Optimism and auditor liability

There is strong evidence that individuals are optimistic in the sense that they underrate the probability of a negative event occurring. This paper provides a positive theoretical analysis of how auditor optimism affects their incentives to take care under two liability rules: strict liability and a negligence rule. Under strict liability, auditors are held liable when they cause damages to investors. Under a negligence rule, auditors are held liable when they cause damages and in addition, act negligently, that is, fail to meet the standard of due care specified in legal and professional rules. I find the following results. (1) If due care is sufficiently close to the efficient level, a negligence rule distorts auditors’ incentives less than strict liability. Under strict liability, optimism makes the auditor overestimate the chances of finding material mistakes and thus induces suboptimal care. (2) If due care is too strict, the auditor will not exert due care but the same level of suboptimal care under either liability rule. (3) With increasing optimism and in the absence of punitive damages, strict liability becomes less preferable to a precise negligence rule. This statement also holds for vaguely defined standards of due care if due care is sufficiently strict or if auditor optimism is sufficiently high. (4) Punitive damages counteract suboptimal incentives generated by auditor optimism, especially under strict liability.     

Negligence,Ignorance and the Demand for Liability Insurance

This paper considers whether lack of information regarding risk exposures can lead to a demand for negligence liability insurance. We find that, under the uniform negligence rule, such as the “reasonable person” standard used to determine negligence in the U.S. and other countries, the value of information is positive and any demand for liability insurance must come from informed individuals. The necessary and sufficient condition is that good risks find it less costly to be negligent and purchase insurance.     

Precision and Manipulation of Non-financial Information: The Curious Case of Environmental Liability

This paper develops a model showing how the environmental liability regime and the precision of the disclosed environmental performance indicator affect managers’ incentives (1) to reduce actual pollution and (2) to manipulate the reported pollution. I assume a company with a separation of ownership and control which can be held liable for environmental damages and distinguish between a negligence regime and strict liability. The results suggest that if there is no manipulation but only a lack of precision of the disclosed environmental performance indicator, a negligence rule induces lower actual pollution levels than strict liability even though a negligence rule is considered to be more lenient. If managers are able to manipulate the disclosed environmental performance indicator, they will do so and actual pollution levels will generally increase. While manipulation makes it easier for shareholders to escape liability under a negligence regime, shareholders suffer from manipulation under strict liability due to higher actual pollution and higher expected damage compensation payments. Therefore, the manipulation level is higher under a negligence regime. My analysis contributes to the environmental performance and disclosure literature by showing that the liability regime is an important determinant affecting environmental reporting and actual pollution decisions.     

The Reasonable Person Negligence Standard and Liability Insurance

We show that, under the reasonable person negligence rule, heterogeneity of potential injurers can be sufficient to create a demand for liability insurance. Potential injurers with a low probability of accidents or a high cost of exercising care have optimal levels of care that are below the negligence standard. For these groups, it may be less costly to be negligent and purchase insurance than to comply with the negligence standard. We show that the availability of insurance is socially desirable.     

On the Judgment Proof Problem

A party who causes harm to others and is found legally liable but cannot fully pay is said to be judgment proof. When the party who causes the harm is judgment proof, the incentives provided by the negligence and strict liability rules diverge. The payment probabilities implied by the two rules also differ. If the cost of care is non-monetary, as in Shavell's analysis, then the different probabilities generated by the two rules and the injurer's risk aversion combine to show that greater care is optimal under the negligence rule than the strict liability rule. If, however, the cost of care is monetary then the difference in probabilities generated by the two rules suffices to show greater care under the strict liability rule than under the negligence rule. The latter case holds for either a risk averse injurer or a corporate injurer.     

On the Judgment Proof Problem

A party who causes harm to others and is found legally liable but cannot fully pay is said to be judgment proof. When the party who causes the harm is judgment proof, the incentives provided by the negligence and strict liability rules diverge. The payment probabilities implied by the two rules also differ. If the cost of care is non-monetary, as in Shavell's analysis, then the different probabilities generated by the two rules and the injurer's risk aversion combine to show that greater care is optimal under the negligence rule than the strict liability rule. If, however, the cost of care is monetary then the difference in probabilities generated by the two rules suffices to show greater care under the strict liability rule than under the negligence rule. The latter case holds for either a risk averse injurer or a corporate injurer.     

Auditors' Liability, Vague Due Care, and Auditing Standards

This paper expands the set of previously considered liability rules to include a negligence liability rule with a vague specification of due care. Auditors who are negligent in conducting their audit are liable for losses that result from reliance on misstated financial statements. However, what constitutes negligence for auditors is not clearly specified in the law. Consequently, courts often resort to Generally Accepted Auditing Standards (GAAS) and Statements on Auditing Standards (SAS) as benchmarks for determining due care. A liability regime that consists of a vague negligence rule supports and amplifies the credibility of auditing standards. While auditing standards alleviate some of the vagueness that is inherent in the legal standard, they also form a lower bound on due care, since an audit of a quality that is lower than the quality that auditing standards require would be considered negligent. Thus, the vague specification of due care enables auditors to commit to audit quality as pronounced in auditing standards. This paper explores this link between professional standards and auditors' legal liability. It establishes that the commitment to auditing standards could not have been as credible as it is, if auditors' liability was determined based on the strict liability rule, or based on a negligence rule with a clearly specified due care, since under these two liability rules courts would not need to refer to auditing standards to establish fault. The paper also demonstrates that a legal regime where audit standards are used as a benchmark to evaluate negligence is not the same as a legal regime where due care is defined clearly. Therefore, previous studies that assumed a negligence regime with clear due care may have overstated the effort level that is induced by legal liability.     

Auditor Reputation Under Different Negligence Regimes

Do auditor reputation effects evolve the same way under precise negligence as under vague negligence? Or are there differences? We assume that investors update their beliefs on unobservable auditor quality when an auditor discloses an inaccurate report. We call this a reputation effect. A necessary condition for reputation effects to occur is that, ex ante, investors expect ‘good’ auditors to take more care than ‘bad’ auditors such that ‘good’ auditors are less likely to issue an inaccurate report. Consistent with empirical evidence, we assume that wealthier (‘good’) auditors tend to take more care than less wealthy (‘bad’) auditors. We find that under vague negligence, reputation effects will occur, inducing both types of auditor to increase the level of care taken. A ‘good’ auditor is likely to exert excessive care. Then, even in the absence of auditor risk aversion, a (properly defined) liability cap is necessary to induce efficient incentives. A contractual liability cap is preferable to a legally fixed liability cap. Under precise negligence, a ‘good’ auditor will exert the standard of due care. However, a ‘bad’ auditor will also do so if sufficiently wealthy. Consequently, ex ante, investors do not expect different levels of care to be taken or reputation effects to occur. A liability cap is not desirable. This paper highlights the importance of non‐legal sanctions in auditor liability. Finally, it links the ‘reputation’ and ‘deep pocket’ hypotheses, both of which have attempted separately in the past to explain the positive correlation between auditor size and auditor quality.     

Audit Standards and Auditor Liability: A Theoretical Model

The business of auditing is heavily regulated. Auditor regulation exists through licensing, professional standards and liability. The auditor's liability for losses to financial statement users from audit failure is subject to a test of negligence. What constitutes due audit care is, however, not generally well-specified. Furthermore, reviews of litigation against auditors conclude that compliance with professional audit standards does not always act as a complete defence to allegations of negligence. The current situation can be described as one where (ex ante)—from the point of view of the auditor—uncertainty exists about the ‘legal’ standard of due audit quality (as seen by the courts in the event of litigation). This uncertainty about legal standards fundamentally affects audit behaviour in ways that are not immediately intuitive. This paper draws on insights from the economics and law literature (e.g., Kolstad et al., 1990; Shavell, 1984a, 1984b and 1987; Calfee and Craswell, 1984 and 1986) and provides an analysis of the effects of uncertainty about auditor negligence on the produced level of audit quality and on audit fees. The auditor subject to a negligence rule will produce too low or too high an audit quality level, as compared to the socially optimal level. It is shown that uncertainty about the legal standard of ‘due audit quality’ is fundamental to understanding audit quality supplied. This uncertainty is the explicator of an insurance component in audit fees. A surprising insight is that a large uncertainty about the legal standard of care can reduce rather than increase the quality of audit work supplied and increase the insurance component. Relying on insurance premiums can be more effective than direct expenditure in reducing risk. The effect of the imposition of ex ante precise audit quality standards, in combination with an uncertain negligence rule, is discussed. Since the influence of ex ante standards is indirect through its effect on ex post liability, auditing standards cannot be analysed independently of ‘legal’ standards. If the legal standard of care were clear, there would be no role for audit standards. Audit standards only affect audit behaviour if legal standards of care are unclear, and they help to clarify the legal standard. An effective combination is for ex ante standards to be set below the ex post standards of care so that they provide a lower bound on acceptable work. Under a lowest common denominator approach set too far below legal standards, audit standards would be irrelevant as far as operational decisions were concerned. As the level of standards are raised, so costs are first imposed on the lowest quality providers.     

Die ökonomische Funktion von Haftungsregeln bei Risikoaversion und Haftpflichtversicherungsmöglichkeiten

Most of the literature on the economic analysis of liability law reduces the economic importance of liability regulations to their prevention or incentive function. This is due to the premise of risk neutral decision behavior or to the assumption of ?costless“ insurance that is very often used in this context. In this paper the case of risk neutrality is discussed briefly. Then the relevance of risk aversion is explained, and results are presented from an analysis which integrates risk averse behavior and employs a more adequate modeling of the insurance supply, such that the risk allocation function of liability rules is given emphasis in addition to the aspect of loss prevention. An important result is that for large numbers of potential victims an ideal solution can be approximated by a negligence rule. This insight is particularly interesting in light of the fact that liability risks which are characterized by large numbers of victims usually are regulated by strict liability.     

Claims‐Made and Reported Policies and Insurer Profitability in Medical Malpractice

The liability crisis of the 1970s led to the introduction of a new type of insurance policy designed to reduce the undiversifiable uncertainty associated with writing long‐tail liability lines. These new claims‐made and reported policies gained favor in place of the traditional occurrence coverage in the early 1980s not only in medical malpractice but also in the general liability arena. The main question we want to address in this article is why two types of contracts that cover the same risk exposure exist in the medical malpractice insurance industry whereas only one exists primarily in other insurance lines.     

Strategic judgment proofing

A liquidity‐constrained entrepreneur raises capital to finance a business activity that may harm bystanders. The entrepreneur raises senior (secured) debt to shield assets from the tort victims in bankruptcy. For a fixed level of borrowing, senior debt creates better incentives for precaution taking than either junior debt or outside equity. The entrepreneur's level of borrowing is, however, socially excessive. Giving tort victims priority over senior debtholders in bankruptcy prevents overleveraging but leads to suboptimal incentives. Lender liability exacerbates the incentive problem even further. A limited seniority rule dominates these alternatives. Shareholder liability, mandatory liability insurance, and punitive damages are also discussed.     

侵权立法对责任保险市场的影响机制

责任保险赖以存在及发展的基础在于完善的法律体系,尤其是侵权责任法.一国侵权责任法的不断完善,不仅有利于公民和法人承担责任,同时也会增加公众的维权和自我保护意识,从而刺激责任保险市场的需求与供给.本文采用CHH模型,通过侵权责任扩张与责任保险危机问题,分析了侵权立法对责任保险市场的影响机制,并基于美国责任保险市场发展模式...     

Pricing and Capital Allocation for Multiline Insurance Firms

We study multiline insurance companies with limited liability. Insurance premiums are determined by no‐arbitrage principles. The results are developed under the realistic assumption that the losses created by insurer default are allocated among policyholders following an ex post, pro rata, sharing rule. In general, the ratio of default costs to expected claims, and thus the ratio of premiums to expected claims, vary across insurance lines. Moreover, capital and related costs are allocated across lines in proportion to each line's share of a digital default option on the insurer. Our results expand and generalize those derived elsewhere in the literature.     

BALANCE SHEET STRUCTURE AND THE MANAGERIAL-DISCRETION HYPOTHESIS: AN EXPLORATORY EMPIRICAL STUDY OF NEW ZEALAND LIFE INSURANCE COMPANIES

The managerial-discretion hypothesis states that in mutual insurance companies policyholders will seek to protect their interests by limiting managerial discretion in investment and financing decisions. Therefore, mutuals are predicted to introduce restrictive mechanisms (e.g., company by-laws) that promote precautionary investment, such as government securities. In stock companies, shareholders are expected to increase their wealth at the expense of policyholders' interests by investing in more speculative assets, such as equities. Differences in investment activity also affect policy valuation and reserving decisions reflected in the liability side of the insurance company balance sheet. The managerial-discretion hypothesis implies that systematic differences in the structure of balance sheets between mutual and stock insurance companies are likely to exist. To carry out an exploratory test of this aspect of the managerial-discretion hypothesis, the present study employs canonical correlation analysis on New Zealand life insurance company data for 1991. However, the empirical evidence does not appear to support the proposition that balance sheet structure varies systematically between mutual and stock companies.     

环境污染责任保险对企业债务融资成本的影响研究

在欧美发达经济体中,环境污染责任保险在实现经济与环境可持续发展中发挥着重要作用。环境污染责任保险在中国尚处于推广阶段,企业投保意愿不强,参保率较低,急需提高企业对环境污染责任保险的价值认同。环境污染责任保险是否具有资金融通效应,是企业主动接纳该类保险的重要驱动因素。为检验环境污染责任保险能否为企业带来资金融通的价值,文章以2014~2015年沪深A股上市公司为样本,基于前环保部2014及2015年公布的投保环境污染责任保险的公司名单,探究环境污染责任保险对重污染型企业债务融资成本的影响。研究结果显示,企业购买环境污染责任保险后债务融资成本显著降低。进一步研究发现,这一影响在民营企业及法制水平较高的地区中更为显著,并且企业环境信息披露行为在这一影响过程中发挥了部分中介效应。文章的研究结论为环境污染责任保险的资金融通价值提供了直接证据,更为推广环境污染责任保险,建立环境治理的市场机制提供参考。     

Medical malpractice: an empirical examination of the litigation process

New data on medical malpractice claims against a single hospital in which a direct measure of the quality of medical care is available are used to investigate the roles of the negligence rule and incomplete information in the dispute settlement process in medical malpractice. We find that the quality of medical care (negligence) is an extremely important determinant of defendants' medical malpractice liability. More generally, we find that the data are consistent with a model in which plaintiffs are poorly informed ex ante about whether there has been negligence, file suit to gather information, and either drop the case if they find that negligence was unlikely or settle for a positive payoff if they find that negligence was likely. We also find that the cases are resolved earlier in the litigation process when the parties are more certain, one way or the other, about the likelihood of negligence.     

Die Deckungsvorsorge der Versicherungsvermittler nach der EU-Versicherungsvermittlungs-Richtlinie

Insurance intermediaries being obliged to be registrated in Germany due to the directive have to comply with severe provisions concerning cover provisions (i. e. Deckungsvorsorge). A third-party liability insurance is virtually compulsory for insurance brokers and insurance agents charged by several insurance companies (i. e. Mehrfach-Agent), other kinds of equal alternatives for them do not exist practically. Concerning exclusively charged insurance agents (i. e. Ausschließlichkeits-Agenten), as well as in a side job, an indemnity clause of their insurance company giving the third party full rights may be a an alternative complying with the directive. The minimum covering funds being prescribed by the directive of € 1 million per event of damage and the minimum annual covering sum of € 1.5 million are appropriate to third party liability risks of an average insurance broker on the German market, for almost all of the insurance agents on this market without a permitted covering provisions, with regard to their very little third party liability risks, they are too high. Nevertheless, the German legislator is not entitled to deviate from them to lower sums for lack of an authorization rule in the directive. German legislator should transform the rules of the directive into national ones as soon as possible in favour of the interests of the consumers worthy of protection, using the existing national regulations on lawyers, notary publics, tax consultants and accountants concerning minimum contents of compulsory cover provisions and agreed exclusive clauses.     

Medicaid coverage expansions and liability insurance

Do changes in the population covered by health insurance affect liability insurers, who compensate billions of dollars in medical claims each year? We examine this question by exploiting the selective rollout across states of Medicaid expansions under the Affordable Care Act. Using data on insurer losses across a range of insurance lines, and employing a triple‐difference research design that contrasts states, years, and lines of insurance, we demonstrate that coverage expansions reduce auto liability and workers’ compensation outlays by 6–11 percent, but do not measurably impact other lines of insurance. Our analysis provides some of the first evidence regarding the use of the tort system particularized to the low‐income population and is the first to consider the impacts of health insurance on medical professional liability and commercial auto insurance claims.     

Quotelung bei Obliegenheitsverletzungen: Alles,Nichts oder die Hälfte

The German Insurance Contract Act of 1908 provided that the insured person would totally loose its claim on the insurance benefit in case of gross negligence. In order to give the insured person better protection the German Insurance Contract Act of 2008 rules that the insurance benefit is only reduced proportionally to the fault of the insured person. This article broaches the issue of how to calculate the amount of reduction. The main thesis is that light and gross negligence do not differ categorically from each other. Gross negligence is rather a gradual increase of negligence. Thus, the criteria that are relevant for the determination of gross negligence also decide over the weight of negligence relevant for the amount of reduction. In case the circumstances regarding a breach of warranty cannot be clarified, it is presumed that the insured person has acted with gross negligence. In this case, the gravity of the negligence has to be determined primarily by the objective weight of the breach of warranty.