Corporate Governance and D&O Insurance

This is a post long overdue.  We run into provocative articles from time to time on the subject of corporate governance.  Predicting Corporate Governance Risk:  Evidence from the Directors' & Officers' Liability Insurance Market by Tom Baker (UConn Law) and Sean Griffith (Fordham Law) fall into that category.  The article explores the relationship between D&O insurance and corporate governance.  Much of the evidence in the piece comes from interviews with D&O underwriters, so some of the information is self serving (the authors make this point throughout).  Here are a few interesting insights:

• Nearly all public corporations purchase D&O policies
• Nearly all shareholder litigation settles within the limits of these policies
• While the average settlement exceeded $24 million in 2004, the median was only $7 million
• The average amount of coverage in 2005 for companies with a market capitalization between $400 million and $1 billion was a bit over $28 million, for companies between $1 and $10 billion, about $50 million and for those over $10 billion, somewhat over $120 million.  
• Average premiums for the same three groups was about $.6 million, $1.2 million and about $3 million.    

In interviews with D&O underwriters, the authors noted that these companies make an effort to assess a company's governance before issuing policies (or determining the relative risk and, concomitantly, the premium).  Rather than conduct a rote count of the number of objective components of governance, the underwriters attempt to screen for culture and character.  This includes the quality of internal controls, the degree of enforcement of insider trading policies, the predilection for risk taking that exceeds norms, or those over committed to growth "because in such situations there will be a strong temptation to misstate results when reality falls behind expectations." 

The article concedes that it is difficult to determine the degree to which governance impacts pricing because underwriters spoke only in general terms  and because "the system is so highly discretionary that insurance companies and even individual underwriters may make inconsistent choices." 

The article concludes that the cost of insurance is "nontrivial" but that it will only influence actual practice if the difference between good companies and bad companies is enough to cause firms to improve.  As the article concludes:

• "Our findings have significant implications for corporate and securities law.  First, they suggest that underwriters, at least, believe that governance matters.  This, by implication, suggests that the merits do matter in corporate and securities litigation.  But, interestingly, our findings also suggest that what matters in corporate governance are not the structural governance variables most often tested in mainstream scholarship on corporate governance.  Our findings thus suggest 'deep governance' variables are a promising direction for future research."

It is a nicely done article, raising more questions than it answers (as a good piece often should).  My impression is that D&O underwriters are increasingly recognizing the value of governance in pricing decisions and will continue to do so.  Moreover, with an emphasis on internal controls, this may well be more important in the context of securities fraud suits than any other specific governance matter.  It is also a place where others make assessment (auditors and management as required by Section 404 of SOX) so there ought to be plenty of information on the subject.