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 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 restatements that are not revenue or expense related, 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. Our results are consistent with past restatements being viewed as evidence of chronic problems with a firm’s financial statements. By analyzing archival data, we can also 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.

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

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