Directors' and Officers' Insurance and Opportunism in Accounting Choice

ABSTRACTIn this paper, the focus is on how excessive directors' and officers' liability insurance coverage is associated with risk-taking behavior in financial reporting. This study examines the implications of two alternative hypotheses. The opportunism hypothesis predicts that the covered executive is overly buffered from recourse via securities litigation, which leads to aggressive accounting choices. The alternative hypothesis is the economic insurance hypothesis which predicts that firms will over-invest in directors' and officers' liability insurance coverage independent of their aptitude for accounting manipulation because of the managers' risk aversion. Aggressive accounting is measured using regulatory accounting enforcement actions and earnings restatements. I find evidence consistent with the opportunism hypothesis in both the enforcement action and restatement setting, suggesting that officers rely on excessive insurance in making financial reporting decisions. The findings have implications for managerial private information and its impact on financial reporting decisions.JEL: M41, K3KEYWORDS: Earnings Quality, Litigation, Insurance(ProQuest: ... denotes formulae omitted.)INTRODUCTIONDirectors' and officers' (D&O) liability insurance "is designed to protect executives, outside directors, as well as the companies they serve against liability arising from actions taken in the course of doing business" (Trautman and Altenbaumer-Price, 2012). The purpose of this study is to test whether protection from excessive D&O coverage helps explain aggressive accounting choices (tested using regulatory enforcement releases and earnings restatements). This study examines whether D&O insurance coverage (managerial private information in the United States) reflects opportunism and impacts risk-taking behavior in financial reporting. Officers and directors require the firm to purchase group D&O insurance on their behalf to minimize personal liability in the event of a lawsuit, and is purchased to approximate the firm-specific litigation risk. I predict that D&O coverage in excess of the expected coverage provides incentives for managers to engage in opportunistic behavior, measured via financial reporting. Opportunism in the D&O setting is predicted to occur when a manager is overly buffered from securities litigation when coverage is unusually high (above that expected given the firm's litigation risk) and increases the proclivity towards risk-taking behavior in financial reporting.The alternative prediction to opportunism follows the economic theory on the demand for insurance, which states that investment in insurance is derived from the risk aversion of the covered individual. For investments like insurance, the firm chooses "certainty in preference to uncertainty" (Friedman and Savage, 1948) and is willing to sacrifice a small payment in the form of an insurance premium to secure certainty. Moreover, insurers serve as monitors, thereby protecting their coverage via a corporate governance role in the firm (O'Sullivan, 1997). In sum, the demand for insurance hypothesis predicts that firms will over-invest in insurance despite the low amount of risk-taking in accounting choice, i.e. low probability of aggressive financial reporting. D&O insurance covers managers, directors, and in some cases entire firms. A recent development in D&O insurance coverage is firm coverage. Firms can purchase coverage to include the firm, along with its executives. It is intended to reduce the agency conflict and deter overly risk averse managerial decision-making by protecting managers against litigation. D&O coverage limits are not disclosed in the United States, whereas the coverage limit is mandatory disclosure internationally. Therefore, D&O is private information which can impact decision-making. According to the Tillinghast-Towers Perrin Directors and Officers Liability Survey, D&O coverage is virtually universal among survey participants, at 97%. …