Directors' and Officers' liability insurance and cross section of expected stock returns: A mispricing explanation

Abstract

To add to the literature on asset-pricing anomaly detection, this study tests the cross-sectional relationship between directors' and officers' liability insurance coverage (D&O insurance) and expected stock returns. A unique, near-complete sample of Taiwanese company stocks is used to document the D&O insurance anomaly that reveals stocks with high-D&O insurance significantly outperforming those with low-D&O insurance by 7% to 13% annually, after accounting for well-known risk factors. This high-minus-low D&O insurance return premium is robust to alternative weighting approaches and to the Fama–MacBeth regressions, which simultaneously control for various standard returns predictors and corporate governance measures. Furthermore, a D&O insurance-mimicking factor is used to document that the characteristic of D&O insurance can subsume the covariance of the D&O insurance-mimicking factor to predict returns, thus rejecting the rational risk explanation of the D&O insurance anomaly in favor of the behavioral mispricing explanation. Further evidence indicates that stocks of firms with high- (low-) D&O insurance tend to be undervalued (overvalued) and the high-minus-low D&O insurance return premium is concentrated among those undervalued stocks and is stronger in the presence of high limits-to-arbitrage, which are interpreted as consistent with the behavioral mispricing explanation.