Financial Statements Insurance

Several causes have been suggested for the corporate scandals and the boom followed-by-bust of the 1990s. Managers' tendency to inflate stock prices -to increase the value of options they were granted in increasing numbers during the 1990's, by misrepresenting financial reports - and auditors' failure to fulfill their role as independent gatekeepers, as well as other causes, were seen as culprits contributing to a price bubble. We define a bubble as the circumstance wherein a subset of stocks is priced above fundamental value. The fact that auditors are paid by the companies they audit creates an inherent conflict of interest that is endemic to the relation between the firm (the principal) and the auditor (the agent). We analyze a financial statement insurance mechanism that eliminates the conflict of interest auditors face and properly aligns their incentives with those of shareholders thus mitigating market inefficiencies arising from uncertainty regarding the quality of financial statements. We show that under the existing legal and regulatory regime governing financial reporting, and the auditing of such statements, a bottom quality of financial statements is chosen. On average, firms that potentially yield low rate of return (low fundamental value) are over-funded relative to firms characterized by a high rate of return (high fundamental value) and have stock prices that exceed the fundamental value - a bubble. We present a mechanism that mitigates this whereby companies would purchase financial statement insurance that provides coverage to investors against losses suffered as a result of misrepresentation in financial reports. The insurance coverage that the companies are able to obtain is publicized, as are the premiums paid for that coverage. The insurance carriers would then appoint and pay the auditors who attest to the accuracy of the financial statements of the prospective insurance clients. Firms announcing higher limits of coverage and smaller premiums would distinguish themselves in the eyes of the investors as companies with higher quality financial statements. In contrast, those with smaller or no coverage or higher premiums will reveal themselves as those with lower quality financial statements. Every company will be eager to get higher coverage and pay smaller premiums lest it be identified as the latter. A sort of Gresham's law in reverse would be set in operation, resulting in a flight to quality.