Show Me the Information: Board Independence and D&O Insurance

1. Show Me the Information:Board Independence and D&O Insurance Shih-Chung Chang Department of Insurance and Financial Management Takming University of Science and Technology Jason Yeh Department of Finance The Chinese University of Hong Kong

2. Directors and Insurance as Governance • In the current environment, companies have a strong incentive to adopt rigorous governance procedures because those that fail to do so will be unable to attract top quality directors and will pay a risk premium in terms of both director compensation and possibly officer and director liability insurance. (Cynthia A. Glassman, SEC Commissioner, in a speech delivered to the National Economists’ Club, April 7, 2003)

3. Money Matters… • CUHK has a D&O insurance policy: • Coverage limit = HK$20,000,000 (per claim and aggregate) • Deductible = HK$50,000 (per claim) • Though rare, outside directors have paid to settle shareholders’ claims (Apr. 23, 2007, WSJ): • Trans union: 10 directors paid $1.35m (1985) • Enron: 10 directors paid $13m (2005, D&O Insurer paid $155m) • WorldCom: 12 directors paid $24.8m (2005, D&O Insurer paid $36m) • Just for Feet: 5 directors paid $41.5m (2007)

4. Literature: Board Effectiveness • Kumar and Sivaramakrishnan (2008, RFS): More independent board (lower monitoring efficiency) may actually perform worse. • Laux (2010, MS): If board oversight is difficult and costly, higher director liabilities lead to a lower level of board oversight, and lower shareholder value. • Duchin et al. (2010, JFE): the effectiveness of outside directors depends on the cost of acquiring information about the firm

5. Literature: D&O Insurance • Mayers and Smith (1982, JB), Holderness (1990, IRLE): insurers providing D&O insurance play an important monitoring role, as they will scrutinize corporate policyholders and thus monitor their management. • Core (2000, JLE): insurance premiums are higher when boards are less independent. • Cao and Narayanamoorthy (2005): D&O liability insurance premiums decline with increased board independence. • Gillan and Panasian (2008) find that propensity of firms to purchase insurance increases with board independence. • Chalmers, Dann and Harford (2002, JF): Managerial Opportunism • Boyer (2003, 2007): no significant association between D&O insurance limits or deductibles and board composition.

6. The Model: Basic Ideas Contract design can hardly change the CEO’s behavior The board oversees the CEO through peer monitoring D&O insurance improves the information transparency Corporate governance reforms are not completely effective

7. Timeline

8. Actors Following the modeling strategy of Adams and Ferreira (2007) and Kumar and Sivaramakrishnan (2008) The firm value given the CEO’s project selection: The CEO: The Board: Weighted function of the firm and the CEO (I as the weight)

9. The Monitoring Cost • The board’s monitoring cost is a function of the monitoring effort, m, and the D&O insurance coverage, K. Let • The function is convex in monitoring effort, m. • The cross-derivative is negative, so the higher D&O insurance coverage leads to lower marginal monitoring costs.

10. Lemma 1 Lemma 1: Given the range of the degree of information transparency , there exists a such that (a) If , then ; Similarly, if , then . (b) Higher K leads to lower m* Higher K leads to higher m*

11. Implications Higher board compensation leads to higher monitoring efforts. However, higher D&O insurance coverage can lead to higher or lower oversight, depending on the degree of information transparency (λ). When λ is low, additional insurance reduces expected liability payments morethan marginal monitoring costs, so the optimal monitoring effort will be lower. When λ is high, additional insurance reduces more marginal monitoring costs than expected liability payments, so the optimal monitoring effort will increase.

12. Proposition 1 Proposition 1：There exists an unique Subgame Perfect Equilibrium (SPE), ,where (a) aninterior solution , , always exists; (b) there exist and such that when , and when . ( is the upper limit of the information transparency.)

13. Implications • Higher equity ownership by directors leads to higher monitoring level, thereby increasing the firm value. • However, higher D&O insurance coverage can lead to higher or lower oversight, depending on the degree of information transparency (λ). • When λ is low, optimal insurance coverage is zero. • When λ is high, more insurance coverage can lead to higher degree of optimal monitoring, thereby improving the firm value.

14. Managerial Opportunism? • Chalmers et al. (2002) use a sample of 72 IPO firms (1992-6) and find a significant negative relation between the three-year post- IPO stock price performance and the insurance coverage purchase. • According to them, one plausible interpretation is that, like insider securities transactions, D&O insurance decisions reveal opportunistic behavior by managers. • However, our model indicates an possible alternative explanation which is less value judgmental. • Insurance reduces two costs: expected liability payments and monitoring costs. • The economic trade-off matters!!! • In some cases (low λ firms), insurance does not work, because it reduces more expected liability payments than monitoring costs, so the monitoring effort will be lower, so is the firm value.

15. Proposition 2 Proposition 2：If , higher board independence implies higher optimal board’s compensation, , and higher optimal D&O insurance coverage , ; However, If , the optimal D&O insurance coverage is zero, , and higher board independence only implies higher optimal board’s compensation, .

16. Implications • Higher degree of board independence implies higher optimal board’s compensation • If the interior solution exists, higher degree of board independence implies higher optimal D&O insurance coverage. • If the optimal insurance coverage is zero, the degree of board independence has no impact on the optimal D&O insurance coverage .

17. Proposition 3 Proposition 3: When the information transparency parameter is within the range of , the D&O insurance purchase will increase the board’s monitoring level. Subsequently, higher board independence will lead to higher monitoring efforts. On the other hand, when , a more independent board will request more insurance, which points to a lower optimal monitoring effort AND lower firm value. In such situation, the best strategy is to purchase zero D&O insurance.

18. Implications • Board independence affects oversight through three ways: • The direct effect: positive. • The indirect effect via board compensation: positive. • The indirect effect via D&O insurance: varies with the information transparency.

19. Proposition 4 Proposition 4: (Firm Value Maximization) From the perspective of shareholders, there exists an interval of information transparency , shareholders will be willing to purchase D&O insurance. In such situation, the optimal insurance coverage shows a substitute relationship with optimal board compensation.

20. Model Extensions • We treat the D&O insurance premium rate, litigation risk, and information cost exogenous variables. • But how do they affect board compensation, D&O insurance purchase, and monitoring level at equilibrium?

21. Proposition 5 Proposition 5: Higher D&O insurance premium rate (r) implies higher optimal board’s compensation, ; However, higher D&O insurance premium rate leads to lower optimal D&O insurance coverage .

22. Board Independence and D&O Insurance Premium Rate • If the insurer offers a rate reduction for a more independent board, would that lead to higher oversight? • Again, it depends! • When λ is low, higher board independence leads to lower premium rate and perhaps LOWER monitoring.[The first (+) dominates the second (-).] • When λ is high, higher board independence leads to lower premium rate and subsequently HIGHER monitoring.[The second (-) dominates the first (+).]

23. Proposition 6 Proposition 6: There exists a cut-off value , where . When , higher litigation risk (q) will lead to lower optimal monitoring level; only when is large enough, the higher litigation risk (q) has the potential to increase the monitoring level.

24. Litigation Risk and Board Oversight • Will higher litigation risk lead to higher oversight? • Only so if it HURTS! • The direct effect is positive only if • Only when the out-of-pocket payment is significant enough will the direct effect surpass the combination of the other two. • Consist with Laux (2010).

25. Information Costs and Board Oversight • Duchin et al. (2010): The effectiveness of outside directors depends on the cost of acquiring information about the firm. • When the cost of acquiring information is low, performance increases when outsiders are added to the board, and when the cost of information is high, performance worsens when outsiders are added to the board. • If there exists two different cost structures, given the optimal D&O insurance coverage K*, due to the differences in the level of acquiring information: high cost c1 and low cost c2 , so • We can obtain that m1* < m2*, and

26. Concluding Remarks We contribute to corporate governance literature: Address the interactions of board independence and D&O insurance. Characterize the importance of information transparency in determining the optimal D&O insurance coverage Enrich discussions on board independence and show that high level of information transparency helps an independent board achieve higher level of monitoring efforts.