Corporate Risk Management: Evidence from Product Liability
Posted: 16 Aug 2004
In this paper we examine the factors that determine how firms manage large, firm-specific risks, in this case, product liability. We study the impact of this high-probability, high-loss risk on a group of firms that all manage product liability through insurance purchases in the early 1980s. A sudden, unexpected increase in the cost of insuring product liability risk in the mid 1980s caused some of these firms to change their product liability risk management strategies. We use this event by examining how firm characteristics affect the decision to continue to purchase product liability insurance after the price increase. Our results show that three factors play the largest role in these firms' product liability insurance purchase decisions. Firms with higher risk capacity as measured by larger firm size, lower expected cost of external financing, and no debt financing are significantly less likely to continue purchasing insurance. Firms with low costs of financial distress - as indicated by very high leverage or the absence of net operating loss carryforwards - are less likely to purchase insurance. Finally, firms whose managers have more options, particularly out-of-the-money options, are also less likely to continue purchasing insurance. We revisit our firms several years after the increase in the price of insurance to see how firms' risk exposure is affected by the decision to either continue or discontinue product liability insurance. We find that the non-purchasing group generally increased risk-bearing capacity and reduced overall firm risk more than the group that continued to buy insurance. The finding is strongest for measures of overall risk.
Keywords: Product liability, risk management
JEL Classification: D81, G22, G30
Suggested Citation: Suggested Citation