Academic journal article Journal of Risk and Insurance

The Liquidity Demand for Corporate Property Insurance

Academic journal article Journal of Risk and Insurance

The Liquidity Demand for Corporate Property Insurance

Article excerpt

ABSTRACT

This article suggests that liquidity may be an important reason for a corporation to purchase property insurance. A model of a risk-neutral producer facing an endogenously determined risk of property damage under an output contract that penalizes underproduction is formulated to exemplify such a real need of liquidity. Under the output contract, the producer may purchase full unfavorable property insurance even when postloss financing is available. Surprisingly, the conclusion may still hold when the cost of postloss financing equals that of long-term capital, provided that the rate of underproduction penalty is sufficiently high. Similar conclusions apply when postloss financing is replaced by planned internal reserve (self-insurance) that may be invested in the short run at an interest rate that is lower than the long-term cost of capital. When the capital market is perfect, however, the holding of planned internal reserve eliminates the purchase of actuarially unfavorable property insurance.

INTRODUCTION

According to Mayers and Smith (1982), shareholders can eliminate insurable risk through diversification so that corporations have no real need for purchasing actuarially unfavorable property insurance. Various authors have provided plausible explanations for optimal corporate insurance purchase with risk-neutral shareholders. Mayers and Smith (1982) and MacMinn (1987) suggest that a widely held corporation may purchase insurance to avoid the costs of bankruptcy. Mayers and Smith (1982) and Main (1983a, 1983b) argue that there are tax incentives for purchasing corporate insurance. Mayers and Smith (1982, 1987), Schnabel and Roumi (1989), and Garven and MacMinn (1993) suggest that property insurance is often required under a bond covenant. Mayers and Smith (1982) argue that insurance companies have high real-service efficiency in handling liability claims. Hoyt and Khang (2000) suggest that insurers have economies of scale in designing and implementing loss prevention techniques. Mayers and Smith (1982) and Han (1996) argue that profit-sharing devices, such as stock options, provided to risk-averse CEOs to resolve potential principal-agent problems may induce the CEOs to purchase corporate insurance to protect their own interests. Finally, Grace and Rebello (1993) show that in the presence of private information on a company's cash flow and insurable losses, corporate insurance purchase can be optimal when high operating revenue is accompanied by a high insurable risk. Unfortunately, some of these explanations, though theoretically appealing, are not fully supported by simulations and empirical evidence. (1)

Recently, some authors have pointed out the similarities between insurance and other capital funding methods as liquidity provision devices. For instance, Doherty (2000) has advocated the "integrated risk management approach" under which insurance may be considered as an alternative source of short-term capital supplementing preloss and postloss debt financing arrangements for replacing damaged property. Bernstein (2000, p. 25) argues interestingly from a practitioner's point of view that insurance companies provide liquidity to decisions, assets, and outcomes that are inherently irreversible and beyond control that can have harmful consequences to their policyholders. Despite the importance of insurance for providing liquidity, no theoretical model is found in the literature to illustrate the nature of the liquidity demand for corporate insurance and how corporate insurance interacts with other alternatives to finance property damage.

The main purpose of this article is to introduce a new theoretical framework for explaining the purchase of actuarially fair or even unfavorable corporate property insurance by a risk-neutral company. This explanation is based on the fact that property insurance provides additional liquidity to a company that needs to replace damaged property to restore its productivity in order to fulfill maturing output contracts. …

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