Insuring the Agents: The Role of Directors' and Officers' Insurance in Corporate Governance

By O'Sullivan, Noel | Journal of Risk and Insurance, September 1997 | Go to article overview

Insuring the Agents: The Role of Directors' and Officers' Insurance in Corporate Governance


O'Sullivan, Noel, Journal of Risk and Insurance


INTRODUCTION

Holderness (1990) suggests that directors' and officers' (D&O) insurance may have an important monitoring role in publicly owned companies. By purchasing D&O insurance, diversified shareholders complement existing monitoring mechanisms in a number of respects. Prior to issuing an insurance policy, D&O insurers are expected to undertake a thorough examination of the individuals for whom insurance protection is sought, thus helping to ensure that directors pursue the interests of shareholders. The corporate purchase of D&O insurance also serves to promote internal monitoring by facilitating the recruitment of outside directors, whose independence of company management is more likely to make them objective guardians of shareholder welfare. Insurer monitoring also occurs during the litigation process. Claims or notifications made under the D&O policy provides the insurer with an opportunity to undertake a comprehensive examination of the specific aspects of the directors' administration giving rise to the dispute.

Holderness (1990) hypothesizes that the purchase of D&O insurance is influenced by the governance structure of the company, specifically the need for shareholder monitoring of corporate management. Using data from the 1979 Wyatt D&O Survey, Holderness (1990) reports that organizations that exhibit clear divisions between the functions of ownership and management (e.g., NYSE and AMEX companies) are more likely to carry D&O insurance than organizations where the owner-manager problem is expected to be less acute (e.g., cooperatives). An interesting empirical question, therefore, is whether companies that purchase D&O insurance exhibit governance characteristics consistent with the monitoring hypothesis. The United Kingdom provides a unique opportunity for such analysis since companies purchasing D&O insurance are obliged to disclose the existence of such insurance in their financial statements. The purpose of this article is to provide an empirical insight on the monitoring hypothesis suggested by Holderness by examining the governance characteristics of a sample of large U.K. companies. The article investigates the significance of board composition, managerial ownership, and external shareholder control on the decision to purchase D&O insurance in a sample of 366 publicly owned companies.

D&O INSURANCE IN THE THEORY OF THE FIRM

Historically, U.K. companies were prohibited from indemnifying directors against liability for negligence, default, breach of duty, and breach of trust. During the 1980s, as the incidence of litigation against directors increased, it was unclear whether this prohibition extended to prevent companies from purchasing insurance policies on behalf of their directors. In 1989, the government resolved this uncertainty with legislation that allows for the corporate purchase of D&O insurance. Critics of the corporate purchase of D&O insurance argue that it weakens the effectiveness of shareholder litigation as a managerial control device.

A number of arguments have been put forward in support of the corporate purchase of D&O insurance. First, the absence of insurance may encourage overly conservative management which is unlikely to be in the interests of shareholders (Jensen, 1993). Second, D&O insurance may be instrumental in encouraging talented individuals to serve as directors. Indeed, there is U.S. evidence that personal liability without insurance adversely affects a firm's ability to attract suitable appointees, and the problem is particularly acute in the recruitment of outside directors (Priest, 1987; Daniels and Hutton, 1993). Third, to the extent that there are market mechanisms (e.g., the takeover market) that encourage managers to work in the interests of shareholders, insurance may not necessarily have adverse incentive effects (Oesterle, 1989). Fourth, the possibility of nuisance suits against directors, often necessitating large personal defense costs, suggests that corporate indemnification should be available to directors (Oesterle, 1989). …

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