Accounting and litigation risk: evidence from Directors’ and Officers’ insurance pricing
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We study whether and how financial reporting concerns are priced by insurers that sell Directors’ and Officers’ (D&O) insurance to public firms. As D&O insurers typically assume the liabilities arising from shareholder litigation, the premiums they charge for D&O coverage reflect their assessment of a company’s litigation risk. Using a sample of public firms in the 2001–2004 Tillinghast D&O insurance surveys, we document that firms with lower earnings quality or prior accounting restatements pay higher premiums after controlling for other factors impacting litigation risk. In addition, insurers’ concerns about financial reporting are most evident for firms with restatements that are not revenue or expense related, are greater in the period following the passage of the Sarbanes–Oxley Act of 2002, and are greater for firms with financial reporting problems that linger. Our results are consistent with past restatements being viewed as evidence of chronic problems with a firm’s financial statements. By analyzing archival data, we can also quantify the effects of other determinants of D&O premiums (such as business risk, corporate governance, etc.) identified by Baker and Griffith (Univ Chic Law Rev 74(2):487–544, 2007a) through interviews regarding the D&O underwriting process.
JEL ClassificationG22 G32 K22 K41 K42 M41
KeywordsFinancial reporting quality Accounting restatements Directors’ and Officers’ insurance Litigation risk D&O Corporate governance
We thank Tillinghast–Towers Perrin for providing the insurance data. We would like to thank several industry participants who have shared their valuable time with us. In particular, we thank Elissa Sirovatka of Tillinghast, David Allan of General Reinsurance Corporation, Dan Bailey of Bailey Cavalieri LLC, Michael Early and Frank Kastelic of the Chicago Underwriting Group, Lori Fuchs of Honeywell, Phil Norton of Arthur J. Gallagher and Co., and Paul Van Zuiden of Risk Management and Insurance Consulting LLC. We acknowledge helpful comments from Stephen Penman (Editor), two anonymous reviewers, Rashad Abdel-khalik, Tom Baker, Paul Beck, Andy Bauer, Michael Donahoe, Todd Green, Dongkuk Lim, Brian Mittendorf, Scott Richardson, Roberta Romano, Theo Sougiannis, Shyam Sunder, Jake Thomas, Anne Thomson, Albert Tsang, Peter Wysocki, Frank Zhang, and seminar and conference participants at the 2012 American Accounting Association Western Region Meeting, Yale School of Management, the University of Connecticut School of Law, the University of Illinois at Urbana-Champaign and the University of Washington Tacoma. Any errors are our own.
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