stock return volatility prob(D & O insurance) firm size
A. D&O insurance and stock return volatility
V. CONCLUDING REMARKS
The existence of D&O insurance coverage can mitigate directors’ and officers’ liability for monetary damages to shareholders. This paper is one of the few papers which examine the effects of D&O insurance on the incentives of directors and officers, and how those incentives affect corporate decision making. Specifically, we focus on the risk-taking implication of D&O insurance. The view of many previous studies of D&O insurance is that because D&O insurance protects directors and officers from the liability resulting from their corporate decisions, it leads to managerial opportunism and reduces the incentives to act in the best interest of the shareholders. For example, studies such as Core (2000) and Chalmers et al. (2002) argue that the purchase of D&O insurance represents opportunistic behavior of managers. We propose an alternative hypothesis in that if a firm is covered by D&O insurance, directors and officers can become less risk-averse and less likely to reject risky but value-adding projects. The Korean market serves as an ideal setting for the study of D&O insurance because firms in Korea disclose their insurance coverage during our sample period of 2002-
40 Small firms tend to have more growth opportunities, but this is mostly controlled for by
38
2008, and there is not an over-proportion of firms that carry insurance. This is in contrast to the D&O insurance market in the U.S., in which the data is unavailable in the public domain and almost all firms carry D&O insurance.
The results of this study have implications similar to studies which examine the effect of overconfident managers (Malmendier and Tate, 2005a, 2005b, 2008; Goel and Thakor, 2008; Gervais et al., 2011; Hirshleifer et al., 2012). While overconfidence can lead to various agency problems which can hurt the firm (for example, Malmendier and Tate, 2008, find that the market reacts more negatively to acquisitions made by overconfident CEOs), overconfidence can benefit shareholders if it leads to accepting good but risky projects. For example, Goel and Thakor (2008) and Gervais et al. (2011) model the role of overconfidence in encouraging managers to take sufficient risk. Hirshleifer et al. (2012) empirically show that overconfident CEOs are more likely to invest in riskier projects and make greater R&D investments. We argue that a similar effect is shown for D&O insurance. While previous studies find that D&O insurance coverage can lead to the opportunistic behavior of managers, we show that it can also make the managers behave in a less risk-averse manner, and this leads to greater firm value for our sample of firms, particularly for firms with higher growth expectation. One possible explanation for observing different effects of D&O insurance is that under a high-litigation environment, such as during an IPO (Chalmers et al., 2002) and M&A (Lin et al., 2011), firms that perceive greater probability of litigation due to their opportunistic behavior are more likely to purchase D&O insurance and have greater coverage amount in order to protect themselves from potential damages. On the other hand, during non-eventful periods (for example, Bhagat et al., 1987) and in a relatively low litigation environment of civil law jurisdiction, D&O insurance can benefit the firm by reducing the risk-averseness of the decision makers. Accordingly, we argue that D&O insurance should be viewed in a different manner from mechanisms that lead to entrenched or poorly governed managers, which studies universally find to have a negative impact on firm’s value.
39
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Table I. Trend of firms with D&O insurance
This table shows the trend of variables related to D&O insurance within our sample period of 2002-2008. The sample of firms in our study comes from the companies listed on the Korea Stock Exchange, the data of which is available on the Korea Listed Companies Association database. We require that (a) the company has a fiscal year end of December 31; (b) the firm does not belong in the financial industry; and (c) the company has equity greater than zero. Information on D&O insurance is collected from each company's annual reports on Data Analysis, Retrieval and Transfer System in the Financial Supervisory Service (http://dart.fss.or.kr).
Year Firms without D&O insurance Firms with D&O insurance Total number of firms Proportion of firms with D&O insurance
2002 230 80 310 0.258 2003 244 85 329 0.258 2004 248 103 351 0.293 2005 255 119 374 0.318 2006 258 130 388 0.335 2007 263 146 409 0.357 2008 259 151 410 0.368 Total 1,757 814 2,571 0.317
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Table II. Trend of D&O insurance information
This table shows the trend of variables related to D&O insurance within our sample period of 2002-2008. Variables on D&O insurance are collected from each company's annual reports on Data Analysis, Retrieval and Transfer System in the Financial Supervisory Service (http://dart.fss.or.kr). D&O insurance coverage amount and D&O insurance premium are in Korean Won.
Year
D&O insurance coverage
amount
Coverage amount/ Lagged asset size
D&O insurance premium
Premium/ Lagged asset size
Coverage Amount/ Insurance Premium 2002 Mean 7,887,500 1.114% 173,221 0.019% 123.62 Median 5,000,000 0.778% 98,218 0.013% 45.68 2003 Mean 8,082,353 1.126% 190,357 0.019% 133.05 Median 5,000,000 0.688% 81,000 0.012% 39.39 2004 Mean 10,305,825 1.442% 188,147 0.020% 131.62 Median 5,000,000 0.753% 76,000 0.012% 63.29 2005 Mean 11,721,008 1.074% 187,844 0.015% 115.92 Median 5,000,000 0.629% 75,830 0.010% 73.60 2006 Mean 14,702,308 1.528% 200,838 0.015% 147.61 Median 5,000,000 0.819% 64,768 0.008% 87.31 2007 Mean 15,502,055 1.860% 176,412 0.011% 203.77 Median 7,500,000 0.838% 47,649 0.007% 121.95 2008 Mean 16,172,848 1.465% 160,600 0.010% 241.11 Median 10,000,000 0.725% 42,269 0.005% 144.62 Total Mean 12,765,356 1.416% 181,679 0.015% 164.39 Median 5,000,000 0.748% 62,031 0.009% 83.05
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Table III. Summary statistics
This table shows the descriptive statistics of firm characteristics for the group of firms that have D&O insurance coverage versus the group of firms that do not have D&O insurance coverage. The mean difference test between the two groups is based on t-statistics. The median difference test between the groups is based on Wilcoxon statistics. Definitions of the variables are provided in the Appendix. ***, **, * denote a significant difference between the two groups of firms at the 1%, 5%, and 10% level, respectively.
Variable
Firms with D&O insurance Firm without D&O
insurance All firms Difference
in mean
Difference in median Mean Median Standard
Deviation Mean Median
Standard
Deviation Mean Median
Standard Deviation Firm size 20.496 20.428 1.467 18.771 18.731 1.067 19.317 19.114 1.450 *** *** Tobin's Q 1.115 0.971 0.531 0.895 0.805 0.421 0.965 0.844 0.470 *** *** Leverage 0.497 0.516 0.197 0.449 0.442 0.213 0.464 0.463 0.209 *** *** Cash holdings 0.129 0.079 0.160 0.139 0.083 0.165 0.135 0.081 0.163 * ROA 0.062 0.059 0.065 0.044 0.045 0.075 0.050 0.049 0.072 *** ***
Stock return volatility 0.499 0.474 0.165 0.536 0.494 0.205 0.524 0.484 0.194 *** ***
R&D 0.008 0.002 0.014 0.005 0.000 0.011 0.006 0.001 0.012 *** ***
Earnings smoothing 0.214 0.469 1.170 0.079 0.500 2.466 0.121 0.493 2.143
Ratio of outside directors 0.380 0.333 0.138 0.298 0.286 0.098 0.324 0.286 0.119 *** *** Controlling shareholder ownership 14.494 8.190 16.892 24.672 24.660 18.462 21.449 20.600 18.590 *** *** Ownership disparity 23.289 21.020 20.700 16.558 8.360 19.461 18.689 11.100 20.103 *** *** Foreign shareholder ownership 18.457 11.775 19.229 7.052 0.630 12.581 10.663 2.040 15.915 *** ***
Chaebol dummy 0.547 1.000 0.498 0.090 0.000 0.286 0.235 0.000 0.424 *** ***
Cross-listing dummy 0.052 0.000 0.221 0.003 0.000 0.053 0.018 0.000 0.134 *** ***
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Table IV. Determinants of D&O insurance
This table examines the determinants of carrying D&O insurance modeled by using a probit regression. The dependent variable is an indicator variable which equals one if the firm carries D&O insurance. All independent variables which are firm specific are lagged one year prior to the measurement of the dependent variable. The first column of each model reports the coefficient of the probit regression. The next column of each model reports the marginal effects of the variables in the probit regression. Model 1 includes the typical determinants of D&O insurance from the previous literature. Model 2 includes variables which are specific to the business and litigation environment in Korea. The marginal effect measures the change in the probability of the firm carrying D&O insurance for a unit change in the relevant variable from its mean value and all other variables remain at their mean values. All variables are defined in the Appendix. Standard errors are corrected for clustering of observations at the firm level. z-statistics are in parentheses. χ2 is the value of the likelihood ratio test for model fit. ***, **, * indicate significance at the 1%, 5%, and 10% levels, respectively.
Variable
Model 1 Model 2
coefficient marginal effect z-
statistic coefficient marginal effect
z- statistic Stock return -0.002*** -0.001*** (-4.26) -0.002*** -0.001*** (-4.40) Stock return volatility -0.165 -0.055 (-0.43) -0.166 -0.056 (-0.43) Stock turnover -1.939 -0.652 (-0.77) -1.447 -0.485 (-0.60)
Tobin's Q 0.590*** 0.198*** (4.78) 0.481*** 0.161*** (3.67)
Firm size 0.576*** 0.194*** (10.21) 0.454*** 0.152*** (6.79)
Earnings smoothing 0.014 0.005 (0.81) 0.012 0.004 (0.69) Risk industry dummy -0.145 -0.047 (-0.80) -0.079 -0.026 (-0.45) Retail industry dummy -0.561 -0.155 (-1.11) -0.764 -0.192** (-1.50)
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Cash holdings 0.141 0.048 (0.43) 0.117 0.039 (0.36) Ratio of outside directors 1.203** 0.404** (2.41) 1.120** 0.375** (2.20) Controlling shareholder
ownership -0.011*** -0.004*** (-2.81) -0.010** -0.003** (-1.97)
Ownership disparity -0.001 -0.000 (-0.35) Chaebol dummy 0.618*** 0.222*** (3.71) Foreign shareholder ownership 0.002 0.001 (0.54) Big audit firm dummy 0.186 0.062 (1.28) Cross-listing dummy -0.849 -0.205** (-1.58)
Class action act dummy -0.017 -0.006 (-0.28)
Constant -12.346*** (-10.79) -10.096*** (-7.79)
Number of observations 2571 2571
Pseudo R2 0.324 0.344
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Table V. D&O insurance and stock return volatility
This table reports the results for the multivariate regression of stock return volatility on D&O insurance and other control variables. Models 1 and 2 show the results for the second-stage regressions of the Heckman selection model. Model 3 shows the results for the second-stage regression of the two-stage regression model in which the insurance dummy is the predicted probability of having D&O insurance. Model 4 shows the results for the second-stage regression