Directors’ and Officers’ Liability Insurance and Loan Spreads

64 Pages Posted: 20 Jun 2011 Last revised: 15 Aug 2013

See all articles by Chen Lin

Chen Lin

The University of Hong Kong - Faculty of Business and Economics

Micah S. Officer

Loyola Marymount University - Department of Finance and Computer Information Systems

Rui Wang (Erik)

Lingnan University

Hong Zou

The University of Hong Kong - Faculty of Business and Economics

Abstract

We analyze the effect of directors’ and officers’ liability insurance (D&O insurance) on the spreads charged on bank loans. We find that higher levels of D&O insurance coverage are associated with higher loan spreads and that this relation depends on loan characteristics in economically sensible ways and is attenuated by monitoring mechanisms. This association between loan spreads and D&O insurance coverage is robust to controlling for endogeneity (because both could be related to firm risk), including instrumental variable specifications, change regressions, and regressions using an exogenous regulatory event that increases managerial liability. Our evidence suggests that lenders view D&O insurance coverage as increasing credit risk (potentially via moral hazard or information asymmetry). Further analyses show that higher levels of D&O insurance coverage are associated with greater risk taking and higher probabilities of financial restatement due to aggressive financial reporting. While greater use of D&O insurance appears to raise the cost of debt financing, the purchase of D&O insurance might not necessarily be harmful to shareholders. We find moderate evidence that D&O insurance coverage appears to improve the value of investment in firms with better internal and external governance despite the lower returns in firms with greater use of D&O insurance.

Keywords: Directors’ and officers’ liability insurance, Loan spreads, Credit risk, Cost of debt financing

JEL Classification: G30, G22

Suggested Citation

Lin, Chen and Officer, Micah S. and Wang, Rui and Zou, Hong, Directors’ and Officers’ Liability Insurance and Loan Spreads. Journal of Financial Economics (JFE), Forthcoming. Available at SSRN: https://ssrn.com/abstract=1865679 or http://dx.doi.org/10.2139/ssrn.1865679

Chen Lin (Contact Author)

The University of Hong Kong - Faculty of Business and Economics ( email )

Pokfulam Road
Hong Kong
China

Micah S. Officer

Loyola Marymount University - Department of Finance and Computer Information Systems ( email )

Los Angeles, CA 90045
United States

Rui Wang

Lingnan University

8 Castle Peak Road
Tuen Mun, New Territories
Hong Kong

Hong Zou

The University of Hong Kong - Faculty of Business and Economics ( email )

Hong Kong

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