Directors’ and Officers’ Liability Insurance and the Cost of Equity
Posted: 7 May 2015
Date Written: April 15, 2015
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
JEL Classification: M41, G30
Suggested Citation: Suggested Citation