Insurer Information, Insiders and Initial Public Offering

Any investor faces important risk when investing in a public firm; risk is even more pronounce when investing in new public firms since relatively little is known at the time of the initial public offering. The information asymmetry problem is partially mitigated through the underpricing of the security at the time of the IPO. The goal of this paper is to examine if at the time of the IPO there is an unused source of information that could be used as a signal for the firms' short-term return. In particular, I study the predictive power of an audit that insurers conduct in firms that acquire directors' and officers' liability insurance contract (D&O insurance) to protect their managers' wealth in the event of a lawsuit against the corporation and its representatives. More precisely, I examine whether D&O insurance contracts offer a glimpse into a firm's stock market return. I find that the more a corporation pays per unit of D&O insurance coverage at the time of the IPO – a signal of its risk of lawsuit – the lower and more volatile its first year return is. This effect disappears in the second year. One implication is that D&O insurance provides information that is an unbiased signal of the firm's risk (because the insurer has a direct financial incentive to correctly assess the firm's liability risk) so that investors should find this information to be as valuable, if not more, than any rating