Corporate risk management: evidence from product liability

In this paper we examine the factors that determine how firms manage large, firmspecific risks, in this case, product liability. The risk of being sued for defective products or damage from defective products poses a small probability of a great loss to the firm. Product liability exposure arises from the firm’s choice of products and markets; choices that are fundamental to the firm’s business strategy and that are costly to alter. Firms are unlikely to be naturally hedged by cash flows with respect to product liability risk. Cash flows will likely be negatively correlated with product liability claims since product liability claims reduce product demand and increase costs through legal expenses and claims payments. We study the impact of this low-probability, high-loss risk on a group of firms that manage product liability through insurance purchases in the early 1980s. Thus in the early 1980s all our firms follow similar strategies for managing product liability exposure. In 1985 a sudden, substantial rise in the price of product liability insurance causes firms to re-evaluate their risk management choices. We study the relationship between firms’ subsequent product liability risk management choices and firm characteristics that affect risk management choices. In particular, we examine firm characteristics related to risk capacity, costs of financial distress, and managerial incentives on the decision to continue purchasing product liability insurance. The decision to purchase product liability insurance depends upon the optimal risk management strategy for the firms as well as private managerial incentives that might cause