Litigation Risk in Directors’ and Officers’ Liability Insurance : The Impact of Company-Related Risk Factors on the Insurance Premium

Abstract

A directors’ and officers’ (D&O) liability insurance policy prices the risk of litigation. The objective of this thesis is to investigate whether company-specific risk factors are incorporated in the pricing, and in such case what effect these risk factors have on the premium. For a sample of Canadian companies listed on the S&P/TSX Composite Index, we collect information on insurance coverage and premiums for a time period ranging from 2010 to 2020. Insurance data are matched with measures of risk estimated from both market and book values, along with information regarding the governance structure of companies. Before assessing how risk factors affect the premium, this study examines how the choice of coverage limit is affected. The empirical analysis further show that several of our hypothesized risk factors do affect the D&O premium, either directly or through the choice of coverage limit. As such, we find that coverage will be more costly for companies with higher litigation risk, proxied by company size, profitability, leverage, volatility, and others. By implementing the Merton Model, we estimate the value and volatility of company assets. Analysing the premium based on these variables yield similar results to the estimation based on the directly observable variables of stock volatility and market capitalization. A common feature for both approaches is that the volatility measures are found to be important determinants of the premium. Additionally, the majority of the other risk measures are found to display similar impacts on the premium no matter the measures utilized for size and volatility. Altogether, the results obtained in this thesis indicate that insurers address and incorporate various company-related risk factors.