Academic journal article Journal of Risk and Insurance

Insurance, Bond Covenants, and Under- or Over-Investment with Risky Asset Reconstitution

Academic journal article Journal of Risk and Insurance

Insurance, Bond Covenants, and Under- or Over-Investment with Risky Asset Reconstitution

Article excerpt

ABSTRACT

Traditional theory predicts that the shareholders of a limited liability company financed partly by bonds may underinvest by not replacing damaged company assets. It also precludes the possibility of overinvestment. By relaxing the restrictive assumption maintained under traditional theory, namely, that the effects of reconstituting damaged assets are nonstochastic, this article shows that both over and underinvestment are possible. It is shown that these moral hazard problems can be mitigated by incorporating appropriate insurance requirements into bond covenants. Moreover, it is shown that the insurance requirements for alleviating underinvestment and overinvestment are quite different. Particularly, for underinvestment, the required insurance only needs to make the bonds riskless in the best asset reconstitution states of the loss states in which the company value falls short of the promised bond repayment; however, for overinvestment, the required insurance should make the bonds totally riskless. The difference in insurance requirements is especially important when insurance is actuarially unfavorable such that more-than-required insurance is always undesirable.

INTRODUCTION

It is well known in the finance and economics literature that the presence of asymmetric information between stockholders and bondholders may lead to suboptimal corporate investment decisions. Two common examples are the asset substitution problem and the underinvestment problem introduced by Jensen and Meckling (1976) and Myers (1977). The seminal article of Mayers and Smith (1987) shows that the underinvestment problem may also occur in the case of reconstitution of damaged corporate assets. Risk-neutral shareholders, who have no precommitment to reconstituting damaged corporate assets, may choose not to replace lost assets in the states of nature in which the value of the company after asset reconstitution is raised but falls short of the bond repayment amount. To illustrate the underinvestment problem, Mayers and Smith (1987) assume that asset reconstitution raises company value and is riskless. Mayers and Smith (1987), Schnabel and Roumi (1989), and Garven and MacMinn (1993) propose that to mitigate the underinvestment problem, a bond covenant should be imposed, specifying that sufficient property insurance is purchased to make the bonds riskless and to prevent the shareholders from taking advantage of the limited liability provision by underinvesting in the states with large property losses. (1)

Recently, some authors (e.g., De Meza and Webb, 1987; Berkovitch and Kim, 1990; Stulz, 1990; Harris and Raviv, 1996; Chung, 1998; Noe et al., 2002; Sigouin, 2003) suggest various reasons that overinvestment may also occur. For example, Berkovich and Kim (1990) suggest that if shareholders are allowed to issue nonsubordinated debt, then the relatively low cost of borrowing may create incentive for excessive investment. Noe et al. (2002) show that in international cooperative ventures, overinvestment occurs when the multinational's bargaining advantage is reinforced by an informational advantage. A natural question that one may ask is whether it is possible that shareholders may overinvest when deciding if damaged assets should be replaced. Under Mayers and Smith's (1987) riskless asset reconstitution assumption, overinvestment will never occur, because any asset reconstitution that reduces company value below the promised bond repayment amount also reduces shareholders' wealth with certainty. What if asset reconstitution is risky?

In reality, there are reasons why reconstituting damaged assets may not always raise the value of a company and may even be risky. For instance, the cost of raising immediate liquidity to finance asset reconstitution may exceed its benefit given imperfect short-term capital markets. Unless there are prearranged contingency loans (which are likely to be insufficient in the case of large property damage), the liquidity needed for asset reconstitution often has to be extracted from other important operations or production activities. …

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