Securitizing Audit Failure Risk: An Alternative to Caps on Damages

Abstract

For several decades, policy analysts have debated whether to establish ex ante caps on damages that audit firms face for violating state or federal law in their audits of public companies. A common argument supporting caps is a claimed inability of audit firms to obtain requisite external liability insurance and need to resort to self-insurance programs. This Article evaluates this claim by assessing existing insurance resources and inquiring into potential additional insurance devices. The assessment suggests that, for auditors, self-insurance is better than external insurance so that the claim does not necessarily support damages caps. Even if the claim were valid, the inquiry concerning additional insurance suggests superior alternatives by using previously-discussed financial statement insurance, to tailor coverage to risks of ordinary audit failure, and the novel innovation of insurance securitization to pool and distribute risks of catastrophic audit failure through capital markets.

Keywords: audit, capital markets, damages caps, insurance securitization

JEL Classification: G34, G38, K22, M41