A proposed corporate governance reform: Financial statements insurance

The inherent conflicts of interest in the auditor–client relationship and the unobservability of financial statement quality are likely culprits in the recent corporate scandals such as Enron and WorldCom. The solution proposed here is a financial statement insurance (FSI) mechanism. Instead of appointing and paying auditors, companies would purchase financial statement insurance that provides coverage to investors against losses suffered as a result of misrepresentation in the financial reports. The coverage and the premiums would be publicized. The insurance carriers then would appoint and pay the auditors. Those 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 would reveal themselves as having lower quality financial statements. Every company would be eager to get higher coverage and pay smaller premiums, lest it be identified as the latter. By transferring the hiring decision to the insurer, this scheme eliminates the auditor's inherent conflict of interest. The publicization of the coverage and the premium credibly signals the quality of the insured's financial statements and direct investments towards better projects. At the same time, the ability to signal the quality of financial statements provides companies with incentives to improve them. Thus, FSI will result in fewer misrepresentations and, accordingly, in fewer suits and smaller shareholders’ losses, as well as a more efficient allocation of resources.