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Q&A: New Baker Book Details How Liability Insurance Undermines Good Corporate Governance

August 05, 2011

“D&O insurance decreases corporations’ intent to be accurate and truthful in their financial statements, and discourages corporate officers from following the duty of care and duty of loyalty.”

Tom Baker
Tom Baker
Deputy Dean and William Maul Measey Professor of Law and Health Sciences

Tom Baker, the William Maul Measey Professor of Law and Health Sciences at Penn Law, researches and publishes on the subjects of insurance, risk, and responsibility using methods and perspectives drawn from across the disciplines of economics, sociology, psychology, and history. This summer he discussed his latest, groundbreaking book, Ensuring Corporate Misconduct: How Liability Insurance Undercuts Shareholder Litigation, with the Law School’s Office of Communications.

Penn Law (PL):  Please tell us a little bit about the book and your reasons for writing it.

Tom Baker (TB):  Most of my research looks at the way that insurance institutions affect legal institutions. I've done a lot of work on how insurance affects personal injury and medical malpractice litigation, and the medical malpractice debate. That research has followed a tradition of people who have studied how the law in action is different from the law on the books— and insurance in the area of liability affects law in action because insurance, in the end, pays for the liability. 

My co-author Sean Griffith and I wrote this book in large part to provide an example of what happens in a world in which you have liability on the part of a big corporation, and the litigation of securities class actions and other kinds of corporate litigation brought on behalf of shareholders— yet Directors & Officers (D&O) insurance is involved, as D&O insurance provides corporate officers financial protection if they’re sued in relation to their duties with a company. So, the idea was to figure out how insurance affects litigation in the corporate context, which hadn’t been investigated by anybody before.

People have looked at how insurance affects litigation, but no one has conducted empirical field research on the question of how insurance manages the deterrent signal set by liability. So, a deterrent signal is sent when insurance companies charge more for higher risk individuals— because paying claims is costly, when writing policies they incentivize you to behave more safely, for example, you pay less for your insurance if you have things like smoke alarms in your house and so forth. But in the corporate context, we wanted to see how insurance works as a transformer of the deterrent signal all the way from selling the insurance to the claims aspect. 

PL:  What exactly do you mean by transforming the deterrent signal in the corporate context?

TB:  Well, so much of corporate law is directed at the transparency of financial reporting, and then at the officer or the executive being the faithful servant of the corporation. In terms of liability, a CEO or corporate officers could be liable for not providing correct information to regulators or shareholders, or there could be liability for breaching the duty of loyalty or duty to care to the corporation. 

With that, no one had ever looked at this subject in a really systematic way from the starting point of selling this insurance all the way through to the managing the claim aspect, to see whether insurance does or does not kind of facilitate deterrent ideas of liability through insurance. And so we did that, as well.

What we found is D&O insurance undermines good corporate governance by reducing the consequences of bad corporate governance for the individuals involved.  The book’s title is a play on words, in that this insurance makes misconduct more possible.

Ensuring Corporate Misconduct
Ensuring Corporate Misconduct: How Liability Insurance Undercuts Shareholder Litigation

PL:  What methodology did you employ?

TB:  We conducted interviews with people who sell the insurance, who buy the insurance, and we interviewed underwriters, risk managers, and brokers— a typical D&O policy for a large, publicly traded corporation will be a seven-figure premium, so these deals are all done through brokers. And we talked to people on the reinsurance side of this, we spoke with “pricing actuaries,” who are the people in insurance companies that set the broad parameters for how the policies are priced. 

What we were trying to figure out was, is there an effort when selling the insurance to price it according to risk? The logic being if the insurance company is going to pay when corporate officers are liable, then theoretically that takes away the prevention incentive. But if it turns out that the price of the insurance is linked or based on your “riskiness,” then that provides some incentive for a CEO or corporate officers to not engage in such risky behavior that could lead to a lawsuit. 

In sum, we went out and investigated to see whether there were any kind of loss prevention efforts made by the insurance companies when it came to D&O insurance. The answer was no, none, zero. Why? The notion that some insurance underwriter is going to tell a CEO what he or she is supposed to do when it comes to financial reporting was a concept that was literally laughable to the subjects we interviewed.

If anything, D&O insurance decreases corporations’ intent to be accurate and truthful in their financial statements, and discourages corporate officers from following the duty of care and duty of loyalty. Now, there are other things that encourage them to be careful and to be loyal, but D&O insurance reduces the deterrent’s incentive rather than increases it. In short, the way D&O insurance works is that if I’m a CEO and get sued for a shareholder’s class action, D&O pays for the lawyer, pays for the settlement— it’s not my money. 

PL:  What kind of reforms or policy recommendations do you suggest in the book?

TB:  One of our policy suggestions is that certain kinds of D&O insurance, we think, ought not to be purchased except with a very high deductible; or that when corporations buy this insurance, they should have what’s called co-insurance, which means that they are on the hook for a percentage of the loss all the way up. 

But beyond the policy implications or recommendations, for law professors and law students the value of the book is that we explain how this securities class action litigation actually operates— what makes me tick is going out and figuring out how a particular part of the world works.  I think in the long run, the book’s value will be felt most by people who are learning to be lawyers, so they understand the role of insurance in the corporate litigation context.