Academic journal article Journal of Risk and Insurance

Strategic Demand for Insurance

Academic journal article Journal of Risk and Insurance

Strategic Demand for Insurance

Article excerpt

ABSTRACT

We focus on the corporate demand for insurance under duopoly. We consider the case in which firms purchase insurance in order to enhance their competitiveness. We show that a higher level of corporate insurance makes a firm more aggressive and its competitor less aggressive in the output market (strategic effect). The optimal coverage of insurance is determined by comparing the strategic effect of insurance and the cost of insurance. The optimal coverage is positive if the strategic effect is greater than the cost of insurance. An interesting implication is that a risk-neutral firm may purchase actuarially unfair insurance. The main strategic effect of insurance comes from the fact that firms purchase insurance before they produce outputs. Insurance makes firms more aggressive due to the limited risk costs of firms.

INTRODUCTION

Explaining the demand for insurance has been a major area of research in the insurance field. Risk aversion, risk shifting, real-service provision, reduction of agency cost, and tax advantage, among others, lead individuals and organizations to purchase insurance (see below for more details). In addition, some recent papers have dealt with the effect of insurance on a firm's competitive strategies in the product market (Ashby and Diacon, 1998; Seog, 2006). (1) In a similar line of thinking, this article is also focused on the strategic demand for insurance. We consider the case in which firms purchase insurance in order to enhance their competitiveness.

Let us briefly review the related literature before discussing the main points of this article. While risk aversion has been considered the main rationale for individuals' demand for insurance since Pratt (1964) and Arrow (1971), it is not enough to explain the corporate demand for insurance, as the owners of public firms can diversify risks. Mayers and Smith (1982) provide rationales for the corporate demand for insurance, such as risk shifting, real-service provision, reduction of agency cost, and tax advantage. MacMinn (1987, 1997), Mayers and Smith (1987), Schnabel and Roumi (1989), Garven and MacMinn (1993), and MacMinn and Han (1990) suggest that insurance can reduce financial distress costs. Han (1996) shows that the corporate demand for insurance can be optimal depending on the managerial compensation scheme.

Han (1999) also shows that a firm may purchase insurance when the costs of insurance are less than the contribution of insurance to the real option value of future investment opportunity. Thakor (1982) and Grace and Rebello (1993) consider the case of asymmetric information. When a firm has private information about its cash flows, it has incentives to purchase insurance if the purchase of insurance signals the private information.

Ashby and Diacon (1998) explicitly focus on the strategic effects of insurance in the product market. In a simple 2 x 2 normal-form game structure of duopoly, they show that two firms may find it beneficial to purchase insurance as an equilibrium strategy or as a Pareto improving strategy. Seog (2006) considers an example in which purchasing insurance affects the strategic behavior of firms and individuals in the product market. Strategic consideration is the main reason for purchasing insurance in both examples.

This article resembles Ashby and Diacon (1998) in that we also consider duopoly in the Cournot-Nash game. However, we consider a more sophisticated model, in which the optimal insurance coverage and the optimal production levels are determined. This article is also related to Brander and Lewis (1986). Brander and Lewis consider the case in which higher financial leverage commits the firm to more aggressive behavior in the output market. Based on their model, we consider the case in which corporate insurance influences the firm's behavior in the output market.

We investigate the situation in which duopoly purchase insurance to cover possible losses that are affected by production activities. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.