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Insuring the agents: the role of directors' and officers' insurance in corporate governance.

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). Finally, if there are reputation costs associated with losing lawsuits, litigation may still be an important control device, even if all direct costs are paid by an external insurer (Bhagat, Brickley, and Coles, 1987).

Three empirical studies have sought to examine the impact of D&O insurance on shareholder welfare. Bhagat, Brickley, and Coles (1987) examine stock returns of New York firms around the announcement of the purchase of D&O insurance and corporate amendments proposing to broaden management indemnification. The authors find no evidence that shareholder wealth is reduced by the purchase of D&O insurance. The empirical results suggest that the effect on shareholder wealth may indeed be positive. Similarly, the broadening of manager indemnification provisions does not appear to result in negative returns to shareholders. In a similar study, Janjigian and Bolster (1990) examine the impact of Delaware's decision to allow companies to eliminate director liability. Their results suggest that liability elimination does not affect shareholder wealth since no significant difference between the performance of Delaware and non-Delaware firms is identified. Brook and Rao (1994) report insignificant stock price reactions to firms' adoption of provisions intended to limit director liability.

THE MONITORING HYPOTHESIS

Corporate governance refers to the way companies are directed and controlled. A primary concern is the likelihood of a deviation in the objectives of corporate managers from those of the owners due to the costs involved in monitoring managerial behavior (Berle and Means, 1932). The existing literature proposes a series of mechanisms which seek to reconcile the interests of shareholders and managers. These include external governance instruments such as the market for corporate control (Manne, 1965), competition in product markets (Hart, 1983), and the managerial labor market (Fama, 1980). The potential for shareholder-manager conflict may also be reduced by the utilization of a number of internal control mechanisms. These include monitoring by large shareholders (Schleifer and Vishny, 1986), monitoring by boards of directors and mutual monitoring by managers (Fama and Jensen, 1983), and the incentive effects of executive share ownership (Jensen and Meckling, 1976).

The benefits of shareholder monitoring are derived from the increase in firm value which is expected to result from additional monitoring. For example, larger firms are expected to be more complex and therefore more value is derived when additional resources are used to monitor managers. Also, firms operating in more volatile environments may derive more value from additional monitoring. The cost (supply) of monitoring depends on the choice of monitoring mechanisms (e.g., the proportion of outside board members) and the costs of these mechanisms, as well as the choice and cost of alternative means of motivating managers to act in shareholders' interests (e.g., share ownership, vulnerability to the market for corporate control). Holding the demand for monitoring constant, the monitoring hypothesis suggests that the use of D&O insurance would increase as the cost of alternative means of motivating managers increases. Similarly, as the demand for monitoring increases, we would expect the use of D&O insurance to increase, holding the relative costs of the various monitoring mechanisms constant.

Viewing the governance role of D&O insurance in this framework highlights some of the problems in attempting to identify a precise role for D&O insurance in the overall monitoring choices made by firms. The problem is particularly acute since we are generally unable to control for the costs and demands of alternative forms of internal monitoring. If all firms had the same demand for monitoring, then the D&O monitoring hypothesis would imply that D&O insurance and high ownership, either by external or internal shareholders, would be substitutes. However, some firms may have a greater demand for monitoring than other firms, and those firms with a greater demand may make greater use of both D&O insurance and high levels of executive ownership. For example, as equity value increases, the cost of high external ownership as a monitoring device increases, since shareholders will need to pay more for a given proportion of the firm's equity (Demsetz and Lehn, 1985). As a result, we would expect large firms to utilize alternative forms of monitoring such as board composition, D&O insurance, and executive ownership. Even though we are unable to control for the cost and demand of all available monitoring mechanisms, by examining the relationship between D&O insurance and other endogenous governance mechanisms, we can provide some initial insight on the role of D&O insurance in firms' monitoring decisions. The remainder of this section discusses possible relationships between the purchase of D&O insurance and alternative forms of monitoring available to shareholders.

The board of directors has an important role in the corporate governance process. The board has a statutory duty to protect and promote the interests of shareholders. The board is authorized to endorse managerial initiatives, evaluate the performance of senior executives, and to reward or penalize that performance. In order to strengthen the monitoring function of the board, it is recommended that membership should comprise both inside and outside directors. While inside directors may contribute to board effectiveness with their skill, expertise, and industry-specific knowledge of the business, outside directors have the advantage of bringing independence and impartiality to the evaluation of management decisions (Baysinger and Hoskisson, 1990; Cadbury, 1992).

An emerging issue in the corporate governance literature is the prudence of having the same individual serving as both company chairman and CEO. Critics of such an arrangement argue that a duality of roles may provide the CEO with a wider power base and locus of control than would be the case if an independent chairman was employed. Moreover, since the responsibilities of a chairman include running board meetings and overseeing the process of hiring, firing, evaluating, and compensating the CEO, it is difficult for an individual who serves both as chairman and CEO to perform these duties objectively. To minimize potential conflicts of interest, the Committee on the Financial Aspects of Corporate Governance (Cadbury, 1992) recommends a separation of the responsibilities of the chairman and CEO: "There should be a clearly accepted division of responsibilities at the head of the company which will ensure a balance of power and authority such that no individual has unfettered powers of discretion" (paragraph 1.2). Similar concerns have been expressed in the United States (Jensen, 1993). It is expected, therefore, that the separation of the roles of chairman and CEO is likely to result in a beneficial monitoring arrangement for shareholders.

It is clear that board composition and leadership are important monitoring mechanisms for companies with diffused ownership. Since D&O insurance is also expected to have a monitoring role in such companies, it may appear that board composition and leadership and D&O insurance may be substitute mechanisms of monitoring employed by shareholders. However, a number of factors suggest that board composition and leadership and D&O insurance may be complementary control mechanisms. Since the purpose of a D&O insurance policy is to indemnify all company directors against negligent behavior, insurers are expected to insist on insured companies having adequate outside representation as well as a separation of the roles of chairman and CEO prior to offering insurance protection. Second, the availability of a D&O insurance policy is expected to facilitate the recruitment of outside directors to serve on company boards. Priest (1987) and Daniels and Hutton (1993) provide evidence that personal liability without insurance adversely affects a firm's ability to attract suitable outsiders to serve on boards. It appears, therefore, in instances where shareholders pursue monitoring through D&O insurance, the D&O insurers are likely to insist on the company appointing a sufficient number of outside directors to the board. Alternatively, where shareholders pursue monitoring through the use of outside directors, these outsiders are expected to insist on the additional protection of a D&O insurance policy. We would expect, therefore, that D&O insurance and board composition and leadership will operate jointly to monitor managerial behavior.

Jensen and Meckling (1976) argue that agency conflicts between managers and shareholders may be reconciled when managers have an ownership interest in their company. According to Jensen and Meckling (1976), managers and directors are inside shareholders who participate in the decision-making process as well as enjoy the benefits of ownership. Outside shareholders play a passive role in the firm's decision-making process. In Jensen and Meckling's convergence of interest model, an increase in the proportion of the firm's equity owned by insiders is expected to result in an increase in firm value as the interests of inside and outside shareholders are realigned. Since executive share ownership serves to realign the interests of shareholders and managers, we would expect a reduced need for the additional monitoring which D&O insurance is likely to provide. However, as the equity value of a firm increases, shareholder monitoring through the ownership of a significant proportion of equity becomes more costly, and, in such circumstances, external shareholders are expected to utilize alternative mechanisms to monitor managers. Two alternative mechanisms which shareholders may utilize are the use of D&O insurance and executive ownership. It appears, therefore, that in larger companies, shareholders will seek to monitor managerial behavior by the use of D&O insurance and executive ownership. In smaller companies, owners are more likely to monitor through the possession of large ownership stakes without the additional (costly) monitoring which D&O insurance provides.

SAMPLE AND VARIABLE DESCRIPTION

Data for this study was obtained from a number of sources: The 1992 edition of the Times 1000 was used to identify the largest 1,000 companies operating in the United Kingdom in 1991. The choice of 1991 is crucial since this is the first year the obligation to disclose the purchase of D&O insurance became effective (Companies Act 1989, Section 137.2). Individual financial statements are used to ascertain whether companies purchased D&O insurance on behalf of their directors. Since the objective of the study is to examine the governance role of D&O insurance in publicly owned companies, all privately owned companies are excluded. Subsidiary companies are also excluded because it is possible that directors in such companies may be indemnified by a policy taken out by the parent company without mentioning the existence of such a policy in the subsidiary's financial statements. Excluded in this category are a large number of U.K. subsidiaries of U.S., Japanese, and European multinationals. These exclusions reduce the final sample to 366 companies. The governance data were obtained from the Arthur Andersen Corporate Register, a twice yearly publication providing such information on all U.K. public companies.

Board monitoring is measured by the proportion of outside directors serving on the main board of directors. A binary variable is used to identify those companies where the same individual serves as chairman and CEO. Separate variables are used to measure the proportion of equity owned by inside directors and the proportion owned by outside directors. Ownership structure is measured in a number of ways. U.K. legislation requires all public companies to disclose the identity and ownership levels of shareholders owning in excess of 3 percent of total equity. Separate variables measure the proportion of equity owned by all shareholders owning in excess of 3 percent, and the proportion of equity owned by the largest single shareholder. In addition, a binary variable is used to indicate those companies where the largest single shareholder is a financial institution (i.e., insurance company, pension fund, or unit trust company). Since firm size is expected to play an important role in the monitoring choices made by firms, the logarithm of market capitalization at the 1991 financial year end is included as the size variable.

EMPIRICAL ANALYSIS

Table 1 presents Pearson correlation coefficients for all the endogenous governance variables as well as the size variable (logarithm of market capitalization). The previous section highlighted the importance of understanding the overall governance framework in which firms operate prior to addressing the specific role of D&O insurance. The correlation coefficients provide an opportunity to examine the relationships among the alternative governance mechanisms and thereby help us to better understand the overall governance choices made by firms. In terms of board composition and leadership, we identify a significant negative correlation between the proportion of outside directors and the proportion of equity owned by managers. This is consistent with our a priori expectations since greater executive ownership is expected to reduce agency costs and hence the use (and additional costs) of outside directors. The previous section also suggested that the efficiency of large external ownership may be an important determinant of the monitoring choices made by firms. As equity value increases, large shareholder monitoring becomes more costly compared to other forms of monitoring. The correlation coefficients in Table 1 support this expectation since both the ownership of the largest 3 percent blockholder and the ownership of all 3 percent blockholders is negatively correlated with the logarithm of market capitalization.

[TABULAR DATA FOR TABLE 1 OMITTED]

The existing literature suggests that the main alternatives to shareholder control are monitoring through board composition and executive share ownership. The correlations presented in Table 1 suggest that, for this sample of companies at least, board monitoring is the preferred alternative. However, caution is needed in interpreting the significant negative correlation between firm size and executive share ownership since we do not control for the economic magnitude of executive share ownership in large firms. For example, an equivalent percentage stake in a large firm amounts to a considerably greater investment than in a small firm. It may be that the financial value of executive share ownership is a more appropriate representation of the incentive effects of managerial ownership than the percentage of equity owned.

Table 2 presents descriptive statistics and mean differences for companies with and without D&O insurance. Table 3 presents the results of a logit analysis of the impact of alternative governance mechanisms and firm size on the likelihood of purchasing D&O insurance. Of the 366 companies included in the sample, 273 (75 percent) possessed a D&O insurance policy in 1991. Our earlier discussion suggested that board composition and leadership are likely to be positively associated with the purchase of D&O insurance. The descriptive statistics in Table 1 show that companies who purchase D&O insurance have a greater proportion of outside directors than their noninsured counterparts. This difference is significant at the 1 percent level. Table 1 reveals little difference between the existence of D&O insurance and the separation of the roles of chairman and CEO. In the logit analysis, the proportion of outside directors on the company board has a positive and significant impact on the likelihood of D&O insurance. Examining the economic magnitude of the logit coefficient, we find for every 10 percent increase in the proportion of outside directors a corresponding 10.3 percent increase in the likelihood of a firm having a D&O insurance policy. The presence of separate individuals in the role of chairman and CEO does not have a significant impact on the D&O insurance decision.

We also hypothesized that ownership structure is likely to affect the D&O insurance decision. As the equity value of a firm increases, the cost of monitoring through external share ownership becomes more costly and, as a result, shareholders are more likely to utilize alternative methods of monitoring managers. We would therefore expect a substitution effect between the proportion of equity owned by large external shareholders and the use of alternative governance mechanisms such as D&O insurance and executive share ownership.

The descriptive statistics in Table 2 and the logit results in Table 3 provide no evidence of a significant relationship between the ownership of large external shareholders and the D&O insurance decision. However, Table 2 shows that executive directors in insured firms have significantly lower equity holdings than their counterparts in uninsured firms. The logit results in Table 3 confirm this with a significant negative relationship between executive share ownership and the likelihood of purchasing a D&O insurance policy. Indeed, the logit coefficient suggests that, for every 10 percent increase in executive ownership, the likelihood of a firm possessing a D&O policy decreases by 9.6 percent. These findings suggest that executive ownership and D&O insurance are substitute governance mechanisms used by shareholders.

By incorporating the correlation results presented in Table 1 with the D&O results shown in Tables 2 and 3 we can provide some useful insights on the role of D&O insurance in the overall monitoring process. Shareholders in smaller companies utilize both external and internal ownership to monitor managers. However, as firm size increases and monitoring through external ownership becomes more costly, shareholders are more likely to utilize outside directors and D&O insurance to monitor managers. It is not clear from our analysis whether the monitoring of outside directors and D&O insurance are jointly deployed by firms or whether the adoption of one influences the other. For example, D&O insurers may insist on increased outside representation on the boards of insured companies or perhaps [TABULAR DATA FOR TABLE 2 OMITTED] [TABULAR DATA FOR TABLE 3 OMITTED] outside directors insist on the company purchasing a D&O policy. We also find a strong negative relationship between the joint monitoring of D&O insurance and outside directors and the proportion of equity owned by executive directors. This confirms our a priori expectations that executive ownership and D&O insurance are substitute monitoring mechanisms. However, our analysis does not provide clear evidence of the expected negative relationship between firm size and executive ownership. We believe that the use of the proportion of equity, rather than the financial value of equity, may have influenced this result.

CONCLUSION

The role of director indemnification is a contentious issue in the theory of the firm. In both the United Kingdom and the United States, legislation has been utilized to prevent directors from abusing corporate indemnification provisions at shareholders' expense. In recent years, the justification for such provisions has come under scrutiny. The principal catalyst for reform has come from the United States, where cases such as Smith v Van Gorkom (1985) have focused attention on the potentially devastating consequences of D&O litigation (Priest, 1987). The reaction in the United Kingdom has been to revise corporate legislation, specifically permitting companies to purchase D&O on behalf of directors (Companies Act 1989, Section 137.2).

Holderness (1990) suggests that D&O insurance may have an important governance role in publicly owned companies. The objective of this article is to provide an empirical insight on the monitoring hypothesis suggested by Holderness (1990). In particular, the article examines the relationship between firms' monitoring requirements and the purchase of D&O insurance. The United Kingdom provides a unique opportunity to perform such analysis since public companies are obliged to disclose the purchase of D&O insurance in their financial statements. The study examines the association between board composition, managerial ownership, the presence of large external shareholders, and the purchase of D&O insurance in a sample of 366 public companies. The empirical analysis provides a clearer understanding of the role of D&O insurance in corporate governance, specifically the nature of the relationship between D&O and alternative mechanisms of shareholder control. Our results suggest that smaller firms utilize both external and internal ownership to monitor managers. However, as firm size increases and external ownership becomes more costly as a means of monitoring, firms are more likely to utilize outside directors and D&O insurance to monitor managers. We also find a strong negative relationship between the joint monitoring of D&O insurance and outside directors and the proportion of equity owned by executive directors. This confirms our a priori expectations that executive ownership and D&O insurance are substitute monitoring mechanisms.

These results provide an important first step in attempting to understand the governance role of D&O insurance. The results presented here make a useful contribution to the governance debate in both the United Kingdom and United States since the existing literature illustrates the similarities between both countries in respect of the instruments utilized to reconcile shareholder and manager interests. In addition, the standard D&O insurance policy is largely similar in both countries - commonality being an obvious requirement for those U.K. companies possessing U.S. subsidiaries. These results also provide some further insights on the demand for D&O insurance. A principal drawback of the analysis is the absence of any information regarding the cost and conditions of D&O insurance. The availability of such information would allow a more comprehensive analysis of the overall demand and supply factors affecting the D&O purchase decision.

The article has benefitted from the detailed comments of two anonymous referees, S. R. Diacon, participants at the 1994 american Risk and Insurance Association conference in Toronto, and the 1995 AIRMIC conference at Nottingham University. The financial assistance of the Association of British Insurers is gratefully acknowledged.

REFERENCES

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Berle A. A. and G. C. Means, 1932, The Modern Corporation and Private Property (New York: Macmillan).

Bhagat S., J. A. Brickley, and J. L. Coles, 1987, Managerial Indemnification and Liability Insurance: The Effect on Shareholder Wealth, Journal of Risk and Insurance, 55: 721-736.

Brook Y. and K. S. Rao, 1994, Shareholder Wealth Effects of Directors' Liability Limitation Provisions, Journal of Financial and Quantitative Analysis, 29:481-497.

Cadbury, A., 1992, Committee on the Financial Aspects of Corporate Governance (London: GEC).

Companies Act, 1989, Section 137 (2).

Core, John E., 1997, On the Corporate Demand for Directors' and Officers' Insurance, Journal of Risk and Insurance, 64: 63-87.

Daniels, R. J. and S. M. Hutton, 1993, The Capricious Cushion: The Implications of the Directors' and Officers' Insurance Liability Crisis on Canadian Corporate Governance, Canadian Business Law Journal, 22:182-230.

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Hart, O. D., 1983, The Market Mechanism as an Incentive Scheme, Bell Journal of Economics, 14: 366-382.

Holderness, C. G., 1990, Liability Insurers as Corporate Monitors, International Review of Law and Economics, 10: 115-129.

Janjigian, V. and P. J. Bolster, 1990, The Elimination of Director Liability and Stockholder Returns: An Empirical Investigation, Journal of Financial Research, 13: 53-60.

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Jensen, M. C. and W. H. Meckling, 1976, Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership Structure, Journal of Financial Economics, 3: 305-360.

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Oesterle, D. A., 1989, The Effect of Statutes Limiting Directors' Due Care Liability on Hostile Takeover Defences, Wake Forest Law Review, 24:31-51.

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Noel O'Sullivan is Lecturer in Accounting and Financial Management at the Business School of Loughborough University.
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Author:O'Sullivan, Noel
Publication:Journal of Risk and Insurance
Date:Sep 1, 1997
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