriters consider

firms with related party transactions or off-balance-sheet entities to be riskier. Off-balance-sheet

entities are assets or debts that do not appear on a company's balance sheet. For example, oil-

drilling companies often establish off-balance-sheet subsidiaries as a way to finance oil

exploration projects. Too often, however, as exemplified in the Enron scandal, off-balance-sheet

entities are used to artificially inflate profits and make firms appear more financially secure than

they actually are. A complex array of investment vehicles, including but not limited to

collateralized debt obligations, subprime-mortgage securities, and credit default swaps are used

to remove debt from corporate balance sheets and are potential sources of litigation.

The business risk variables used to control for this alternative set of explanatory variables

are the same as those used in the analysis of the D&O premium: SIZE, PRIOR_LIT, ROE, and

US_OPS. Data on CEO and CFO, board, and Audit Committee experience are collected from

individual firms’ proxy statements. Data on auditor fees, years of service, and number of Audit

May 2011 Kang 63

Committee meetings are obtained from firms’ annual information forms, or 20-Fs. Information

regarding whether a firm has related party transactions or off-balance sheet financing during the

policy year is disclosed in the firm’s annual report. Merger activity data, within the range of

January 2008 to December 2009, is collected from Thomson One Banker. Finally, Audit

Analytics, a specialized industry database is used to find whether a restatement occurred and for

what reason. It should be noted that the Audit Analytics database is especially useful because it

includes stealth restatements, which are financial statements that are restated in a quarterly or

annual report without formally filing a disclosure announcement in the SEC 8-K form (Her,

Young-Won, and Son 2010).

The regression model in column 1 of Table 11 shows that the audit committee and board

experience variables do not add as much explanatory power to the model for log(premium) as do

the governance structure variables. The model has an adjusted R2 of 40.0%, about half that of the

governance structure model. Column 1 includes as regressors the entire set of audit committee

and board variables outlined in Table 4. Of this set, BOARD_FIN and US_OPS are significant at

the 10% level and SIZE at the 5% level. This means that the determinants of the premium in this

model are the percent of the board with finance experience, the size of the company, and the

company’s jurisdiction. The significance of US_OPS is further evidence that companies

incorporated in the U.S. but not listed on a U.S. exchange pay lower premiums than equivalent

U.S. exchange-listed firms. It is somewhat surprising that the audit and board variables do not

explain more of the variance in the D&O premium. The reason for this is investigated further in

this section.

Column 2 of Table 11 takes as independent variables the five variables predicted to most

significantly affect the premium: AUDIT_CONSULT, AUDIT_EXP, BOARD_FIN, RESTATE,

May 2011 Kang 64

and MERGER. Like the model in column 1, the one in column 2 controls for size, return on

equity, prior litigation, and U.S. operations. The first point to note is that dropping seven of the

initial variables actually increases the adjusted R2 relative to the first model. Inference is

unaffected by doing so; as before, BOARD_FIN is significant at the 10% level, suggesting that

the percentage of the board with finance experience influences the firm’s D&O premium.

Secondly, despite the high correlation between restatements and D&O claims, the restatement

dummy variable is not significant. This result is not entirely surprising. Since not all restatements

trigger substantial market capitalization losses, restatements do not necessarily lead to securities

class action lawsuits. Investors are more likely to suffer large losses—and in turn file lawsuits—

if a company discloses revenue overstatements as opposed to balance-sheet misclassifications

(Turner and Weirich 2006). Thus, only restatements that are litigated positively affect the D&O

premium. Despite their low significance, the five explanatory variables in column 2 explain as

much of the D&O premium as the full set of variables in column 1.

In column 3, I include indicators for the five largest accounting firms to test whether the

identity of the company’s auditor affects the D&O premium. There is a dummy variable for

PricewaterhouseCoopers, Deloitte & Touche, Ernst & Young, KPMG, and other (representing all

other auditors). ERNSTY is omitted for collinearity. In decreasing order of representation in the

sample, KPMG serves 34% of the firms, PricewaterhouseCoopers and Deloitte & Touche each

serve 26%, Ernst & Young 10%, and other 4%. As shown in column 3, the auditor dummies are

themselves significant at the 5% level and increase the significance of the independent variables.

The auditor dummies are each negatively related to the D&O premium, with Deloitte & Touche

having the largest effect. However, an F-test (p = 0.13) does not reject the restriction that the

May 2011 Kang 65

coefficients on the indicators are all zero. Overall, the coefficients on the five auditor dummies

are too similar in magnitude to have substantial meaning.

The purpose of this section has been to examine an alternative set of determinants of the

D&O premium. Since D&O claims are usually triggered by poor stock performance following

financial restatements, I focus on which factors affect restatements. I identify and test a set of

variables that collectively try to measure the attentiveness and financial proficiency of the board.

However, unlike the governance structure variables of the previous section, this set of variables

was not collectively significant. I attribute this result to three main reasons.

The first reason is that questions, such as does the firm have complex off-balance-sheet

entities or frequent merger activity, matter, but are only part of the larger picture. When asked

which factors they consider when pricing D&O insurance, underwriters name the factors tested

in this analysis. Any one factor by itself, though, does not explain much. For instance, merger

activity is highly significant before controlling for size, prior litigation, return on equity, and U.S.

operations. This suggests that merger activity is indeed a component of D&O pricing, but is not

itself a direct determinant. This could said to be the case for many of the variables in this

analysis.

The second reason explaining the low significance of the audit variables is that the

variance of these variables occurs in a range that is unimportant. For instance, several of the

variables are constrained by law. Sarbanes-Oxley required each audit committee to have at least

one ―financial expert,‖ causing the variable audit committee experience to fluctuate closely

around 33.3% (one out of three members is an audit committee financial expert). Thus, though

more experienced audit committees are indeed associated with lower D&O premiums, the effect

is not significant. In addition to audit committee experience, auditor fees are also constrained by

May 2011 Kang 66

law. After the Enron and Arthur Andersen scandal, firms are restricted as to what percentage of

auditor fees consist of consulting fees versus audit fees. Moreover, auditors are so wary after

Arthur Andersen that D&O insurers and regulators think it unlikely that auditors would be

willing to engage in fraud in exchange for more tax and consulting fees. The law thus limits the

variance of several variables, which is important because D&O insurance is often priced taking

into account any extreme values.

A final reason for why the governance structure variables explain the D&O premium

better than the audit variables is that the audit variables are too coarse to differentiate between

good and bad risks. For instance, the variable BOARD_MEET tells us how many times a year

the board meets, whereas we really want to know, ―Does the board meet enough times?‖

Similarly, variables such as AUDIT_MEET and AUDIT_EXP are only second-best at

determining ―Is this is a good Audit Committee?‖ On the other hand, governance structure

variables, such as INS_VALUE and DIR_OUT, vary widely between firms and accurately

measure insider ownership and the percentage of outside directors, respectively. Overall, the

coded variables for audit committee and board experience are too rough to proxy for the

underlying factors.

8. CONCLUSION

Using a sample of D&O premiums gathered from the proxy statements of Canadian

companies, this paper finds a detectable variation in D&O premiums that is related to variables

that proxy for the quality of a firm’s governance. This association between the governance

variables and the D&O premiums is robust to a number of alternate specifications. The results

verify Core (2000), who used cross-sectional data from 1993, and improve upon his original

May 2011 Kang 67

model by including proxies for intrafirm incentive and constraints. By showing that the proxies

for weak governance are positively associated with excess CEO compensation, I provide indirect

evidence that D&O insurers charge firms higher premiums when firms adopt governance

structures that make shareholders worse off.

These results have important policy implications, particularly in the United States where

D&O insurance details are not publicly disclosed. My study provides empirical support for D&O

disclosure, which Baker and Griffith (2007) have advocated for using qualitative evidence from

extensive interviews and surveys. The direct evidence in this paper suggests that U.S.

shareholders would find the independent assessment contained in these premiums to be a useful

summary of the likelihood of litigation associated with firms’ governance structure. The indirect

evidence, however, suggests that the same shareholders could use this as an additional tool for

assessing the relative effectiveness of firms’ governance structures in maximizing shareholder

returns. Directly or indirectly, the results suggest that the D&O premium contains information

useful to investors.

Specifically, the D&O premium can be converted into a proxy for governance quality

with a few simple adjustments for market capitalization, coverage limits, and industry. One of

the most important firm-specific characteristics is market capitalization, as shown by the high

significance of SIZE in all regressions. To account for market capitalization, we can use a simple

ratio dividing a firm’s annual D&O premium by its market capitalization on the effective date of

policy. For this ratio to yield useful comparisons, though, it must control for insurance limits.

Baker and Griffith (2007) suggest adjusting the D&O premium ratio by recalculating the

premium per dollar of coverage:

May 2011 Kang 68

Per dollar premium = ( )

( )( )

By calculating the per dollar D&O premium, we adjust for firms’ coverage limits and market

capitalizations. We can account for industry differences by comparing the per dollar premium

within industries, similar to how P/E ratios and valuation multiples are used in practice. This per

dollar premium figure is easy to calculate and comparable across firms. In cases where firms are

already covered by equity analysts, disclosure of D&O insurance information may provide useful

supplemental information on governance quality due to underwriters’ unique access to non-

public information through non-disclosure agreements. There are many public companies that

don’t receive any analyst coverage at all, yet almost all firms purchase D&O insurance. For these

firms, the information signaled through the disclosure of D&O details may therefore be the only

reliable third-party assessment of governance quality. Evidently, D&O information contains

information valuable to capital market participants.

One may wonder, however, whether corporations try to manage insurance costs by

eliminating those governance features that lead to higher premiums. There are two possibilities.

The first is desirable: D&O premiums could provide companies incentives to improve their

corporate governance. By continually optimizing their governance structures, they can find

themselves paying consistently less for D&O insurance than their competitors and enjoying

higher earnings and improved share values. The second possibility is more Machiavellian: firms

could conceivably game the system by adopting ―good‖ governance practices while still

maintaining bad management practices. Empirical data suggests, however, that corporations do

not manage insurance costs. The average total premium has a small effect on the corporation’s

net income, so the marginal costs of regularly reviewing and revising internal governance

policies outweigh the marginal benefits of saving in policy premiums. Managers certainly could

May 2011 Kang 69

improve the firm’s bottom line by cutting their salaries, giving back benefit packages, and firing

loyal but ineffective allies, but they will generally be disinclined to do so. Overall, it would not

be surprising if bad managers to refuse to be (or just appear) good in order to reduce an expense

that is ultimately borne by shareholders. This is an important outcome. If firms fail to continually

optimize their corporate governance and firms with worse corporate governance pay more for

D&O insurance than firms with better governance, then investors can use D&O pricing as an

accurate proxy to evaluate the quality of a firm’s corporate governance.

If D&O insurance information signals the quality of a firm’s governance, as this paper

shows, it is logical to ask why this signal is not already being sent. Baker and Griffith (2007)

suggest three main reasons. The first is that the value of D&O policy information is purely

comparative. Relevance of a firm’s premium and payout limits emerges only upon comparison

with similarly situated firms—for instance, taking a broad industry-wise sample and controlling

for such variables such as market capitalization and volatility. I show, however, that the per

dollar premium serves as a decent substitute. The second reason that D&O information is not

disclosed in the U.S. despite its value to investors is that each of the firms within an industry is

disinclined to produce this information because of free rider effects. The information is of value

largely to investors of other firms who cannot be charged for it. Those firms may also fear

backlash from disclosing D&O details. When not placed in context, millions of dollars of D&O

insurance expense does not reflect well on the company’s management. This is a classic example

of a first mover disadvantage. Finally and most importantly, firms fear that mandatory disclosure

of D&O insurance details will encourage the filing of non-meritorious (nuisance) suits by

plaintiffs’ lawyers seeking to reach insurance assets. This is the most commonly voiced objection.

However, is unlikely that disclosure will change the dynamics of shareholder litigation. Plaintiffs’

May 2011 Kang 70

lawyers are well aware that average limits for companies with assets in excess of $100 million

are in tens of millions of dollars and can estimate a company’s coverage within a fairly accurate

range. Disclosure of details would not add anything substantial to lawyers’ arsenals. Free-riding,

first mover disadvantage, and fear of attracting nuisance suits are the main concerns hindering

the disclosure of D&O details.

However, other countries that now mandate D&O disclosure, such as Canada and the

United Kingdom, overcame these same issues. The results of my study using U.S. cross-listed

firms support a robust negative relationship between D&O premiums and quality of corporate

governance. This is a rich area for future research. Overall, there is a growing consensus inside

and outside academia that weak governance is costly to outside shareholders. This paper shows

that the D&O premium can be a valuable source of information, henceforth unavailable or

unknown to the general investing public, to mitigate some of the costs associated with weak

governance.

May 2011 Kang 71

9. APPENDIX

Figure 1a: Relationship between firms’ D&O limit and market capitalization

Figure 1b: Relationship between firms’ D&O premium and market capitalization

-

20,000,000

40,000,000

60,000,000

80,000,000

100,000,000

120,000,000

140,000,000

160,000,000

180,000,000

Small Cap ($400M-1B) Mid Cap ($1B-10B) Large Cap (>$10B)

Annual D&O Policy Limits by Market Capitalization Category

mean

median

-

200,000

400,000

600,000

800,000

1,000,000

1,200,000

1,400,000

1,600,000

Small Cap ($400M-1B) Mid Cap ($1B-10B) Large Cap (>$10B)

Annual D&O Policy Premiums by Market Capitalization Category

mean

median

May 2011 Kang 72

Figure 2: Relationship between firms’ D&O premium and premium paid for coverage

Figure 3: Industry Composition of 92 TSX-US cross-listed firm sample

Mining

Diversified

Industries

Life

Sciences

Technology

Financial

Services

Industry Composition

Table 1. Descriptive Statistics for the D&O premium and its Hypothesized Determinants

Variable Variable Definition Predicted

sign

Mean Median Min Max Std. Dev.

D&O insurance variables

D&O premium Dollar amount of annual D&O insurance

premium

799,194 443,501 40,466 4,694,717 894,007

Log (premium) Logarithm of D&O premium 12.998 13.002 10.608 15.362 1.156

D&O limit Annual D&O coverage limit 75,580,344 40,000,000 5,000,000 4.5×108

80,861,085

Log (limit) Logarithm of D&O limit 17.621 17.504 15.425 19.925 1.073

Governance structure variables

INS_VOTE Percentage of share votes controlled by inside

directors

+ 5.7% 0.4% 0.0% 94.1%

16.2%

INS_VALUE Percentage of share value owned by inside

directors

2.9%

0.4%

0.0%

61.7%

7.4%

OUT_BLOCK =1 if an outside blockholder owns over 10% of

the stock

0.500

0.500

0.000

1.000

0.503

DIR_OUT Number of outside directors as a percentage of

the total number of directors

76.9%

80.0%

0.0%

100.0%

15.1%

DIR_APP

Percentage of outside directors that start board

service after CEO joins board

+ 63.7%

66.7%

0.0%

100.0%

33.3%

CEO_COB =1 if the CEO is also board chair + 0.163 0.000 0.000 1.000 0.371

May 2011 Kang 74

CONTRACT =1 if the CEO or any other top executive has

employment contract

+ 0.826 1.000 0.000 1.000 0.381

GOLD_PAR =1 if the CEO or any other top executive has a

golden parachute

0.826 1.000 0.000 1.000 0.381

POIS_PILL =1 if the firm has a poison pill or any other

takeover restriction

+ 0.163 0.000 0.000 1.000 0.371

INC_COMP Percentage of total CEO compensation

consisting of short-term incentive (bonus)

payment

+ 17.6% 16.0% 0.000 53.0% 14.8%

The sample consists of 92 observations. All variables are measured at the end of the fiscal year 2009 or for the fiscal year ending prior to the year of purchase of D&O insurance.

Dollar amounts are in U.S. dollars.

May 2011 Kang 75

Table 1. continued

Variable Variable Definition Predicted

sign

Mean Median Min Max Std. Dev.

Business risk variables

CEO_EXP Logarithm of the number of years

CEO has served on the board

1.517 1.609 0.000 3.258 0.936

ROE Net income before extraordinary items

divided by ending equity

-0.77% 2.9% -741.9% 697.7% 126.5%

SIZE Logarithm of year end market cap + 21.074 20.852 15.453 25.146 2.488

PRIOR_LIT

=1 if the firm experienced litigation

during the past 10 years

+ 0.152 0.000 0.000 1.000 0.361

US_OPS

=1if the firm is headquartered in the

U.S. and has U.S. sales or assets

+ 0.120 0.000 0.000 1.000 0.326

The sample consists of 92 observations. All variables are measured at the end of the fiscal year 2009 or for the fiscal year ending prior to the year of

purchase of D&O insurance. Dollar amounts are in U.S. dollars.

Table 2. Correlation Matrix of D&O premium and its Hypothesized Determinants

Table 3. Descriptive Statistics for CEO Compensation and tis Hypothesized Determinants

Variable Variable Definition Predicted

sign

Mean Median Min Max Std. Dev.

CEO compensation

Total compensation Total of (1) base salary; (2) annual

incentive payments; (3) the estimated

value of option grants and grants under

long-term incentive plans; plus (4) the

cash value of any benefits and perquisites

3,865,045

1,770,766

11,572

21,205,815

4,164,168

Log (Total compensation) Logarithm of total compensation 14.491 14.387 9.356 16.870 1.324

Explanatory variables

GOVERNANCE_QUALITY

Standardized linear composite of the

governance structure quality variables

defined by Equation (8)

0.000 0.025 -2.913 2.259

1.000

SIZE Logarithm of year end market cap + 20.833

20.472

15.391

25.074

2.491

GROWTH Market to book equity ratio + 2.209

1.682

-9.353

20.132

3.388

RETURN Percentage annual stock return + 79.6%

50.4%

-84.9%

722.3%

131.9%

ROE Net income before extraordinary items

divided by ending equity

+ -0.8%

3.2%

-741.8%

697.7%

126.5%

US_OPS =1if the firm is headquartered in the U.S.

and has U.S. sales or assets

+ 0.120

0.000

0.000

1.000

0.326

May 2011 Kang 78

The sample consists of 92 observations. All variables are measured at the end of the fiscal year prior to the year during which CEO compensation is earned, except for RETURN

and ROE, which are measured in the fiscal year during which the compensation is earned. Dollar amounts are in U.S. dollars.

Table 4. Descriptive Statistics for the Audit and Finance Experience Determinants of the D&O premium

Variable Variable Definition Predicted

sign

Mean Median Min Max Std. Dev.

Audit and finance variables

AUDIT_TOTAL Percentage of total auditor fees

attributed to audit and audit-related fees

88.6% 92.5% 24.0% 100.0%

12.8%

AUDIT_CONSULT Ratio of audit to non-audit fees 262.1

12.5

0.308

893.5

126.5

AUDIT_MEET Number of audit meetings per year 5.686

5.000

1.000

12.000

2.249

AUDIT_EXP Percentage of audit committee with

substantial finance or accounting

experience

44.8%

33.3%

0.0%

100.0%

24.7%

AUDITOR_YRS

Number of years of company’s

relationship with outside auditors

+ 10.700

8.000

1.000

41.000

890.6%

CEO_EXP Logarithm of the number of years the

CEO has served in this position

6.107 5.000 1.000 24.000 5.156

CFO_EXP Logarithm of the number of years the

CFO has served in this position

4.686 4.000 1.000 17.000 3.896

BOARD_MEET Number of board meetings per year 10.971 10.000 5.000 24.000 4.132

BOARD_FIN Percentage of board with substantial

finance or accounting experience

29.9% 29.0% 0.0% 60.0% 14.2%

RESTATE =1 if the firm has restated its financial

statements in the past three years

+ 0.200 0.000 0.000 1.000 0.403

May 2011 Kang 80

MERGER =1 if the firm has engaged in a merger

activity in the previous or current year

+ 0.586 1.000 0.000 1.000 0.496

OFF_BS =1 if the firm has off-balance-sheet

entities for financial transactions

+ 0.343 0.000 0.000 1.000 0.478

RELATED_PARTY =1 if the firm has related party

transactions during the policy year

+ 0.514 1.000 0.000 1.000 0.503

The sample consists of 92 observations. All variables are measured at the end of the fiscal year 2009 or for the fiscal year ending prior to the year of purchase of D&O insurance.

Table 5. Correlation Matrix of D&O premium and Audit Variables

Table 6. Regressions of the Logarithm of the D&O Premium

* p<0.05, ** p<0.01, *** p<0.001 F-test 27.62 31.31 24.46 23.88 Adjusted_R-squared 0.814 0.823 0.830 0.827 (0.75) (0.64) (0.69) (0.77) Constant 7.247*** 7.557*** 7.289*** 5.498*** (0.06) LDEDUCT 0.200** (0.21) PHARMA 0.443* (0.15) MINING 0.025 (0.30) COMMEDIA 0.092 (0.22) FINANCE 0.421 (0.22) TECH 0.169 (0.39) (0.39) (0.39) INC_COMP 0.772 0.945* 0.897* (0.09) (0.09) (0.09) (0.11) Residuals 0.977*** 0.979*** 0.923*** 0.683*** (0.20) (0.20) (0.20) (0.20) US_OPS -0.500* -0.468* -0.467* -0.093 (0.16) (0.16) (0.16) (0.18) PRIOR_LIT 0.266 0.324* 0.262 0.312 (0.05) (0.04) (0.05) (0.04) ROE -0.065 -0.072 -0.044 -0.069 (0.03) (0.03) (0.03) (0.03) SIZE 0.253*** 0.235*** 0.250*** 0.206*** (0.08) (0.07) (0.07) (0.07) CEO_EXP 0.160* 0.152* 0.162* 0.145* (0.15) (0.15) (0.15) (0.16) POIS_PILL 0.160 0.197 0.293 0.055 (0.15) (0.15) (0.15) (0.16) GOLD_PAR 0.360* 0.350* 0.381* 0.197 (0.17) CONTRACT 0.146 (0.16) (0.15) (0.16) (0.15) CEO_COB -0.201 -0.213 -0.242 -0.070 (0.22) (0.21) (0.21) (0.21) DIR_APP -0.717** -0.696** -0.662** -0.467* (0.41) (0.39) (0.40) (0.38) DIR_OUT 0.407 0.437 0.101 0.342 (0.12) OUT_BLOCK -0.054 (1.10) (1.05) (1.08) (1.11) INS_VALUE -3.924*** -4.018*** -4.309*** -3.792** (0.47) (0.45) (0.45) (0.49) INS_VOTE 2.097*** 2.095*** 2.239*** 1.804*** b/se b/se b/se b/se Model 1 Model 2 Model 3 Model 4

May 2011 Kang 83

Table 7. Partial F-test that βgovernance structure = 0

Model 1 Model 2 Model 3 Model 4

Industry effects NO NO YES1 NO

F-test for the

restriction that the

coefficients on all

of the governance

structure variables

are 0

6.24*** 7.74*** 8.38*** 4.34***

*** significant at the 0.001 level (two-tailed) 1

The high-risk industries are technology, finance, communication and media, mining, and pharmaceuticals.

Table 8. Factor Analysis of Independent Variables

Table 9. Regressions of the Logarithm of the D&O Premium and the Logarithm of the Limit

inc_comp -0.0056 0.4184 0.5267 0.3276 0.4402 pois_pill 0.1177 0.0943 -0.7134 0.2215 0.4192 gold_par -0.0463 0.7161 -0.1857 0.0717 0.4454 contract 0.1403 0.6990 0.1916 -0.0848 0.4478 ceo_cob 0.2786 0.0024 0.6681 -0.0156 0.4758 dir_app 0.5469 -0.2831 0.1674 0.0821 0.5860 dir_out -0.1128 0.2067 -0.1991 0.7943 0.2740 out_block 0.1862 0.3433 -0.1335 -0.7066 0.3304 ins_value 0.8798 0.0896 0.0070 -0.1219 0.2031 ins_vote 0.8142 0.0170 0.0202 -0.1304 0.3194 Variable Factor1 Factor2 Factor3 Factor4 Uniqueness

Rotated factor loadings (pattern matrix) and unique variances

* p<0.05, ** p<0.01, *** p<0.001 F-test 68.31 60.15 28.64 Adjusted_R-squared 0.838 0.820 0.646 (0.48) (1.09) (0.66) Constant 7.877*** -2.548* 11.605*** (0.08) LOG_LIMIT 0.898*** (0.08) RES_LIMIT 0.979*** (0.18) (0.19) (0.24) US_OPS -0.468** -0.275 -0.215 (0.14) (0.15) (0.19) PRIOR_LIT 0.324* 0.112 0.236 (0.04) (0.04) (0.06) ROE -0.072 -0.038 -0.038 (0.02) (0.03) (0.03) SIZE 0.235*** -0.013 0.276*** (0.06) (0.06) (0.08) CEO_EXP 0.152* 0.001 0.167* (0.05) (0.06) (0.07) GOVERNANCE_QUALITY -0.446*** -0.155* -0.322*** b/se b/se b/se Log(premium) Log(premium) log(limit)

May 2011 Kang 84

Figure 4: Plot of Log(premium) on Governance Quality

Table 10: Confirmatory Evidence Using CEO Compensation

* p<0.05, ** p<0.01, *** p<0.001 F-test 41.49 44.23 Adjusted_R-squared 0.727 0.740 (0.72) (0.70) Constant 6.020*** 5.974*** (0.15) PREMIUM_RES 0.306* (0.26) (0.26) US_OPS -0.394 -0.404 (0.06) (0.06) RETURN -0.130* -0.122* (0.07) (0.07) ROE 0.107 0.109 (0.03) (0.03) GROWTH 0.007 0.010 (0.03) (0.03) SIZE 0.413*** 0.415*** (0.08) GOVERNANCE_QUALITY -0.031 b/se b/se Model(1) Model (2)

May 2011 Kang 85

Table 11: Regressions of the Logarithm of the D&O Premium and Audit Variables

* p<0.10, ** p<0.05, *** p<0.01 squared 3.88 6.49 5.31 Adjusted_R 0.400 0.417 0.448 (1.39) (1.24) (1.33) Constant 8.206*** 7.561*** 8.889*** (0.64) OTHER -1.105* (0.38) KPMG -0.895** (.) ERNSTY 0.000 (0.39) DELOITTE -1.007** (0.40) PRICEWC -0.917** (0.40) (0.39) (0.38) US_OPS -0.769* -0.707* -0.795** (0.37) (0.35) (0.34) PRIOR_LIT 0.374 0.447 0.514 (0.10) (0.09) (0.09) ROE -0.056 -0.070 -0.078 (0.07) (0.06) (0.06) SIZE 0.172** 0.231*** 0.208*** (0.23) RELATED_PARTY -0.070 (0.30) OFF_BS 0.475 (0.25) (0.23) (0.24) MERGER 0.256 0.303 0.362 (0.31) (0.28) (0.28) RESTATE -0.166 -0.180 -0.137 (0.96) (0.92) (0.91) BOARD_FIN 1.830* 1.725* 1.853** (0.02) AUDITOR_YRS -0.004 (0.03) BOARD_MEET 0.019 (0.04) CFO_EXP 0.021 (0.03) CEO_EXP -0.015 (0.59) (0.53) (0.53) AUDIT_EXP -0.037 -0.068 -0.226 (0.06) AUDIT_MEET 0.047 (0.00) (0.00) (0.00) AUDIT_CONSULT 0.000 -0.000 -0.000 b/se b/se b/se Model 1 Model 2 Model 3

May 2011 Kang 86

Figure 5a. Normality of residuals

Figure 5b. Normality of residuals

May 2011 Kang 87

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