Professional liability insurance contracts for auditors: differential pricing and the audit quality effect

In recent years, the Chinese government and the public accounting profession have advocated the audit practitioners’ use of professional liability insurance (PLI). As a tool to divert audit firms’ business risk, PLI contracts could decrease auditors’ diligence in conducting audits, which might harm audit quality. Insurance companies might perceive the transfer of audit risks, thus having an incentive to monitor risky audit firms to mitigate potential economic losses related to audit failures. We use proprietary PLI contract data and find that insurance companies charge smaller audit firms a significantly higher price and show a lower tendency to offer favourable indemnity clauses. The difference-in-differences analysis reveals that the magnitude of audit adjustments significantly increases after small audit firms purchase PLI and the effect is dominated by income-decreasing audit adjustments. Our evidence supports the notion that insurance contracts play a governance role for audit intermediaries with a higher risk profile.