Directors and officers liability insurance: an analysis of determinants of disclosure

Abstract

In this paper, we investigate factors that explain the disclosure of Directors and officers liability (D&O) insurance. D&O insurance is used extensively in top management compensation. Surprisingly, only a handful of firms listed in the US disclose their D&O insurance practices (based on our extensive search of publicly available databases on corporate disclosure). Using a sample of firms from 2004 to 2008, we focus on level of competition, threat of increase in lawsuit, and internal governance to examine the determinants of the disclosure practices. Consistent with the hypothesis, the results show that firms in competitive industries, firms with a high threat of lawsuits, big firms, and firms with weak internal governance are less likely to disclose D&O insurance. We further find that variations in the scope and nature of disclosure are associated with the firms’ litigation risk and governance structure.

Keywords:

• directors and officers liability insurance
• disclosure
• determinants

Notes

1. Other studies document higher restatements (Kim 2005), greater earnings management during seasoned equity offering (Boubakri, Boyer, and Ghalleb 2008), and lower timeliness of earnings (Chung and Wynn 2008).

2. A point can also be made that, in competitive markets, even firms that offer attractiveness employment packages will be reluctant to provide details of their compensation structure for fear of engineering costly compensation race.

3. Skinner (1994) suggests that firms voluntarily disclose bad news to preempt lawsuits or reduce the expected cost of lawsuits. There is also a view that the threshold for legal action is relatively low for firms with a history of mismanagement or lawsuits; such firms may preempt future lawsuits with voluntary disclosures (Field, Lowry, and Shu 2005). Francis, Philbrick, and Schipper (1994), however, find little evidence that firms follow such disclosure habits. To the contrary, Francis, Philbrick, and Schipper (1994) show that warning disclosures can trigger lawsuits.

4. We begin data collection in 2004 to avoid any discontinuities in disclosure that may stem from the Sarbanes Oxley Act of 2002.

5. The Wyatt (1997) Report states that the chance of having a claim made against directors or officers of large companies is 63% while the chance of having a claim made against directors or officers of small companies is 12%.

6. The full sample has 50 cross-listed firms, with 39 and 11 of the firms in the test and control samples, respectively.

7. Drawing from Towers Perrin (2004), we assume that all control firms have D&O policy but chose not to disclose it.

8. As an alternative to including separate governance variables in the model, we identified firms in the sample for which the Gompers governance index, GINDEX, is available on Risk Metric. Only 20 firms in sample of test firms have valid GINDEX. We then replace the governance variable with GINDEX and re-run the logit model. Based on the revised sample, the coefficient on GINDEX is positive in line with our prediction, but insignificant.

9. The ANALYSTS variable is dropped from this analysis because analysts’ following is missing for most firms that provide both coverage and premium information.

10. Untabulated pairwise tests of difference in means/medians among the three groups show that premium-only firms differ more significantly from the rest of the disclosing firms. In particular, premium-only firms operate in markets that are more concentrated (LHINDEX) and have greater number of CEOs with dual roles (DUAL), compared to either coverage-only or coverage-premium firms. At the other end, they have higher litigation risk, smaller board size, more CEOs with lower equity ownership, and are smaller in size compared to other disclosing firms. The premium-only firms thus appear to have greater governance problems than the other disclosing firms. Coverage-only and coverage-premium firms differ more substantively with respect to litigation risk and board size: Firms disclosing both coverage and premium information have lower litigation risk and larger board size, which is typically expected of firms with better governance.