Directors’ and Officers’ Liability Insurance and the Cost of Equity

Posted: 7 May 2015

See all articles by Zhihong Chen

Zhihong Chen

Hong Kong University of Science and Technology

Oliver Zhen Li

National University of Singapore (NUS)

Hong Zou

The University of Hong Kong - Faculty of Business and Economics

Date Written: April 15, 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

JEL Classification: M41, G30

Suggested Citation

Chen, Zhihong and Li, Oliver Zhen and Zou, Hong, Directors’ and Officers’ Liability Insurance and the Cost of Equity (April 15, 2015). Journal of Accounting & Economics (JAE), Forthcoming. Available at SSRN: https://ssrn.com/abstract=2603532

Zhihong Chen (Contact Author)

Hong Kong University of Science and Technology ( email )

Clear Water Bay
Kowloon
Hong Kong
Hong Kong
(852)-2358-7574 (Phone)
(852)-2358-1693 (Fax)

Oliver Zhen Li

National University of Singapore (NUS) ( email )

Bukit Timah Road 469 G
Singapore, 117591
Singapore

Hong Zou

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

Hong Kong

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