Directors’ and Officers’ Liability Insurance and Loan Spreads

Abstract:     
We analyze the effect of directors’ and officers’ liability insurance (D&O insurance) on the spreads charged on bank loans. We find that higher levels of D&O insurance coverage are associated with higher loan spreads and that this relation depends on loan characteristics in economically sensible ways and is attenuated by monitoring mechanisms. This association between loan spreads and D&O insurance coverage is robust to controlling for endogeneity (because both could be related to firm risk), including instrumental variable specifications, change regressions, and regressions using an exogenous regulatory event that increases managerial liability. Our evidence suggests that lenders view D&O insurance coverage as increasing credit risk (potentially via moral hazard or information asymmetry). Further analyses show that higher levels of D&O insurance coverage are associated with greater risk taking and higher probabilities of financial restatement due to aggressive financial reporting. While greater use of D&O insurance appears to raise the cost of debt financing, the purchase of D&O insurance might not necessarily be harmful to shareholders. We find moderate evidence that D&O insurance coverage appears to improve the value of investment in firms with better internal and external governance despite the lower returns in firms with greater use of D&O insurance.

Number of Pages in PDF File: 64

Keywords: Directors’ and officers’ liability insurance, Loan spreads, Credit risk, Cost of debt financing

JEL Classification: G30, G22

Accepted Paper Series