The Missing Monitor in Corporate Governance: The Directors' & Officers' Liability Insurer

Abstract:     
This article reports the results of empirical research on the monitoring role of directors' and officers' liability insurance (D&O insurance) companies in American corporate governance. Economic theory provides three reasons to expect D&O insurers to serve as corporate governance monitors: first, monitoring provides insurers with a way to manage moral hazard; second, monitoring provides benefits to shareholders who might not otherwise need the risk distribution that D&O insurance provides; and third, the "bonding" provided by risk distribution gives insurers a comparative advantage in monitoring. Nevertheless, we find that D&O insurers neither monitor corporate governance during the life of the insurance contract nor manage litigation defense costs once claims arise. Our findings raise significant questions about the value of D&O insurance for shareholders as well as the deterrent effect of corporate and securities liability. After exploring various explanations for these findings, we conclude that the absence of monitoring is due, at least in part, to the agency problem in the corporate context. Our analysis thus suggests that the existing form of corporate D&O insurance both results from and contributes to the relatively weak constraints on corporate managers. Corporate managers buy D&O coverage for self-serving reasons, and the coverage itself, because it does not control moral hazard, reduces the extent to which shareholder litigation aligns managers' and shareholders' incentives.

Number of Pages in PDF File: 48

Keywords: insurance, corporate governance, directors and officers

JEL Classification: G30, K13, K22

working papers series