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Directors and officers liability insurance and default risk

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Abstract

This paper investigates the effects of directors and officers (D&O) liability insurance on default risk. Using unique panel data of non-financial listed firms in Taiwan from 2010 to 2017, the empirical results indicate that D&O insurance exerts a significantly positive influence on firms' expected default frequency (EDF), controlling for the endogeneity of D&O insurance coverage and fixed effects. Further analyses reveal that such an effect exists particularly among firms with a high D&O insurance coverage ratio. Firms with D&O insurance have higher default risk than those without. Our findings differ from those in the existing literature by showing that D&O insurance coverage reflects firms' EDF and by capturing more insight on firms' EDF (market value, stock return volatility and firm asset volatility). The evidence indicates that D&O insurance may serve as a real-time, publicly observable signal of default risk for insurers and investors, enabling better contracting and risk management.

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Notes

  1. For instance, firms in the U.S. are not mandated to disclose information on D&O insurance, such as insurance premiums and coverage amount. The typical source of D&O insurance data for U.S. firms is the Tillinghast Towers Perrin survey (Hwang and Kim 2015).

  2. Such risks include claims by government departments (e.g. violations of the Securities Exchange Act for false financial statements in Taiwan), breach of intellectual property rights, infringement of consumer rights, claims by shareholders according to corporation regulations and claims by employees for violations of labour laws. Numerous large- and medium-sized Taiwanese enterprises have raised funds overseas by issuing Global Depositary Receipts, American Depositary Receipts and Euro-Convertible Bonds to enhance competitiveness and corporate visibility. Nonetheless, such overseas funding also exposes enterprises to worldwide risks and the possibility of facing lawsuits from foreign investors (Yeh Law Group 2020).

  3. XPEC Entertainment purchased D&O insurance in 2017. During the litigation process, XPEC was reimbursed by FUBON Property & Casualty Insurance from D&O insurance coverage for the costs of investigation and legal defence. The directors and officers could also obtain reimbursement from the D&O insurance, excluding illegal wrongdoing (Hsu 2017).

  4. When directors and officers are fully insured, they simply bear entrepreneurial risks rather than individual responsibilities as directors and officers (Baker and Griffith 2007). The moral hazard issue increases the agency risk for shareholders. Agency risk increases the volatility of future cash flows, resulting in a firm’s high default risk (Ashbaugh-Skaife et al. 2006).

  5. The EDF is fitted non-parametrically to the distance to default and is thus robust to model misspecification (Berndt et al. 2017).

  6. The models that forecast corporate defaults have elicited attention in academic research and practice due to the initiation of various corporate debt products and credit derivatives. Merton (1974) suggested the DD model, in which the equity of a firm is a call option on the underlying value of the firm with a strike price.

  7. They measure the loan spread at the origination of a loan using the all-in-drawn spread from DealScan to proxy the cost of bank loans.

  8. They proxied credit ratings using the Taiwan Corporate Credit Risk Index (TCRI) proposed by Taiwan Economic Journal (TEJ). Firstly, the TCRI financial data are analysed using financial statement analyses and statistical models to calculate the ‘comprehensive scores’. Secondly, a ‘basic rating’ is assigned according to the comprehensive scores. Thirdly, the TEJ calculates two threshold limits by considering risk-tolerance level and revenue scale. Finally, the TEJ employs certain non-quantitative factors (e.g. accounting quality, information before the release of the next financial reports, industry future prospects and the risk preference level of the management team) to determine the TCRI (Taiwan Economic Journal 2020).

  9. Liao et al. (2017) proxy credit ratings using the TCRI, which is based on a ‘semi-expert judgment’ process to obtain the rating of each company by accounting ratio-based models. The credit risk of bank loan spread is determined by taking the market value of the assets of the debtor when a bank issues the loan (Lin et al. 2013). Accounting statements present the historical, not future, performance of a firm. EDF estimates default risk by calculating the distance from the market value of the assets and liabilities of a firm when the debt is due using option pricing techniques. A key strength of EDF is that market value is independent of the accounting policies of a company. Market value should reflect book value plus future abnormal cash flow expectations and the expectations of future performance. EDF includes the stock price and stock return volatility for assessing the market value and volatility of firm assets; the face value of debt, considering the debt in one half of the long-term debt and existing liabilities to calculate the probability, indicates that the value of a firm’s assets is less than the face of its debt.

  10. The insurance company covers a corporation and/or its managers by paying for the costs of settlement and defending lawsuits according to the policy clause, provided that the directors and officers act in good faith (Boyer and Stern 2014).

  11. The two non-linear equations in Merton’s (1974) model are avoided and solved simultaneously, and the measure for realised losses is captured well (Chu and Wu 2009).

  12. Chang (2016) empirically reported that Taiwan was substantially affected by the Asian (1997–2000) and global (2007–2009) financial crises.

  13. Following the Enron Scandal in 2001, Procomp Informatics Ltd was reported to default on corporate bonds worth USD 95.66 billion in 2003. Procomp’s stock price at TWD 368 per share was among the highest of Taiwan’s listed firms in March 2000. However, it dropped to a record low of TWD 6.4 per share in June 2004.

  14. Corporate fraud by the Rebar Group indicated the agency problems associated with family-owned businesses. It was one of the top Taiwanese family businesses, and was involved in construction, real estate, hotels, vehicles, non-life insurance, retail services, banking, media and textiles.

  15. The European debt crisis could be behind the high EDF. In response to the effects of the European debt crisis and associated uncertainties in international capital movement, foreign exchange rates and oil prices, the Taiwanese government required relevant departments to implement several policies. Stabilising the financial market, funding for enterprises, promoting employment and consumption, accelerating industrial restructuring, improving the quality of the workforce, strengthening the effectiveness of government expenditures, innovating public construction financial strategies and relaxing regulations are a few examples.

  16. According to Imhoff (2003), board governance becomes seriously compromised if a firm’s CEO is also the board chair (also known as CEO duality).

  17. The TCRI data are retrieved from the TEJ (2020), in which scores from 1 to 10 are used to proxy for the credit rating of a firm. TEJ classifies the credit risk of a firm into nine levels. Scores of 1 to 4 represent low risk, 5 to 6 represent medium risk and 7 to 9 represent high risk. ‘D’ refers to firms that have violated agreements or defaulted on their debt payments and is thus quantified as 10 (Liao et al. 2018). Firms with higher TRCI scores have high credit risk according to the credit rating agency, and vice versa.

  18. Firms that have a moderate D&O insurance coverage ratio have a DOICR that is lower than the sample median; firms with a DOICR that is higher than the sample median are included in the high D&O insurance coverage ratio group.

  19. The 2SLS approach requires an instrumental variable that is strongly correlated with DOICR but does not directly affect default risk.

  20. The intention behind using industry-average insurance coverage ratio as an IV is that the D&O insurance arrangements of a firm may be highly related to industry peers due to a similar business mix and investment activities. However, such an industry average is unlikely to affect the default risk of a firm directly.

  21. Liability exclusions include the dishonest, criminal or fraudulent conduct of directors and officers; fines; penalties and punitive damages; and wilful or intentional wrongdoing.

  22. Jia and Tang (2016) discover a negative association between D&O insurance and the attendance of independent directors at board meetings in China. Their content analysis of independent director opinions indicate that D&O insurance encourages them to behave less responsibly, implying that D&O insurance reduces the monitoring role and effectiveness of independent directors in corporate governance. Examining listed non-financial firms in South Korea, Regan and Hur (2007) suggest that firm characteristics (e.g. firm size and ownership structure) play an important role in determining their demand for D&O insurance; they also report that members of chaebols have higher demand for D&O insurance than unaffiliated firms.

  23. In most Western countries, such as the U.S., U.K. and Canada, the majority of listed firms are covered by D&O insurance (Wang and; O’Sullivan 2002). Ninety-five percent of Fortune 500 companies hold D&O insurance policies in the U.S. (Egger et al. 2015), but information on D&O insurance coverage in the U.S. does not have to be publicly disclosed (Weng et al. 2017).

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  1. Department of Insurance and Finance, National Taichung University of Science and Technology, Taichung, Taiwan

    Li-Su Huang

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Huang, LS. Directors and officers liability insurance and default risk. Geneva Pap Risk Insur Issues Pract 47, 375–408 (2022). https://doi.org/10.1057/s41288-020-00197-0

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