M. Martin Boyer

Abstract

This paper contributes to our understanding of the role of Directors’ and Officers’ (D&O) insurance by answering three specific questions: Do directors and corporations actively optimize their decision to purchase D&O insurance? Can we devise a profitable investment strategy based on D&O insurance information? And does D&O insurance motivate managers to increase profitability? To answer the first question, the paper argues that the most important determinant of a firm’s decision to purchase D&O insurance in any given year is whether it purchased such insurance the previous year, suggesting that managers do not frequently reassess their need for coverage. Regarding the second question, the paper finds that profitable investment strategies exist by buying stock in corporations with relatively high D&O insurance unit prices (premium divided by coverage) and selling stock in corporations with relatively low unit prices. The author attributes this profitability to D&O insurance serving as an aggregate measure of board efficiency and corporate governance health. Finally, using a cross-section of Canadian unit trust companies, the paper shows that D&O insurance appears to demotivate managers from extracting cash flows from assets, although this effect does not seem to be reflected in stock market performance. The paper notes two caveats: the analysis is based on a short time period and involves only Canadian corporations, as information on D&O insurance has only recently become available and remains inaccessible to the public in the United States.

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