failed governance: a comment on baker and griffith's ensuring corporate...

Failed Governance: A Comment onBaker and Griffith’s EnsuringCorporate Misconduct

Carol A. Heimer

TOM BAKER and SEAN J. GRIFFITH. 2010. Ensuring Corporate Misconduct: How LiabilityInsurance Undermines Shareholder Litigation. Chicago: University of Chicago Press.Pp. viii + 285. $33.19 cloth.

This essay evaluates Baker and Griffith’s book, Ensuring Corporate Misconduct,as a contribution to the social science literatures on regulation and governance, risk, andinsurance. Previous social science work on insurance often took an “insurance on theground” perspective comparing how insurance actually works with the theory of insuranceand scrutinizing the actions of insurers as well as the actions of their policyholders. In linewith this perspective, Baker and Griffith find that directors and officers (D&O) insurersdo not actually charge premiums that vary with risk or monitor the actions of the officersand directors covered by the insurance. Because insurers and governments share gover-nance tasks (a point Baker makes elsewhere), insurers’ failures in fact amount to “failedgovernance” of the corporate world.

WHERE DOES INSURANCE FIT INTO GOVERNANCE ANDREGULATION?

The tasks of societal provision, distribution, and regulation have usually belonged tostates and have often been studied as “government.” In recent years, scholars have begunto study “governance” instead. The linguistic shift signals both a broadening of howscholars understand the package of activities that goes into running a society and a beliefthat something has changed in how those activities are divided between governmentsand private entities in the contemporary world (Braithwaite, Coglianese, andLevi-Faur 2007; Vogel 2008; Carrigan and Coglianese 2011; among the early piecesnoting the changed relationship between governments and other entities, see especiallyRosenau and Czempiel 1992; Haufler 1999). It is especially in regulation—more thanprovision or distribution—that these new relationships between private and publicactors have been studied, and particularly in regulatory activities that span nationalboundaries and so necessitate shared jurisdiction. Governments still play a big role inregulation, but the balance between private and public regulation has clearly shifted andthe number and variety of entities (including businesses themselves) involved in regu-latory activities have increased. Moreover, as the literature on new governance pointsout, these regulators deploy a wider variety of instruments and use them much more

Carol A. Heimer is Professor of Sociology at Northwestern University and Research Professor at theAmerican Bar Foundation. She can be contacted at [email protected].

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flexibly (de Búrca and Scott 2006; Sabel and Simon 2011–2012). Many of the regulationshave an ambiguous legal status. Often, they are soft law, essentially obligatory but lackingthe force of law (Abbott and Snidal 2000).

Depending on how regulatory activities are conceptualized, though, one couldargue that private regulation and government/business regulatory partnerships haveexisted for a very, very long time. With the blessing of governments, guilds andprofessions regulated the activities of their members—and also did their best to preservetheir monopolies. Often, these regulatory activities involved not just collaborationsbetween government and regulated businesses, but also included a variety of thirdparties, such as insurers and standard-setting, classification, and certification societies.Permission to ply a trade, work in a profession, run a business, enter into some forms ofcontract, or hold a governmental position often required that people purchase bonds orinsurance, and insurers often would offer insurance coverage only to those who had metthe standards of a third-party inspector. Marine classification societies and marineinsurers are a particularly good example of the complex relations between private andpublic regulatory bodies.

Thus insurers have long been among the private entities involved in regulation.And, of course, insurers have been present on both sides. As regulated entities, theyhave been subject to government oversight of rate setting, reserves, and conditions ofcoverage, although they have rather successfully resisted government oversight in theUnited States, where insurance is subject to state but not federal regulation. As partnersin regulating others, insurers have been able to shape behavior (“your insurance cov-erage only holds if . . .” or “your rates are will be higher if . . .”) without the extensivepublic debate that would occur if governments were themselves laying down rules aboutappropriate conduct. In return, insurers have received government help in creatingdemand for insurance products through the mandating of many forms of insurancecoverage.

Despite the important role insurance plays in regulation, neither regulatory schol-ars nor those studying insurance have devoted much time to thinking about insurancequa regulation. This is surely partly because of how the literature on insurance devel-oped. For many years, that literature consisted largely of two categories of writings:pedagogical materials, such as textbooks on insurance and insurance law, and hagio-graphic insurance company histories. For those conducting scholarly investigations ofinsurance, there were also primary materials, such as advertising pamphlets and samplecontracts, buried in the files of the American College of Insurance or the New YorkPublic Library. The records of state insurance regulators surely contained much usefulmaterial, but what was available and how it was organized varied from one state toanother. Much material that might have been useful remained under the control ofinsurance companies. Although the publications of insurers’ main professional associa-tions gradually became both more academic and somewhat more theoretical,1 they

1. For instance, one core publication, the American Risk and Insurance Association’s Journal of Riskand Insurance, has been published continuously since 1964. But it began publication with Volume 31 becauseit grew from the Journal of Insurance, which published Volumes 24–30 between 1957 and 1960. Thispublication in turn grew from the fusion of the Review of Insurance Studies (Vols. 1–3, 1954–1956) and theJournal of the American Association of University Teachers of Insurance (Vols. 4–23, 1937–1956). The latter, in

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retained their focus on the practical problems confronting insurance practitioners,including (as will become clear below) the problem of how to anticipate and regulatethe behavior of policyholders.

Only in the late 1970s and early 1980s did insurance become a topic of con-tinuing interest to social scientists and sociolegal scholars who were not themselvesinsurance professionals. This new scholarship brought insurance into the family ofsocial institutions routinely studied by social scientists so that actual practices werecompared to the practices described in textbooks or training manuals, alleged benefitswere contrasted with what was in fact provided to policyholders, and insurance wasanalyzed alongside other techniques for dealing with catastrophes and reducing risktaking. Some of this new social science literature pointed out the biases in insurancepractices, such as the pervasive racially-based redlining that has helped perpetuateinequalities in access to housing (Squires, DeWolfe, and DeWolfe 1979; Heimer1982; Squires 1997). Other studies asked what insurance companies and theiremployees actually did and how that compared with what they were alleged to do(Ross 1970; Baker and McElrath 1996; Baker 2001). The close scrutiny by socialscientists also led to some rethinking of how insurance fits in with large social trans-formations, for instance in our willingness to attach a monetary value to human life(Zelizer 1979), and compared insurance techniques with the strategies employed inother arenas to manage the risks of social life (Heimer 1985). Social scientific atten-tion also meant employing the broader lenses of key theorists; in this vein, onenotable strand drew on Foucault’s work on governmentality to examine insurance asan institution of nonstate governance (Simon 1988; O’Malley 1991; Baker andSimon 2002 generally, but especially Heimer 2002 and O’Malley 2002; Ericson,Doyle, and Barry 2003).

To summarize, then, only some of the social science literature on insuranceaddresses regulatory questions, and not always very directly. For the most part, the piecesthat do bear on regulatory questions (e.g., Heimer 1985; O’Malley 1991; Baker andSimon 2002; Ericson, Doyle, and Barry 2003) have thought about regulating individualsrather than regulating corporations and those who manage them and have not exam-ined insurance in the context of other regulatory institutions.

MORAL HAZARD AS AN EXAMPLE OF THE LIMITATIONS OFRESEARCH ON INSURANCE

Social scientific research on moral hazard illustrates this combination of accom-plishments and deficiencies—the widened focus that now scrutinizes both insurersand those they insure while nevertheless retaining an individualistic and acontextualperspective. Insurers have long worried about moral hazard, the shift of incentivesthat can occur once an insurance contract is in place. An insurance contract transfersmuch of the cost of risk taking to the insurance company even though control over

turn, was the successor to the Proceedings of the Annual Meeting of the American Association of UniversityTeachers of Insurance (Vols. 1–3, 1933–1935).

LAW & SOCIAL INQUIRY482

risk taking remains with the policyholder. With the insurance company now footingthe bill for losses, the policyholder may be less careful and losses may consequentlyrise. For instance, car owners whose auto insurance policies cover theft should, onaverage, be slightly less vigilant about locking their cars and should therefore expe-rience marginally more thefts. This “reactivity” of risk makes actuarial calculationsdifficult and can, in extreme situations, mean that actual insurance losses far outstripestimated losses.

Beginning with the work of Kenneth Arrow (1963, 1971), the concept of moralhazard traveled in the 1960s and 1970s to economics and on to the other social sciences.En route, it was refined, stripped of its moral overtones,2 and applied to a wide varietyof empirical problems in areas other than insurance. In essence, moral hazard came tobe understood as an incentive problem that arises because of common features of sociallife, such as information asymmetries (where one party to a contract has informationthe other lacks), and common social arrangements, such as agency relationships (whereone party, a principal, arranges for a second, an agent, to act on his or her behalf). Toput it in more ordinary language, people (and collective actors) cheat, shirk, and gamethe system, and they do this in a wide variety of social situations.

The early work by insurers had conceived moral hazard only as a problem ofpolicyholder behavior. However, when social scientists finally brought the now morefully theorized concept back to the insurance industry, they examined both policyhold-ers (as the earlier literature had) and insurers (whose behavior the earlier insuranceliterature had ignored) (Baker 1996; Ericson, Barry, and Doyle 2000; Heimer 2003).The new research found that, given how insurance contracts are structured, moralhazard was almost certainly a bigger problem among insurers than among policyholders.This discovery should not surprise us since insurers bring vastly greater resources to thetable and have all the advantages of repeat players discussed by Galanter (1974).Indeed, as Baker (2010, 445) puts it, they are “massively repeat players.” Massivelyrepeat players certainly have the time, resources, and motivation to game the systemand to use neutral terms and fine print to disguise the ways they have structured thesystem to their advantage. Individual auto policyholders may be less likely to lock theircars, as I argued above, but insurance companies control most features of insurancearrangements and policyholders are often chagrined when they learn what the arcaneterms in their contracts actually mean, how deductibles work, what documentation isrequired to receive a reimbursement, and how the magnitude of a reimbursement isdetermined. Often, both parties suspect that they have been had. However, even themore fully theorized and more even-handed literature on moral hazard continues toignore the broader social context in which both insurer and policyholder moral hazardare part of a larger regulatory story.

2. Insurers in fact distinguish between “moral hazard,” which is conceived as a matter of poorcharacter, and “morale hazard,” which is more about situations that tempt policyholders into dishonesty.(On the relation between these two aspects of moral hazard, see generally Heimer 1985; Baker 1996.) Socialscientists do not distinguish between moral and morale hazard. However, their emphasis on situationallybased changes in incentives is closer in spirit to morale than moral hazard. However, especially in econo-mists’ formulations, the moral overtones have largely disappeared with the adoption of the neutral languageof risk shifting.


D&O INSURANCE—THEORY AND PRACTICE

Directors’ and officers’ (D&O) insurance is liability insurance that protects thedirectors and officers of a company and the company itself when shareholders bring suitsagainst directors and officers for alleged wrongful acts or misconduct. Ensuring CorporateMisconduct introduces readers to the encounter between two groups of massively repeatplayers—the directors, officers, and corporate entities, who are the policyholderscovered by D&O insurance, and the D&O insurers themselves. D&O insurance coversthe whole panoply of costs—defense costs as well as settlements in civil, administrative,and criminal cases. D&O insurance, in Baker and Griffith’s estimation, “producessignificantly greater moral hazard than more traditional property and liability insur-ance” (18). But the devil is in the details here and depending on exactly how thecontracts are arranged, what insurers do during the life of a policy, and how claimsdepartments handle policyholder requests for reimbursements, D&O insurance mightwork to encourage good behavior or support bad behavior by the leaders of companies.This is precisely Baker and Griffith’s question: On balance, does D&O insurancesupport or undermine shareholder attempts to control directors and managers throughlitigation? With savvy players on all sides, it is hardly obvious how things will turn outand this is what makes Baker and Griffith’s empirical investigation so very valuable. Bylucidly spelling out the arcane details of D&O insurance and interviewing key partici-pants,3 Baker and Griffith help readers understand what transpires in an exalted buthidden corner of the business world. Considerable patience, diplomacy, and skepticismwere surely required to sort through the myriad details of insurance arrangements, to getrespondents to talk so forthrightly, and to make the materials speak to each other. Thisimportant book helps us understand yet another piece of the puzzle of the 2008 financialcrisis by clarifying why it has become so hard for shareholders to hold corporate leadersaccountable.

Baker and Griffith’s answer to their own question, nicely summarized in the titleand supported in the astonishingly candid assessments by the insurers themselves, isthat D&O insurance, rather than discouraging bad behavior by officers and directors ofcorporations, “ensures” that corporate misconduct will occur. Most of the costs of mostkinds of misbehavior are covered by D&O. The exception—at least in theory—is fraud.Yet the fraud exclusion is crafted and interpreted so narrowly that it applies “only in theevent of final adjudication of actual fraud” (186), which is exceedingly rare. In practice,then, reimbursements are not limited to the costs of “misjudgments” or “honest mis-takes.” The words of one claims department head make this point crystal clear: “Youknow, the ultimate paradox of this product is that we insure securities fraud. But fraudis uninsurable under this policy or anybody else’s policy” (186). The words of anotherhead of claims show that there is no ambiguity about the purpose of these insurancearrangements: “Willful violations of the law are not covered. But at the end of the day,that is exactly what they are buying the policy for” (188, emphasis in original).

3. Baker and Griffith gathered data by participating in industry conferences and conducting semis-tructured interviews with a nonrandom sample of over a hundred people working in D&O insurance,including underwriters, claims managers, lawyers (representing a variety of parties), brokers, risk managers,and specialists in assessing damages and settling claims.


Despite the baldness of those assessments, it is anything but simple to explainhow is it possible to have a practice that accomplishes something so at odds with itsannounced purpose. In explaining why and how D&O insurance does not andperhaps cannot work the way it is supposed to, Baker and Griffith follow the vener-able path forged by previous insurance scholars who conducted law-on-the-books/law-in-action type of analyses of insurance. According to insurance theory, insurers shouldgather data on the risks they are covering and set premiums in accordance with themagnitude of the risks. If premiums vary with risk, the theory goes, then policyholdersshould reduce risk to obtain lower premiums. Insurers should also check episodicallyto make sure their policyholders are doing what they can to reduce risk. These checksgive insurers a chance to pressure policyholders to behave well and also provide earlyinformation that something is amiss. Policies should be structured so that policyhold-ers are unable to recoup all their losses. Policyholders need to have some skin in thegame so that they will always have a reason to be careful. Of course, insurance onlycovers monetary losses, so policyholders will always have some stake in the outcome(reputation, goodwill, time, and trouble), but insurers usually insist that they alsoshare monetary losses through deductibles. The details of how these principles areapplied vary from one line of insurance to another—periodic inspections in fire insur-ance, “sue and labor” clauses (requiring policyholders to do what they can to mini-mize losses when accidents occur) and inspections by certification societies in marineinsurance, deductibles in most lines of insurance. For instance, a typical insuredhomeowner would not truly be “made whole” after a burglary because he or she wouldlose the deductible, be unable to replace fully unique objects or objects with senti-mental value, and have to do the work of documenting losses, filing forms, andworking with the adjuster.

In D&O insurance, the gap between theory and practice is particularly large.Despite the rhetoric, none of the interviewees seemed to believe that making D&Oinsurance premiums commensurate with risk had any substantial deterrent effect.Insurers did report trying to avoid insuring executives “whose appetite for risk exceedsthe norm” (like the chief financial officer of one manufacturing company whodemurred that it was only a small aquifer he had polluted) (93). And they did reportbasic algorithms and systems of credits and debits used to adjust price to risk. But theydid not believe that the difference in the size of premiums charged to “good” and“bad” companies was sufficiently large to send a signal and, in any case, because thepremiums were dwarfed by overall corporate budgets, no one thought they receivedmuch attention. As one underwriter put it, “however high D&O premiums climb,they are not going to climb high enough to get the companies to really, really payattention” (102). Insurers do not in fact require that policyholders adopt any par-ticular governance practices as a condition of insurance and they do not do muchmonitoring of their clients once the contract is signed. Business executives apparentlydo not welcome any restrictions on their freedom to manage as they see fit and do notwant anything in the files suggesting that insurers advised them to adopt particularloss-preventing practices. These preferences are mostly honored by D&O insurersbecause of pressure to generate premiums in a highly competitive environment (99).Provisions for sharing losses are supposed to mean that the corporation and its direc-tors and officers share the loss rather than shifting all of it to the insurer. However,


looking at publicly available information on how much of settlements was contrib-uted by the defendant corporation, Baker and Griffith concluded that “the risk trans-fer from the insured to the insurer is not quite complete, but it is very nearly so”(10–11), and that surely means that the share of the executives and board memberswas even smaller. Moreover, because the losses in question are almost entirely mon-etary, there is very little nonmonetary cost that remains with the policyholder.4 D&Oinsurance is thus 0 for 3 on deterrence.

But the deterrence problem is actually grimmer still and here we need to turnagain to insurance theory. In early thinking about insurance, some risks were consid-ered insurable while others were not. In particular, insurance was not believed to bean appropriate mechanism for managing risks that were directly controlled by poli-cyholders. It was for this reason that insurers distinguished between fidelity and suretybonds (covering honesty and performance, respectively) and insurance. Insurersbelieved that it was counter to public policy and a bad business practice to offerinsurance to cover the dishonesty of employees, for instance, because employee theftwas under human control and insurance-related changes in incentives would there-fore be especially likely to increase losses. Employers whose workers were covered byfidelity bonds might be less careful in screening and monitoring employees andemployees might believe that their dishonesty would do no serious harm because theemployer would be made whole by the insurer. As demand for fidelity and suretybonds grew, insurers dealt with their reservations about this form of insurance byarguing that fidelity and surety bonds should be treated as loans, to be repaid bypolicyholders once they put their affairs in order.

Gradually, insurers came to believe that it was possible to offer insurance foremployee theft (and similar causes of loss) as long as there was some distance betweenthe person purchasing the insurance and the person whose actions might be covered bythe insurance. The reactivity of risk varies with distance, so a normally reactive risk(i.e., one in which some person controls the loss-causing event) sometimes can betreated as if it were nonreactive (Heimer 1985). People at the bottom of organizationsare unlikely to be privy to the details about insurance arrangements to protect theiremployer from the effects of their bad behavior and certainly do not benefit directlyfrom such insurance. But insurers seem to have stepped onto a slippery slope as theycreated new product lines. D&O insurance essentially ignores that relation betweendistance and reactivity, offering insurance coverage for acts that are largely controllableand are in fact under the control of the very people who will benefit from the insurancearrangements that they know are in place to protect them. It can’t get much worse thanthis. Interestingly, although Baker and Griffith’s informants do talk about whether theycan successfully deter irresponsible or dishonest behavior by officers and directors, theydo not even broach the larger policy question of whether the risks covered by D&Oinsurance are insurable by the original criteria (about not offering insurance for acts thatare partly or fully under policyholder control).

4. In contrast to other property or liability insurance (such as for automobile accidents, fire, or theft),where the insured party may have uncompensated (emotional or other) losses, it is generally believed thatD&O insurance comes very close to compensating all losses.


MORAL HAZARD REDUX—INSURER INCENTIVESIN D&O INSURANCE

From a societal perspective, a second big moral hazard problem in D&O insuranceis that insurers are paid even though they are not doing their job. In fact, they are paideven though the insurance they offer increases the likelihood that corporate executiveswill misbehave in ways that harm the rest of us. To put it bluntly, corporations usemoney entrusted to them by shareholders to pay insurers to reimburse them when theybehave stupidly or dishonestly. Although this sometimes violates the law,5 by skillfulcrafting of contracts and careful silence to avoid any acknowledgment that mistakeshave been made or laws broken, the actions of corporations, executives, and directorsend up being just barely technically legal. But although they manage to be technicallylegal, without a doubt they violate the spirit of the law. Why exactly do insurers do this?

Insurance is a lucrative business. What makes it lucrative is often not insurers’ skillat predicting and controlling losses, but their skill in generating premiums and ininvesting those premiums. Insurance profits are investment profits, not underwritingprofits.6 Insurers are thus under pressure to generate premiums, which in turn inducesthem to cut corners on assessing risk. Underwriters are rewarded for generating a lot ofpremium income in the short run, and punished much less for having a record of poorjudgment that only shows up much later in losses. Lawyers on both sides of shareholderlitigation cases confirmed the importance of investment income, noting that this meantthat insurers were eager to set internal reserves high (so they would have a lot to invest)and to delay payouts on claims as long as possible (to give investment income more timeto grow). It should go without saying that this will happen more when interest rates arehigh than when they are low.7 This matters because it means that despite the rhetoricto the contrary, insurers do not have a great deal of concern about reducing losses. Asone defense lawyer commented, insurers “can have a very high payout ratio and be veryprofitable [because of their investments]” (137, insertion in original). Reducing insur-ance losses would mean that premiums could be lower, but that in turn would mean lesspremium income to invest while insurers waited to reimburse losses.

This situation also depends on an alignment of policyholder and insurer incen-tives. Insurers want high premiums and policyholders are not very sensitive to variationsin premium. This alignment has not occurred, though, in lines of insurance where

5. In most states, indemnification for settlements and judgments in “derivative suits” is not allowed(43). Derivative suits are those in which defendants (usually the directors and officers) have harmed thecorporation and therefore, “derivatively,” the shareholders. Settlements are paid by defendant directors andofficers to the corporation, but corporations often have agreed to reimburse (indemnify) directors and officersfor such payments—“pocket shifting in extreme,” Baker and Griffith conclude (43). Yet although commen-tators argued that insurers could not legally offer insurance coverage for legally prohibited payments (43),states often expressly allowed corporations to carry insurance to reimburse them for the very payments theyhad prohibited (44).

6. Insurance underwriters assess the risks associated with particular potential policyholders and makedecisions about whether and how much insurance coverage to offer them and at what price. If underwritersdo their job well, then the premiums should more than cover losses, leaving some “underwriting profit.”

7. Baker and Griffith found data suggesting that investment returns varied between 11 percent and 28percent (136). (This is aggregated information for the category “other liability insurance”; information forD&O alone is not available.)


policyholders care more about the size of their premiums. For instance, it was becauseof insurers’ reluctance to reward loss-prevention programs with lowered premiums thatpolicyholders themselves banded together to form the Factory Mutuals, a group ofpolicyholder-owned fire insurance companies that did worry about reducing fires and firelosses (Schneiberg 2002; Heimer 1985).

The main point here is that insurance is as much or more an investment businessas it is a risk-management or risk-reduction business. As long as insurers and theiremployees are making a good living, they may favor the business of making a living overthe business of managing risks. Once again, insurers’ own concepts work well to analyzetheir behavior. If the earth rests on a plate on the back of a turtle and then it is “turtlesall the way down,” it seems that insurance rests on some contractual provisions that reston moral hazard and then it is “moral hazard all the way down.”

D&O INSURERS AS (FAILED) COREGULATORSOF CORPORATIONS

There is really no big mystery, I believe, about why insurers and policyholders likeD&O insurance. Policyholders (executives, board members, and the corporations them-selves) are protected from the financial consequences of most legal actions againstthem, whether those suits are frivolous or serious, whether they arise from malfeasanceor honest disagreements, and whether decisions look foolish from the outset or onlywith the more complete information of hindsight. And they obtain the benefit of thisinsurance coverage with very little insurer interference in company governance. Theinsurers receive premium income and profits from investing that income. And as longas interest rates are reasonably high, they can make a good living without having to betoo careful about underwriting and certainly without having to monitor their clients.Lawyers for both sides should also like this insurance since they get substantial fees forworking out the settlements either in court or before a trial occurs.

The only remaining question, then, is why the rest of us put up with this. Thetheory here is that all sorts of “stakeholders”—stockholders, customers, suppliers,employees, creditors, and the society at large—should favor this insurance because itallows companies to attract well-qualified leaders who would otherwise be unwilling totake these leadership positions because their personal assets could be at risk in share-holder suits. But for “us,” the insurance comes with more costs. First, insofar as premi-ums are paid by the corporations, they really are a cost to stockholders. But moreimportantly, it is by no means clear that the (unquantifiable) benefit of a larger pool ofcandidates for executive positions is balanced by the very significant moral hazardproblem created by this type of insurance. It is by no means clear that we wantexecutives to feel free to take inappropriate risks with stockholders’ resources.

Although Baker and Griffith offer strong evidence on how D&O insurance encour-ages corporate misconduct, what we still lack is some sense of how D&O insurance fitsinto the regulatory landscape. By focusing their gaze on the relationship betweeninsurance and shareholder litigation, they unfortunately overlook other elements of theregulatory landscape. A broader focus and a more robust sociology of regulation suggestthat what we are seeing in D&O insurance is no longer really insurance but, instead,


one part of a regulatory veneer. That veneer is just thick enough to be convincing andto make it difficult for anyone to charge that regulatory reform is needed.

The D&O insurance veneer bears a family resemblance to the “fantasy risk man-agement” described by Clarke (1999). Using a host of chilling examples (preparationsfor oil spills or nuclear accidents), Clarke (1999) walks us through the process by whichkey risks are identified, solutions are proposed and rehearsed, often with best-case ratherthan worst-case scenarios, and then accepted. D&O insurance and fantasy risk-management programs share a shallow approach to investigating the magnitude of riskand an equally superficial attempt to reduce risk. Both aim for an illusion of safety thatlulls us into allowing risky operations to proceed. Nuclear power plants can be allowedto operate because they have a plan for evacuation should an accident occur—thoughit is rather alarming that their model for the evacuation is the relative orderliness of anormal rush hour. D&O insurance encourages us not to worry too much about whatexecutives are up to because, of course, the insurers would not sell them insurancepolicies if they were taking inappropriate risks. Those who are not “lulled” becomeprogressively less able to warn us of dangers because “studies” have been done andrisk-management programs put in place. No one is able to regulate the regulators, toensure that they are doing their job.

Unless risks are assessed and managed in such a way as to decrease the likelihoodof corporate misconduct, insurance is, as Baker and Griffith argue, mere “pocket shift-ing.” (The phrase’s overtones appropriately call up images of a shell game played inbusiness attire rather than on the street.) We the public are in fact often duped by thispocket shifting. We believe that our interests are allied with those of the insurers—elsehow could they make a living?—and so we believe that our investments are safer whencorporations are able to buy D&O insurance. That they are able to make the purchasesuggests to us that someone is tending the store and that the officers, directors, and eventhe corporate entity have been examined and found to be sound.

We already knew, then, that organizations employ the rhetorical tools of riskanalysis and risk management to convince others that all is well. Through thesesymbolic moves, risks are made acceptable—or at least sufficiently acceptable to allowpower plants to be built, oil to be transported in tankers, and so forth. What new do welearn from Baker and Griffith? We learn, first, about the pervasiveness of superficial riskmanagement and, once again, that this symbolic management of risk tends to benefitthose in positions of power and wealth. It is not, after all, the people whose pensions arelost when markets crash who are protected by D&O insurance, just as it is not thosewhose livelihood from fishing was lost by the oil spill in Prince William Sound whogained by permitting oil shipping to proceed on the strength of false claims about theefficacy of clean-up operations.

Equally importantly, this book allows us to see how much regulatory failuredepends on entirely mundane social processes of moral hazard coupled with nondeci-sion. Although the players may be rather high in the world of business, what we see israther ordinary: people so preoccupied with doing their jobs that they only rarely reflecton what they are accomplishing. It is not, then, that insurers have decided that it isacceptable to support corporate misconduct. Rather, it is that the actions that end upsupporting corporate misconduct have become entirely routine. Selling insurance onthe terms that have been in place for some time or on marginally modified terms is the


nondecision. Selling insurance on radically modified terms—terms that more closelymatch insurance theory by setting prices commensurate with risk and by monitoringpolicyholder behavior—is what would require deliberation and a conscious decision.The pressures all push in one direction because the people able to exert pressure orshape contract conditions are those who are covered by the insurance or who profit fromselling it. No one else has a regular place at the table, though from Baker and Griffith’saccount it seems that no one is spending much time at the table in any case.

The world of D&O insurance therefore also resembles the world of the Challengeraccident, so ably described by Diane Vaughan (1996). Insurance surely contains fewerchecks than are present in preparations for space shuttle flights and somewhat lessfiltering out of information because there is no single event to which all insurer actionsare oriented. Where the resemblance is strong, though, is in the modifications ofdefinitions of “normal” in a highly technical world where outsiders will lack theexpertise and credibility to note and challenge such shifts. After all, two very smartscholars had to go to a lot of trouble to be able to tell us how, why, and by whatmechanism it became “normal” for D&O insurance to offer insurance coverage forfraud.

The complexity of this system should also remind us of Perrow’s influential NormalAccidents ([1984] 1999). Perrow argues that in complex, highly interdependent systems,accidents should be expected—they are normally occurring events. The solution, hesuggests, is to reduce complexity. In the world of D&O insurance, we are not mostlytalking about “accidents” (hence the question about whether insurance is really possiblein this field), but we are talking about an interdependent system where that interde-pendence increases the likelihood of loss. Moreover, my guess would be that thecomplexity of the system probably has more effect on the growth of risk when it isbehavioral (rather than physical) risk that is causing the losses. Although other kindsof risk may be magnified by the complexity and interdependence of systems, they are notso deeply affected by the tendency of human actors to take advantage of opportunitiesthat complex systems offer to cover their tracks and to feign innocence.

A final piece of the context in which we should read Baker and Griffith comes fromBaker himself. Baker (2010) argues that insurance (and particularly liability insurance)and civil justice (essentially tort law) codefine each other. This is particularly true whenwe look at law and insurance in action rather than law and insurance on the books.Insurance and civil law complement each other, with some tasks, such as monitoring,handled better by insurance, and others, such as an insistence on insurance coverage asa condition of participating in key activities, handled better by law. One importantbenefit of insurance, Baker astutely notes, is that it matches a repeat player (the insurer)with every tort defendant. Although this need not be the case, in fact the likelihood ofa suit depends heavily on whether the defendant has insurance coverage, since manydefendants will otherwise not be worth pursuing. In this arrangement, day-to-daygovernance is mostly delegated to insurers. In some circumstances, this would be afelicitous arrangement. What’s not to like about making sure every defendant has arepeat player by his or her side in a tort case? What’s not to like about having a morenimble body than the government to monitor policyholders and exert some pressure onthose who are not avoiding risks? Unfortunately, the answer is that there is somethingnot to like. When repeat players side with other repeat players against the interests of


other stakeholders, power differences are magnified rather than mitigated. When insur-ers engage in “fantasy risk management” rather than actual underwriting and monitor-ing, we are lulled into thinking that our corporations are in safe hands. Under thesecircumstances, the delegation of regulation to private bodies means the subversion ofregulation and shared governance becomes failed governance, with the layers ofcomplexity making it all the harder to fix.

We owe a huge debt to Baker and Griffith for pulling the wool from our eyes. Butit behooves us to use what we have learned to reconstruct our understanding of keyregulatory institutions and the complex relations among them.

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