Directors ’ and Officers ’ Insurance : Ordinary Corporate Expense or Valuable Signaling Device ?

After many years in which directors have used directors’ and officers’ (D&O) coverage to shield themselves from personal responsibility for corporate failure, directors at Enron and WorldCom have been forced to pay $31 million out of their own pockets to settle securities class action lawsuits stemming from two of the largest corporate governance scandals in U.S. history. These settlements have brought the question of director's liability to the foreground, generating interest in the extent to which a firm’s D&O liability coverage reveals valuable information regarding its quality of corporate governance. Since insurers are expected to perform a thorough examination of the directors for whom insurance protection is sought, there is reason to believe that poor governance increases litigation risk and thus the size of the insurance premium. Using a sample of D&O premiums gathered from the proxy statements of firms cross-listed in the U.S. and Canada, I find a significant negative relationship between D&O premiums and variables that proxy for the quality of firms’ governance structures. This association is robust to a number of alternate specifications. As further evidence that the D&O premium reflects the quality of a firm’s corporate governance, the proxies for weak governance are positively related to excess CEO compensation. Overall, these results suggest that the D&O premium can be a useful measure of the quality of a firm’s governance.