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Directors’ liability insurance and investment-cash flow sensitivity

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Abstract

We examine the association between directors’ liability insurance and investment-cash flow sensitivity with listed firms in Taiwan. We find that directors’ liability insurance increases the investment-cash flow sensitivity. Specifically, insured firms are more likely to have excessive investment than uninsured firms given the same level of cash flow. This is the result of managerial opportunistic behaviors fueled by moral hazard inherent in directors’ liability insurance. Although managerial opportunism could certainly increase the likelihood of corporate wrongdoing, our results show that it could be mitigated by having improved regulation or corporate governance.

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Notes

  1. We use the term, directors’ liability insurance (DLI), primarily for the reason that the information of officers’ liability insurance is not reported and the focus of this paper is on the board of directors. However, as DLI also includes coverage for officers, it can be interchangeable with directors’ and officers’ (D&O) liability insurance.

  2. Although Core (2000), or Boyer and Stern (2014) provide evidence that insurers do have information advantage about the firm’s prospects and adjust premiums to reflect insurees’ risks, opportunistic managerial behavior, however, confirmed by several recent works as discussed in later paragraphs seems to exist still even after the purchase of DLI. On the other hand, Boubakri et al. (2008) in their empirical tests do not find that lower DLI premiums are associated with good corporate governance quality. While our focus is on whether managerial opportunism would be observed in investment-cash flow sensitivity, examining if insurers would be able to detect insurees’ inappropriate behavior might not be the first priority in this paper. Potentially, a negative relation between DLI and investment-cash flow sensitivity, if exists, may indirectly signal insurers weakness in monitoring their customers.

  3. About the relation between corporate governance and the cost of external financing, there are some researchers with different opinions. For example, Klock et al. (2005) with firm-level data during the period from 1990 to 2000 find that antitakeover governance provisions, although not beneficial to stockholders, are viewed favorably in the bond market. However, as our concern is the linkage among DLI, corporate governance or agency conflicts, and investment-cash flow sensitivity, no matter whether the costs outweigh the benefits of DLI or vice versa, there should be an association between this insurance and investment-cash flow sensitivity unless the protection of DLI in Taiwan does not have any significant effects.

  4. Based on our discussion in prior paragraphs and reviewed literature related to DLI and investment-cash flow sensitivity, the protection of DLI could potentially affect investment-cash flow sensitivity since, on one hand, the costs brought by DLI may not necessarily outweigh the benefits and vice versa in all situations. On the other hand, the effect from DLI, if any, may not necessarily influence firms’ investment behavior and cash management in the same magnitude making the effect of this insurance on investment-cash flow sensitivity to be somewhat unclear. However, considering recent negative empirical evidence on the value of DLI, combined with the intuition that improving investment-cash flow sensitivity appears to meet shareholder expectations, our primary focus in this paper thereby is to examine whether the protection of DLI would reduce investment-cash flow sensitivity. As Griffith (2006) advocates that regulators should mandatorily require firms to disclose DLI policy details, such as premiums, limits, or retentions under each type of coverage because such information would convey the insurers’ assessment of firms’ governance quality. However, because of the fact that not all nations have adopted this requirement and insured firms might hesitate to disclose such details, we could reasonably suspect that insured firms appear to have stronger moral hazard incentives especially when they have poor corporate governance.

  5. Overinvestment, in general, is estimated by the difference between total investment expenditure and the expenditure necessary for maintaining assets.

  6. Since examining investment-cash flow sensitivity requires data in yeart-1, the sample firms with missing data in

    yeart-1 are deleted as well.

  7. The alternative measure of DLI as discussed in Section 5 is the natural log of insurance coverage in the sample year. Although using a dummy variable allows us to easily identify the insured firms, using the actual insurance coverage further shows the level of protection as well as moral hazard incentives to insured directors. However, considering the fact that calculating insurance coverage could be challenging as firms may have multiple insurance contracts to cover different months in a sample year, we only apply this measure in our robustness tests. Moreover, Core (2000) reports that DLI premiums contain useful information about the quality of corporate governance. As a result, insurance premiums could be used to indirectly measure the moral hazard incentives. This variable, however, is not available in Taiwan for the time being.

  8. The coefficient of the interactive term with observations in which I and CF are both positive is 0.011 and significant at the 1% level.

  9. All variables, unless otherwise specified, are measured at the end of each sample year. However, results remain similar to those in regression (4) of Table 5 when we calculate each variable at the beginning of each year.

  10. The negative and significant coefficient of Log (firm age) appears to reasonably support that elder firms tend to be relatively more matured and short of investment opportunities.

  11. The negative coefficient of the interactive term, CF/K*DLI, in Panel B suggests that firms with institutional ownership that is higher than the sample median tend to have lower investment-cash flow sensitivity if protected by DLI. This is possibly because that when firms face more regulations, DLI provides the insured firms more room to manipulate their cash flows as well as their investment decisions due to the insurance protection. Therefore, the sensitivity between cash flow and investment is lower. However, this outcome does again support the argument that DLI is likely to motivate managers to pursue opportunistic behaviors.

  12. In each panel, we also test the difference between the interactive terms in the subgroups. The differences are all significantly different from zero.

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Authors and Affiliations

  1. Department of finance, Tunghai University, Taichung, Taiwan, 40704

    Chia-Chung Chan, Yung-Ho Chang & Chia-wei Chen

  2. School of Management, Marist College, Poughkeepsie, NY, 12601, USA

    Yuwei Wang

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  1. Chia-Chung Chan
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  2. Yung-Ho Chang
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Correspondence to Yuwei Wang.

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Chan, CC., Chang, YH., Chen, Cw. et al. Directors’ liability insurance and investment-cash flow sensitivity. J Econ Finan 43, 27–43 (2019). https://doi.org/10.1007/s12197-017-9425-7

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