Probability Updating and the Market for Directors’ and Officers’ Insurance

Abstract

Over the past decade, much attention has been given to the topics of corporate governance and corporate risk management. One increasingly important insurance product associated with each of these issues is directors' and officers' (D&O) liability insurance. Given the interconnectedness that exists between D&O insurance, corporate risk management, and corporate governance, we exploit industry-specific D&O data to explain how industries most associated with the corporate scandals of the early 2000s adjusted demand patterns during periods of certainty and uncertainty. The rich data set coupled with dramatic changes in the marketplace allows for the testing of insurance demand patterns and enables us to offer insight into the market's response to a unique type of loss shock. The results of this study suggest evidence in favor of demand-side probability updating, whereby those industries most associated with the corporate scandals of the early 2000s adjusted the demand for D&O insurance during periods of greater uncertainty.

Operação Lava Jato: Impactos no Mercado Segurador de Responsabilidade Civil de Executivos

“…What sets that research apart from previous publications is the quantitative methodology used to assess the D&O insurance market, an unparalleled approach in the Brazilian case. However, the qualitative explanations of Rodrigues (2011) and Faria (2015) about the moments of higher growth of the D&O line in Brazil corroborate the probability updating hypothesis (Fier et al, 2015), since the three years of highest growth observed (2004, 2010, and 2015) were preceded by events that raised the risk perception by economic agents. This research hypothesizes that the performance of D&O insurance in 2015 is related to the outbreak of CWO in 2014.…”

“…The literature calls this type of increase in demand as probability updating (Browne & Hoyt, 2000;Fier et al, 2015;Froot & O'Connell, 1997). The probability updating is heightened after catastrophic events, due to their severity and to the emphasis given to them by the media.…”

“…Despite the greater recurrence of the probability updating in the catastrophic risk insurance line, its occurrence in other lines is possible, through an exogenous unforeseen event that comes to significantly affect the claims of the insurance line. Fier et al (2015) assessed the effects of the probability updating on the demand for D&O insurances in a period of uncertainty on the liability of US executives (and, as a result, of the claims of D&O insurance), in the context of the implementation of the Sarbanes-Oxley law (SOX).…”

“…To achieve their study goal, Fier et al (2015) observed data on the demand for D&O insurance, voluntarily provided by companies between 1991 and 2007, splitting that time interval into five periods related to higher or lower uncertainty about executive accountability. In addition, they divided companies into two groups: those impacted and those not impacted by corporate scandals.…”

“…The main objective of this study is to evaluate the relation between the growth in revenues of D&O insurance premiums in Brazil and CWO, under the premise that the shock of demand for that type of protection occurred due to an updating on the perception of exposure to risks covered by that type of insurance, on the part of the exposed economic agents, after the developments of the operation, in a process known as probability updating (Fier, McCullough, Gabel, & Mansfield, 2015). As a methodology, a two-stage regression method for panel data was used (Cragg, 1971) to quantify the effect of deflagrations from different CWO phases on the supply of insurance contracts, for the insurers.…”