Directors' and officers' liability insurance and the cost of equity

We examine whether directors' and officers' (D&O) liability insurance affects a firm's cost of equity. We find a positive association between D&O insurance and the cost of equity. Information quality and risk-taking appear to be two underlying channels through which D&O insurance affects the cost of equity. Further tests suggest that this positive association is not due to optimal risk-taking, as evidenced by a negative market reaction to an increase in D&O insurance coverage, a lack of improvement in firms' cash flow and a low valuation associated with high D&O insurance. Overall, our evidence is consistent with the notion that MO insurance weakens the disciplining effect of shareholder litigation, leading to an increase in the cost of equity. (C) 2015 Elsevier B.V. All rights reserved.