On The Demand For D&O Liability Insurance: Theories And Chinese Evidence

A typical D&O liability insurance policy consists of two parts, namely the personal coverage and the corporate coverage. While risk aversion unquestionably explains the insurance demand arising from individual needs, the incentives motivating companies to buy D&O insurance remain one of the most intriguing facets in economic theories and corporate finance theories. Starting from the insightful propositions by Mayers and Smith (1982), various hypotheses have been developed which relate the specific characteristics of a company to its purchase decision on the D&O insurance. This dissertation examines for the first time in mainland China these theories and conducts an empirical investigation on Chinese listed companies. It is organized as follows: Section one provides a review of the theoretical and empirical literature in this domain. Motivations and novelty of this study are also illustrated.Section two follows with a primer of D&O liability insurance. D&O insurance is highly law dependent, since the risk covered is shareholder litigation brought upon the D&Os in case of their breach of fiduciary duties. The difference in corporate statutes results in the popularity of D&O insurance in some jurisdictions and resistance in others. Together with CIPs and LLPs, D&O liability insurance is one of the three D&Os protective devices in use worldwide. A comparative look explains the significance of D&O insurance and its advantages over the other two.One issue the dissertation tries to address is the most contending aspect of D&O insurance– whether D&O protective measures are in the best interest of shareholders, because discharge of the executives'financial liabilities poses a severe threat to the disciplinary power of shareholder lawsuits. As damages caused by actions in bad faith is not covered in any case, views diverge only on whether losses incurred in duty of care suits are indemnifiable. The reasoning proceeds in two steps. The first step aims to clarify if the deterrence effect of civil liability would be significantly diminished with the assumption that deterrent effect exists. To see this, four scenarios are presented with the consideration of different legal statutes– the presence or absence of the indemnification as well as insurance policies, kind of corporations dealt with– public or private, and the disposition of the suit– dismissed or settled. The outcomes indicate that the adoption of D&O insurance is really possible to reduce the ex-ante preventive function of derivative lawsuits in some degree, especially when the company concerned is a private one. However, at mean time the ex-post compensatory function is significantly enhanced. Overall, D&O insurance should be viewed as a device to protect the welfare of corporation and to ease its exposure to catastrophic loss, other than attracting and retaining the risk-averse managers to serve on board.This conclusion is strengthened by the observation that any of the presumed deterrent effect is problematic, as it is anomalous to speak of deterrence in the context of negligence. Executives are unlikely to become less conscientious and exert fewer degree of care just because they know they are insured or will be indemnified. There are some effective inside and outside mechanisms restraining them from misbehavior. Previous empirical studies also deny any negative impact by the adoption of D&O insurance on the corporate value to its shareholders. Broader reasons are also given to justify and support the concept of this insurance, including the maintenance of economic stability. Therefore, the dissertation upholds the view that the D&O insurance benefits the company and its shareholders without substantial sacrifice. For the public companies, D&O insurance is by far the optimal. Any possible moral hazard can be curbed by some loss - sharing schemes.Economic rationale is discussed in section three. Investors are supposed to be risk averse and would take risks only if they are paid for that. Risk aversion is therefore believed to be the reason for individual demand on insurance. However, we cannot expect the risk neutral companies to buy insurance only for the sake of risk shifting. According to Mayers and Smith, additional benefits beyond risk shifting accrue to shareholders in a host of ways: real service efficiencies, reducing agency costs, tax costs and regulatory costs. The net cash flow and subsequently the value of the company increases due to these cost-saving mechanisms.To test if those findings also apply in a culture that is not so litigious, section four conducts an empirical investigation on the Chinese listed companies, using a sample of 102 companies/years gaining the approval from the shareholders meetings to buy D&O insurance, and a match sample. Four hypotheses are formulated, specifically: companies of more internationalized capitalization are more likely to purchase D&O insurance; companies with more independent directors serving on the board are more likely to purchase D&O insurance; companies with more tunneling incentives are more likely to buy D&O insurance; companies exposed to more litigation risks due to some general factors are more likely to purchase to D&O insurance. The descriptive statistics and multivariate analysis confirm our hypothesis that the most important determinant accounting for the Chinese listed companies'demand on D&O insurance is the increasing litigation risk resulting from overseas listing and B share issuing.Independence of the board and the identity of the controlling shareholder also have some bearing, but the influence is not eminent.The dissertation concludes with some policy implications from diverse perspectives. Institutionally, the corporate code and securities code shall be constructed to such an effect that meritorious shareholder litigations encouraged and cosmetic suits deterred. For the regulatory bodies, it is suggested to mandate listed companies'disclosing liability of the relevant D&O insurance information, which is useful for guiding investors'decision. What an insurer can learn is adapting their product to the home market. Recommendation to companies is to introduce and optimalize the D&O protective mechanisms.