Accounting and Litigation Risk: Evidence from Directors' & Officers' Insurance Pricing

Abstract:     
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 insurance 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 non-revenue/expense restatements, 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 into the future. Our results are consistent with past restatements being viewed as evidence of chronic, ongoing problems with a firm’s financial statements. By analyzing archival data, we are also able to quantify the effects of other determinants of D&O premiums (such as business risk, corporate governance, etc.) identified by Baker and Griffith (2007a) through interviews regarding the D&O underwriting process.

Number of Pages in PDF File: 58

Keywords: Financial reporting quality, accounting restatements, Directors’ and Officers’ insurance, litigation risk, D&O, corporate governance

JEL Classification: G22, G32, K22, K41, K42, M41

working papers series