Accounting and Litigation Risk

Abstract:     
Litigation risk has been hypothesized to affect managerial behavior in a number of ways. An understanding of the determinants of litigation risk is a necessary first step to analyzing managerial behavior. We examine the determinants of an ex-ante measure of litigation risk, namely, Directors and Officers (D&O) liability insurance premium. We find that accounting risk is priced by D&O insurers. There is only limited evidence of traditional corporate governance measures getting priced. We also find some support that certain provisions of the Private Securities Litigation Reform Act, 1995 created specific litigation risk. Additionally, we present evidence that pricing for D&O premiums is lower for companies which adopted limited liability provisions to limit directors' exposure to litigation risk. Thus, adoption of these provisions can be a useful tool to reduce litigation risk. Finally, we find that the historical rise in insurance premium from 2001 to 2002 is associated with an increase in concerns about accounting quality.

Keywords: Litigation risk, accounting, D&O insurance

JEL Classifications: G18, G22, K22, K41, M41

Working Paper Series