Directors' and officers' liability insurance and acquisition outcomes

We examine the effect of directors' and officers' liability insurance (D&O insurance) on the outcomes of merger and acquisition (M&A) decisions. We find that acquirers whose executives have a higher level of D&O insurance coverage experience significantly lower announcement-period abnormal stock returns. Further analyses suggest that acquirers with a higher level of D&O insurance protection tend to pay higher acquisition premiums and their acquisitions appear to exhibit lower synergies. The evidence provides support for the notion that the provision of D&O insurance can induce unintended moral hazard by shielding directors and officers from the discipline of shareholder litigation.     

Industry contagion in loan spreads

Spreads on new and renegotiated corporate loans are significantly higher when the loan originates (or is renegotiated) in the two years surrounding bankruptcy filings by industry rivals. This industry-specific contagion is particularly severe in the middle of industry bankruptcy waves. Furthermore, this contagion in loan spreads is mitigated in concentrated industries, consistent with the hypothesis and evidence in Lang and Stulz (1992) that bankruptcy filings in concentrated industries can have positive consequences for rivals (increased market share and/or power). There is also some evidence that contagion affects non-spread terms in loan contracts.     

Directors' and officers' liability insurance and stock price crash risk

We investigate the impact of directors' and officers' insurance (D&O insurance) on stock price crash risk. We find that D&O insurance in China is negatively associated with stock price crash risk. This association is robust to a series of robustness checks including the use of alternative sample, Heckman two-step sample selection model, propensity score matching procedure, fixed effects model, the inclusion of some possibly omitted variables, and bootstrap method. Further analyses show that the impact of D&O insurance on crash risk is more pronounced in firms with lower board independence, non-Big 4 auditors, lower institutional shareholdings, and weaker investor protection; and the negative relationship between D&O insurance and crash risk is not driven by the eyeball effect. Moreover, we find that D&O insurance purchase is associated with less financial restatements and more disclosure of corporate social responsibility reports. Our findings provide support to the notion that D&O insurance appears to improve corporate governance.     

Voluntary versus mandatory disclosure of liability insurance coverage limit

This article analyzes the disclosure of the liability insurance coverage limit and the impact of mandating disclosure of the coverage limit in a setting where voluntary disclosure of a firm’s cash flow information is subject to litigation risk and the firm has directors’ and officers’ (D&O) liability insurance. Disclosure of cash flow information is costly, but disclosure of the insurance coverage limit features no direct disclosure friction. We find that, when the litigation environment is weak, the usual unraveling argument applies, and the manager always voluntarily discloses the coverage limit in equilibrium. However, when the litigation environment is strong, either no coverage limit is disclosed or only sufficiently high coverage limits are disclosed in equilibrium. Further analysis shows that mandatory disclosure of the coverage limit increases the voluntary disclosure of cash flow information.     

Asymmetric information effects on loan spreads

This paper estimates the cost arising from information asymmetry between the lead bank and members of the lending syndicate. In a lending syndicate, the lead bank retains only a fraction of the loan but acts as the intermediary between the borrower and the syndicate participants. Theory predicts that asymmetric information will cause participants to demand a higher interest rate and that a large loan ownership by the lead bank should reduce this effect. In equilibrium, however, the asymmetric information premium demanded by participants is offset by the diversification premium demanded by the lead. Using shifts in the idiosyncratic credit risk of the lead bank's loan portfolio as an instrument, I measure the asymmetric information effect of the lead's share on the loan spread and find that it accounts for approximately 4% of the total cost of credit.     

Corporate governance and the cost of debt: Evidence from director limited liability and indemnification provisions

We find that firms that provide limited liability and indemnification for their directors enjoy higher credit ratings and lower yield spreads. We argue that such provisions insulate corporate directors from the discipline from potential litigation, and allow them to pursue their own interests by adopting low-risk, self-serving operating strategies, which coincidentally redound to the benefit of corporate bondholders. Our evidence further suggests that the reduction in the cost of debt may offset the costs of directorial shirking and suboptimal corporate policies occasioned by this insulation, which may explain why stockholders have little incentive to rescind these legal protections.     

Internal liquidity risk in corporate bond yield spreads

The recent global financial crisis reveals the important role of internal liquidity risk in corporate credit risk. However, few existing studies investigate its effects on bond yield spreads. Panel data for the period from year 1993 through 2008 show that corporate internal liquidity risk significantly impacts bond yield spreads (and changes) when controlling for well-known bond yield determinant variables, traditional accounting measures of corporate debt servicing ability, cash flow volatility, credit ratings, and state variables. This finding indicates that internal liquidity risk should therefore be incorporated into bond yield spread modeling.     

Providers’ affiliation,insurance and collusion

This paper provides a theoretical analysis of the benefits for an insurance company to develop its own network of service providers when insurance fraud is characterized by collusion between policyholders and providers. In a static framework without collusion, exclusive affiliation of providers allows insurance companies to recover some market power and to lessen competition on the insurance market. This entails a decrease in the insured’s welfare. However, exclusive affiliation of providers may entail a positive effect on customers’ surplus when insurers and providers are engaged in a repeated relationship. In particular, while insurers must cooperate to retaliate against a fraudulent provider under non-exclusive affiliation, no cooperation is needed under exclusive affiliation. In that case, an insurer is indeed able to reduce the profit of a malevolent provider by moving to collusion-proof contracts when collusion is detected, and this threat may act as a deterrent for fraudulent activities. This possibility may supplement an inefficient judicial system: it is thus a second-best optimal anti-fraud policy.     

Corporate misreporting and bank loan contracting

This paper is the first to study the effect of financial restatement on bank loan contracting. Compared with loans initiated before restatement, loans initiated after restatement have significantly higher spreads, shorter maturities, higher likelihood of being secured, and more covenant restrictions. The increase in loan spread is significantly larger for fraudulent restating firms than other restating firms. We also find that after restatement, the number of lenders per loan declines and firms pay higher upfront and annual fees. These results are consistent with banks using tighter loan contract terms to overcome risk and information problems arising from financial restatements.     

Optimal pension insurance design

In this paper we analyze how the traditional life and pension contracts with a guaranteed rate of return can be optimized to increase customers’ welfare. Given that the contracts have to be priced correctly, we use individuals’ preferences to find the preferred design. Assuming CRRA utility, we cannot explain the existence of any form of guarantees. Through numerical solutions we quantify the difference (measured in certainty equivalents) to the preferred Merton solution of direct investments in a fixed proportion of risky and risk free assets. The largest welfare loss seems to come from the fact that guarantees are effective by the end of each year, not only by the expiry of the contract. However, the demand for products with guarantees may be explained through behavioral models. We use cumulative prospect theory as an example, showing that the optimal design is a simple contract with a life-time guarantee and no default option.     

Institutional stock trading on loan market information

One of the most important developments in the corporate loan market over the past decade has been the growing participation of institutional investors. As lenders, institutional investors routinely receive private information about borrowers. However, most of these investors also trade in public securities. This leads to a controversial question: Do institutional investors use private information acquired in the loan market to trade in public securities? This paper examines the stock trading of institutional investors whose portfolios also hold loans. Using the Securities and Exchange Commission filings of loan amendments, we identify institutional investors with access to private information disclosed during loan amendments. We then look at abnormal returns on subsequent stock trades. We find that institutional participants in loan renegotiations subsequently trade in the stock of the same company and outperform trades by other managers and trades in other stocks by approximately 5.4% in annualized terms.     

Reinsurance and corporate taxation in the United Kingdom life insurance industry

There are two main tax-related arguments regarding the use of reinsurance – the income volatility reduction and the income level enhancement arguments. The income volatility reduction argument contends that firms facing convex tax schedules have incentives to hedge in order to reduce the volatility of their annual taxable income and thereby lower expected tax liabilities [Smith, C.W., Stulz, R.M., 1985. Optimal hedging policies. Journal of Financial and Quantitative Analysis 19, 127–140]. The income level enhancement argument, advanced by Adiel [Adiel, R., 1996. Reinsurance and the management of regulatory ratios and taxes in the property–casualty insurance industry. Journal of Accounting and Economics 22, 207–240], is more specific to hedging via reinsurance. This perspective holds that reinsurance enhances current reported earnings via the receipt of reinsurance commissions and so increases tax liabilities. Consequently, insurance firms with high marginal tax rates should use less reinsurance than those with low marginal tax rates if tax matters. Prior studies using data on financial derivatives have produced mixed results on the validity of the first argument, while Adiel (1996) finds the second argument insignificant in his study of the use of reinsurance by a sample of United States (US) property–liability insurance firms. This study tests the two tax-related arguments using 1992–2001 data for a sample of United Kingdom (UK) life insurance firms. We find that UK life insurers with low before-planning marginal tax rates tend to use more reinsurance; in contrast, tax convexity is found to have no significant impact on the purchase of reinsurance and so the volatility-reduction argument is not supported.     

Regulatory competition and forbearance: Evidence from the life insurance industry

Regulatory separation theory indicates that a system with multiple regulators leads to less forbearance and limits producer gains while a model of banking regulation developed by Dell’Ariccia and Marquez (2006) predicts the opposite. Fragmented regulation of the US life insurance industry provides an especially rich environment for testing the effects of regulatory competition. We find positive relations between regulatory competition and profitability measures for this industry, which is consistent with the Dell’Ariccia and Marquez model. Our results have practical implications for the debate over federal versus state regulation of insurance and financial services in the US.     

Deposit insurance, bank regulation, and financial system risks

Empirical evidence is presented to show that in modern times banks can hedge liquidity shocks but could not do so prior to FDIC insurance. However, the government's limitations in properly pricing FDIC insurance are leading to many current examples of moral hazard. A model is presented to show that if insurance premiums are set to be “actuarially fair,” incentives for banks to take excessive systematic risks remain. Motivated by empirical evidence that money market mutual funds also can hedge liquidity shocks, I consider an alternative government insurance system that mitigates distortions to risk-taking yet preserves liquidity hedging and information synergies.     

The effects of firm-initiated clawback provisions on bank loan contracting

Although firm-initiated clawbacks reduce accounting manipulation, they also induce managers to engage in suboptimal activities (e.g., reduce research and development (R&D) expenses) to achieve earnings targets. To assess the effectiveness of clawback provisions, we examine their impact from debtholders' point of view. We find that banks use more financial covenants and performance pricing provisions in the loan contracts and decrease interest rates after firms initiate clawbacks. Moreover, we also find that loan maturity increases and loan collateral decreases subsequent to clawback adoption. Taken together, our findings indicate that firm-initiated clawback provisions enhance financial reporting quality, thereby reducing the information uncertainty that financing providers face.     

Mergers and acquisitions in the US property-liability insurance industry: Productivity and efficiency effects

This paper analyzes the productivity and efficiency effects of mergers and acquisitions (M&As) in the US property-liability insurance industry during the period 1994–2003 using data envelopment analysis (DEA) and Malmquist productivity indices. We seek to determine whether M&As are value-enhancing, value-neutral, or value-reducing. The analysis examines efficiency and productivity change for acquirers, acquisition targets, and non-M&A firms. We also examine the firm characteristics associated with becoming an acquirer or target through probit analysis. The results provide evidence that M&As in property-liability insurance were value-enhancing. Acquiring firms achieved more revenue efficiency gains than non-acquiring firms, and target firms experienced greater cost and allocative efficiency growth than non-targets. Factors other than efficiency enhancement are important factors in property-liability insurer M&As. Financially vulnerable insurers are significantly more likely to become acquisition targets, consistent with corporate control theory, and we also find evidence that M&As are motivated to achieve diversification. However, there is no evidence that scale economies played an important role in the insurance M&A wave.     

Board size and the variability of corporate performance

This study provides empirical evidence that firms with larger boards have lower variability of corporate performance. The results indicate that board size is negatively associated with the variability of monthly stock returns, annual accounting return on assets, Tobin's Q, accounting accruals, extraordinary items, analyst forecast inaccuracy, and R&D spending, the level of R&D expenditures, and the frequency of acquisition and restructuring activities. The results are consistent with the view that it takes more compromises for a larger board to reach consensus, and consequently, decisions of larger boards are less extreme, leading to less variable corporate performance.     

Forecasting the fragility of the banking and insurance sectors

Linkages between banks and insurance companies are important when forecasting the fragility of the banking and insurance sectors. We propose a novel empirical framework that allows us to estimate unobserved linkages in panel data sets that contain observed regressors. We find that taking unobserved common factors into account reduces the root mean square forecasts error of firm specific forecasts by up to 9%, of system forecasts by up to 14%, and by up to 39% for systemic forecasts of more distressed firms relative to a model based on observed variables only. Estimates of the factor loadings suggest that the correlation of financial institutions has been relatively stable over the forecast period.     

How the Subprime Crisis went global: Evidence from bank credit default swap spreads

How did the Subprime Crisis, a problem in a small corner of U.S. financial markets, affect the entire global banking system? To shed light on this question we use principal components analysis to identify common factors in the movement of banks' credit default swap spreads. We find that fortunes of international banks rise and fall together even in normal times along with short-term global economic prospects. But the importance of common factors rose steadily to exceptional levels from the outbreak of the Subprime Crisis to past the rescue of Bear Stearns, reflecting a diffuse sense that funding and credit risk was increasing. Following the failure of Lehman Brothers, the interdependencies briefly increased to a new high, before they fell back to the pre-Lehman elevated levels – but now they more clearly reflected heightened funding and counterparty risk. After Lehman's failure, the prospect of global recession became imminent, auguring the further deterioration of banks' loan portfolios. At this point the entire global financial system had become infected.     

The reaction of emerging market credit default swap spreads to sovereign credit rating changes

This paper examines the effect of sovereign credit rating change announcements on the CDS spreads of the event countries, and their spillover effects on other emerging economies’ CDS premiums. We find that positive events have a greater impact on CDS markets in the two-day period surrounding the event, and are more likely to spill over to other emerging countries. Alternatively, CDS markets anticipate negative events, and previous changes in CDS premiums can be used to estimate the probability of a negative credit event. The transmission mechanisms for positive events are the common creditor and competition in trade markets.