Directors' and Officers' Liability Insurance, Liquidity Risk, and Stock Returns: Evidence from Taiwan's Stock Market

Abstract

This study reveals a notable anomaly in Taiwan's stock market, where stocks with substantial directors' and officers' (D&O) insurance coverage tend to yield higher expected returns, partly due to their exposure to liquidity risk. First, firms purchasing extensive D&O insurance coverage experience increased stock illiquidity, which is influenced by the inadequate quality of information disclosure. This observation supports the moral hazard-based information opacity hypothesis. Second, we introduce an illiquidity-based mimicking factor and show that portfolios with higher (lower) D&O insurance coverage display positive (negative) loadings on this factor, underscoring the importance of liquidity risk in asset pricing. Third, this market-wide illiquidity mimicking factor explains approximately one-third of the observed premium associated with variations in D&O insurance coverage across certain model specifications. This research challenges the behavioral mispricing hypothesis by highlighting the liquidity-driven covariance risk linked to the D&O insurance anomaly, thereby providing fresh insights into asset pricing dynamics in emerging markets.