Directors' and Officers' Liability

Insurance and The Cost of Equity

(Chen, Z., Li, O.Z., & Zou, H., 2016)

Presented by:
Alotaibi Abdulaziz - 27431835
Boen Belinda - 29563100
Lee Carol - 19910541
Pujianto - 30312124
Azam Kazi Rashidul - 29391741
Sulaeman Anna - 30321026
 Table of Contents
1. Research Question
2. Motivation for the Study
3. Contribution of the Study
4. Literature Review
5. Hypothesis Development
6. Sample Selection
7. Research Design
8. Results and Analysis
9. Conclusion
10.Limitations 2
Research Question
Whether D&O insurance affects a firm’s cost of equity and how it
affects a firm’s cost of equity.

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Motivation for the Study

- The cost of equity plays an important role in

financing and capital budgeting decisions,
- and it is affected by cross-country variation
in shareholder litigation threat;
- however, little evidence on how disciplining
role of shareholder litigation affect cost of
equity is available.

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Contribution of the Study

- This study contribute to the research

on the consequences of D&O
insurance,
- and document how D&O insurance
affects the cost of equity.

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 Literature Review
Hail and Leuz,2009;Karuna and Raman 2004.
- Cost of equity is affected by cross-country variation in shareholder litigation threat.
- Cost of equity is a measure of how investors perceive the risk and return trade-offs of investing in equity.
Baker and Griffith ,2010.
- The disciplining effect of D&O litigation is reduced by directors insurance which effectively shields D&O from
bearing personal financial liabilities.
Chen et al;core,1997,2000.
- There is a positive association between the cost of equity and D&O insurance, which is driven by endogeneity since
D&O insurance purchase is a firm’s choice.
Barzuza, 2012.
- D&O are no longer liable for a breach of duty of care. They are only liable if their behaviours involve both;
- Breach of duty of loyalty and,
- An intentional fraud.
Kothari et al;2005.
- There is a positive association between D&O insurance and absolute value of performance-adjusted discretionary
accruals.
- Consistent with D&O insurance reducing financial reporting and disclosure quality, increasing stock illiquidity and
investors estimation risk. 6
Hypothesis Development
D&O insurance increases the cost of equity in two ways:
1. Weakens the disciplinary effect of shareholders litigation.
2. Increases risk-taking by D&Os due to a reduction in legal liability.

1.D&O insurance, reporting/ disclosure quality and the cost of equity.

● Legal liabilities are reduced by increasing transparency among D&Os through
litigation for inadequate and untimely disclosure.
2.D&O insurance, risk-taking and the cost of equity.
● D&O are risk averse due to the possibility of bearing legal liability in shareholder
litigation against bad outcomes.
● The following hypothesis was obtained from the above explanation and the
literature review;

★ The cost of equity increases in D&O insurance

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Sample Selection
● Canadian firms listed on Toronto Stock Exchange
(TSE) due to requirement to disclose D&O insurance

● Steps to determine samples:

○ D&O insurance obtained from annual proxy circular filings for TSE in
System for Electronic Document Analysis and Retrieval (SEDAR)
○ Matched D&O insurance data with COMPUSTAT North America
○ Merged data with I/B/E/S database to obtain the related earnings
forecasts
○ Resulted in about 2000 firm-year used in for baseline regression testing

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Research Design
To test association between D&O insurance and Cost of
equity

● RAVG - RF (i.e. dependent variable):

○ Estimated ex-ante cost of equity

● DOICOV (i.e. independent variable)

○ D&O insurance coverage ratio

● Control Variables 9
Descriptive Statistics Results
Results:
• 70.9% of firms have D&O insurance
• Mean insurance coverage of C$44.7m
• Significant variation in insurance coverage
ratio across firms
• Significant difference between low and high
insurance coverage firms

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Regression Results
Results:
• Overall significant positive
association between Cost of
equity and D&O insurance,
which supports hypothesis
• Signs of control variables also
consistent with theories and
prior empirical findings

• Positive association between

Cost of equity and D&O
insurance not affected by model
specifications
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Lead-lag Effect

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Lead-lag effect

Result: An alteration in
the D&O insurance
precedes an alteration
in the cost of equity

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Market Reaction to Disclosure of D&O Insurance
• The authors want to see the market reaction against the disclosure of D&O insurance.
• Investor gets information of D&O insurance from proxy circular.
• If a high COE invested in a high D&O insurance coverage companies, incremental in
the companies’ D&O insurance should decrease the companies’ share prices.

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Market Reaction to Disclosure of D&O Insurance

Result: Market reaction has an inverse relationship with the Disclosure of D&O Insurance.
(-): Proxy circular usually contains many information, not only the D&O insurance.
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Controlling for the Expected Litigation Risk
• As we learned before, incremental in the companies’ D&O insurance coverage
decreases the companies’ share prices.
• It implies that the investors can get the information about the D&O perspective
regarding to the future litigation through the disclosure of D&O insurance.
• The authors want to see the degree of expected future litigation risk against the
positive relationship between the D&O insurance and the cost of equity.

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Controlling for the Expected Litigation Risk

Result: Expected litigation risk can explain the association.

(-): Expected litigation risk is not a sole driver.
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D&O’s Private Information & Association between
D&O insurance & Cost of Equity
5 Proxies for
D&Os’ private
information

Result: A positive association between D&O insurance and the cost of equity exists in firms
with a low level of D&Os' private information.
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Evidence from an Exogenous Law Change Lowering
After the law
D&O’s Legal Liabilities change in 2001

POST: the indicator for the

period after the law change.

NV: the indicator for Nevada-

incorporated firms.

Result: According to Column (2),

the coefficient is 1.352, indicating
that the change in the cost of
equity for Nevada-incorporated
firms after the law change is
1.352% greater than that for
matched firms.
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Channels through which D&O insurance
increases the cost of equity
1. D&O insurance & the Absolute Value of Discretionary Accruals
2. D&O Insurance & Stock Illiquidity
3. D&O Insurance & Analysts Forecast Properties
4. D&O Insurance & Risk Taking
5. D&O Insurance & Future Cash flows

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D&O insurance & the Absolute Value of Discretionary
Accruals

Result: High D&O

insurance coverage is
associated with a low
level of financial
reporting quality.

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 Two proxies to
D&O Insurance & Stock Illiquidity measure stock
illiquidity

Result: D&O
insurance
reduces stock
liquidity.

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 Two measures
D&O Insurance & Analysts Forecast Properties of analysts
forecast

Result:
Estimation risk
is higher for
firms with a
higher level of
D&O insurance.

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D&O Insurance & Risk Taking
● To examine whether the D&O Insurance has association with market risk as measured by
stock beta
● As D&O insurance encourages D&O risk taking, thus it increases the exposure of the Firm to
market risk

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 D&O Insurance & Risk Taking

Result: D&O Insurance has significant positive association with market risk as measured by
stock beta. Thus, the D&O Insurance increases the exposure of market risk to the Firms
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D&O Insurance & Future Cash flows
● To examine the association between D&O Insurance and future operating performance
● However, based on the prior results, the authors noted that investors react negatively to D&O
insurance coverage; thus, D&O insurance coverage is not generating more cashflow to the
Firm.

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D&O Insurance & Future Cash Flows

Using 3 different method,

the coefficient of DOICOV
never significantly
positive, but significantly
negative at t+1 by using
Fama Macbeth Regression

Conclusion: There is no
evidence that the D&O
Insurance Coverage
encourages risk-taking
which is beneficial for the
shareholders
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Cross Listing and The Association of D&O Insurance
and the Cost of Equity
● Some of the sample firms are cross listing in the US. As in the US, the shareholders litigation’ disciplining roles are
stronger compare to Canada, the authors expect that the D&O Insurance are more important for those firms which are
cross listing in the US. Thus, the Firms require a higher D&O Insurance Coverage.
● The authors expect that the association between D&O Insurance and the Cost of Equity is more profound in the Firms
which are cross listing in the US.

Results : The association is

more profound in the
Firms which are cross
listing in the US.

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Conclusion

1. D&O Insurance Coverage is positively associated with ex

ante cost of equity
1. Investors reacts negatively to the announcement of the
increase of D&O Insurance Coverage
1. D&O Insurance has association with low quality of financial
reporting, low stock liquidity, low analyst forecast accuracy
and high forecast dispersion
1. D&O Insurance has significant positive association with
stock beta, however, there is no evidence that D&O
insurance encourages risk-taking which are beneficial for
the shareholders

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The possibility that the results are contributed by risk anticipation
argument cannot be ruled out.

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