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| Does Directors' and Officers' Insurance Deter Corporate Fraud？A Study from the Perspective of Insurance Institutions' Governance |
| LI Conggang, XU Rong
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| Dongwu Business School, Soochow University; School of Finance/Chinese Financial Policy Research Center, Renmin University of China |
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Abstract The important influence of institutional investors, especially financial institutions, on corporate governance is attracting more and more attention from researchers. Previous studies focus on the supervisory effect of bank loans, the active intervention of hedge funds, and the activities of institutional investors, such as mutual funds and pension funds, that may obtain board seats or even threaten to withdraw investments. However, unlike the above-mentioned institutions, which have economic incentives for holding equity and creditor’s rights, insurance institutions directly address the governance risks associated with corporate governance deficiencies by providing directors’ and officers’ insurance (“D&O insurance” hereinafter) to listed companies. Therefore, insurance institutions may have more direct incentives to play a corporate governance role.
Corporate fraud has severely damaged investor confidence and reduces the efficiency of capital markets. Therefore, preventing and deterring corporate fraud are very important to protect the interests of investors and the healthy development of capital markets. Both internal and external governance mechanisms are considered to be important factors in preventing corporate fraud because they directly affect the cost of corporate fraud. However, although D&O insurance is an important corporate governance mechanism, its effect on corporate fraud has not been fully studied. Existing theories show that D&O insurance can not only increase the cost of corporate fraud through active and effective external supervision by insurance institutions, but also stimulate the moral hazard and opportunistic behavior of directors and executives by transferring potential litigation risks to insurance companies, thereby increasing the likelihood of corporate fraud. Therefore, the actual role of D&O insurance in corporate fraud is an important empirical research topic.
Using a sample of A-share firms listed on the Shanghai and Shenzhen exchanges in the 2000 to 2016 period, we find that D&O insurance significantly reduces the probability of corporate fraud, which conforms the supervisory effect hypothesis. These conclusions remain valid after robustness tests based on the instrumental variable method, Heckman two-stage model, and propensity score matching method. We then discriminate between the supervisory hypothesis and collusion hypothesis to identify the impact mechanism. The collusion hypothesis holds that insurance institutions tend to help insured companies hide corporate fraud to protect their own interests. Therefore, D&O insurance may reduce the probability of corporate fraud's being revealed but not really affect the corporate fraud tendencies of insured companies. The supervisory hypothesis holds that external supervision by insurance institutions can effectively reduce corporate fraud and increase the probability of inspection. The regression results of a bivariate probit model with partial observability show that D&O insurance is negatively correlated with corporate fraud tendencies and positively correlated with the probability of inspection. We also find that D&O insurance reduces agency costs, which significantly inhibits managerial opportunism. The above results support the supervisory hypothesis and suggest that the collusion hypothesis is not valid.
We also do further research in the following three areas.(1) After differentiating between types of corporate fraud, we find that the supervisory effect of D&O insurance on fraud committed by businesses is the most significant.(2) By examining the combined effects of D&O insurance and other governance variables on corporate fraud, we find that D&O insurance has a better governance effect on corporate fraud for state-owned enterprises, when chairmen and CEO positions are separated, and when auditors come from the “Big Four” accountancy firms. However, when insurance institution are shareholders, the marginal governance effect of D&O insurance on corporate fraud is weaker. (3) Grouping the regressions shows that the supervisory effect of D&O insurance on corporate fraud is more significant in poor external supervisory environments or when there is high transparency of internal information.
This study not only provides evidence that insurance contracts affect corporate fraud through corporate governance channels, but also shows that insurance institutions provide a more effective corporate governance mechanism for China's capital market through D&O insurance. Finally, this study may prompt theorists, legislators, and regulators to rethink how decisions about D&O insurance affect corporate governance and corporate fraud. They could provide a reference for decision makers to promote the development of the D&O insurance market.
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Received: 19 July 2018
Published: 02 July 2020
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