Winning us with trifles: Adverse selection in the use of philanthropy as insurance

Abstract

Research Summary: We study the use of corporate philanthropy as a form of reputation insurance, developing a formal model of such insurance to examine how the terms of insurance in equilibrium change under different assumptions about the firm and its stakeholders. We then test the predictions from this model in the U.S. petroleum industry and find that philanthropic donations offer insurance‐like benefits, but are also positively associated with subsequent oil spills—firms that give more, spill more—with this association being stronger for spills that are under firms’ control and in states with low civic capacity. These results are consistent with an adverse selection/moral hazard equilibrium and suggest that the use of philanthropy as reputation insurance may benefit firms at the cost of society. Managerial Summary: Firms that donate to social causes develop a reputation for being socially responsible, and are often given the benefit of doubt when negative information about them comes to light. But are philanthropic firms truly more responsible? We argue that firms that donate more may be more likely to do harm—those that expect to do harm later are likely to give more now, and those that know their reputation protects them may become less careful. Evidence from the U.S. petroleum industry is consistent with this argument, with firms that give more having more subsequent oil spills, but only the type of spills that are under the firm's control, and only in states where the firm faces weaker scrutiny.

Do firms use corporate social responsibility to insure against stock price risk? Evidence from a natural experiment

“…Indeed, some scholars (Godfrey, ) may suggest that CSR undertaken in such a transparently instrumental fashion would produce few insurance‐like benefits. Other scholars, however, surmise that firms do pursue CSR for such benefits (Luo et al, ). Thus, while previous research has only been able to conjecture that firms seek CSR insurance benefits, our study offers proof.…”

“…Evidence on the insurance role of CSR mostly comes from studies that examine its insurance‐like benefits. Specifically, firms with higher CSR experience less severe stock and bond price decline in the face of negative legal or regulatory events (Godfrey et al, ; Luo et al, ; Shiu & Yang, ), product recalls (Minor & Morgan, ), and litigation risk (Koh et al, ). While these findings are insightful, they do not inform whether managers purposefully invest in CSR as insurance against the future risk of possible negative events nor whether CSR activity undertaken for this instrumental purpose actually does so.…”

“…As well, it is unclear whether CSR undertaken for the instrumental purpose of protecting against future negative events actually does so (Godfrey, ). Luo, Kaul, and Seo () highlight the importance of this issue by finding that the insurance‐like benefits of philanthropy appear to be opportunistically used by petroleum firms as a shield for more oil spills. In this study, we address these gaps in the literature by exploiting the natural experiment of Reg SHO to examine whether firms invest in CSR in response to greater stock price risk, and whether such investments provide intended insurance‐like benefits.…”

Private action in public interest: The comparative governance of social issues

“…Third, ex post information asymmetry may arise where transactions are complex and their outcomes are causally ambiguous (Chi, 1994;Lippman & Rumelt, 1982), so that it may be hard to tell, even ex post, whether the observed outcome was the result of deliberate action (or inaction) on the part of the transaction partner. Finally, ex post information asymmetry may also result from challenges in measuring transaction outcomes (Besley & Ghatak, 2005;Chi, 1994;Hwang & Powell, 2009), for instance, where the outcomes of a transaction are imperfectly measured so that there is a gap between perfunctory performance and consummate performance, leaving room for quality-shading (Hart, 2003(Hart, , 2008Hart & Moore, 2008) and moral hazard (Chi, 1994;Hölmstrom, 1979;Luo, Kaul, & Seo, 2018); where the benefits to the recipient are complex (Hölmstrom & Milgrom, 1991) or subjective (Waguespack & Salomon, 2015); or where measurement is costly, making comprehensive assessment infeasible . In all these cases, ex post information asymmetry impairs the functioning of markets, making it challenging for transacting parties to correctly assess the value of transactions (Anheier & Ben-Ner, 1997;Hansmann, 1980), and causing skeptical actors to choose not to transact, while naïve actors receive less than they pay for.…”

Will Companies with Poor Environmental Performance Be More Inclined to Donate?

“…From the perspective of reputation theory, enterprises can obtain moral capital through charitable donation, which can reduce the reputation loss of enterprises caused by negative events, thereby reducing the corresponding economic losses [37]. Corporate philanthropic donations can also divert public attention from negative corporate events and influence the public's attribution of negative events [38]. Because corporate charitable donation acts have the similar role of "reputation insurance", this paper argues that enterprises with poor environmental performance will be more inclined to charitable donation, in order to reduce the negative impact of environmental performance on enterprises under the pressure of environmental regulation, and improve the legitimacy of enterprises themselves.…”