Directors’ and Officers’ Liability Insurance and the Cost of Equity Capital
47 Pages Posted: 12 May 2011 Last revised: 13 Nov 2017
Date Written: April 2, 2015
Abstract
We examine whether directors’ and officers’ (D&O) liability insurance affects a firm’s cost of equity. We find a positive association between D&O insurance and the cost of equity. Information quality and risk-taking appear to be two underlying channels through which D&O insurance affects the cost of equity. Further tests suggest that this positive association is not due to optimal risk-taking, as evidenced by a negative market reaction to an increase in D&O insurance coverage, a lack of improvement in firms’ cash flow and a low valuation associated with D&O insurance. Overall, our evidence is consistent with the notion that D&O insurance weakens the disciplining effect of shareholder litigation, leading to an increase in the cost of equity.
Keywords: legal liabilities, directors' and officers' (D&O) insurance; cost of equity; investor protection
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