Academic journal article Journal of Risk and Insurance

On the Corporate Demand for Insurance: The Case of Korean Nonfinancial Firms

Academic journal article Journal of Risk and Insurance

On the Corporate Demand for Insurance: The Case of Korean Nonfinancial Firms

Article excerpt

ABSTRACT

Several theories have been developed to explain the motives for corporate insurance purchases, but there are few empirical tests of these theories. Furthermore, the empirical results are not consistent across studies, suggesting the need for further research. This study uses accounting data for 433 publicly listed nonfinancial firms in Korea to test the determinants of insurance demand for the period 1990 through 2001. Our results support the theory that firm size, tax considerations, and firm ownership are important determinants of insurance demand. Firms that are members of chaebols demand more insurance than unaffiliated firms, all else equal. Contrary to theory, our results also indicate that firms that have higher debt-to-equity ratios demand less insurance than less leveraged firms, and that firms that have greater liquidity demand more insurance. This might be related to the overall high debt levels of firms in the period leading up to the Korean financial crisis in 1997, but that investigation is beyond the scope of this study.

INTRODUCTION

Risk aversion as a motive for the purchase of insurance by individuals is well supported. However, the motive for the purchase of insurance by large, publicly traded corporations is less well understood. Mayers and Smith (1982) and Main (1983) argue that since individual shareholders can diversify firm-specific insurable risk by holding a portfolio of stocks, insurance does not increase the value of the firm because insurance premiums contain loading factors. Thus, even though they might be risk averse as individuals, well-diversified shareholders would not choose to reduce their wealth by authorizing the firm to purchase insurance against its own idiosyncratic risk. Contrary to this theoretical prediction, however, evidence indicates that corporations purchase substantial amounts of insurance. For example, commercial property and liability insurance in the U.S. market accounts for just over 50 percent of the approximately $350 billion in insurance premiums collected in 2002 (Hartwig, 2003).

Several theories have emerged to explain this seemingly irrational behavior. One argument is that convexity in the tax code encourages insurance purchases as a way to decrease expected tax liabilities (see, e.g., Main, 1982,1983; Mayers and Smith, 1982). Mayers and Smith (1982) also argue that insurance allows firms to reduce expected bankruptcy costs by shifting the cost of high-severity events to an insurer. In addition, regulators might require the purchase of some forms of insurance, such as workers compensation insurance in the U.S. market. Furthermore, insurers provide services such as claims settlement and safety recommendations that might be valuable to the firm.

Agency theory provides additional reasons for the corporate purchase of insurance. Myers (1977) argues that shareholders might forego potentially profitable investments if the benefits accrue to bondholders. In this case, insurance can be used to bond investment decisions (see, e.g., Smith, 1986; MacMinn, 1987; Mayers and Smith, 1987; Schnabel and Rouimi, 1989; Garven and MacMinn, 1993). Han (1996) examines the link between optimal managerial compensation contracts and the purchase of insurance when managers are risk averse. Insurance can signal reliability (Main, 1982; Grace and Rebello, 1993) and act as a monitor of firm quality for the firm's shareholders and trading partners. However, a firm with a greater degree of institutional ownership might rely less on insurance to act as a monitor of bankruptcy potential, since the institutional investors may have a comparative advantage in monitoring. The ownership structure of the firm can also influence the purchase of insurance. A closely held firm may be more likely to purchase insurance than a widely held one, since its owners may be less well diversified.

Empirical tests of these theories are scarce owing to the difficulty in gathering information on corporate insurance purchases, especially for U. …

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