Academic journal article Journal of Risk and Insurance

An Empirical Investigation of the Japanese Corporate Demand for Insurance

Academic journal article Journal of Risk and Insurance

An Empirical Investigation of the Japanese Corporate Demand for Insurance

Article excerpt

INTRODUCTION

In Japan, as well as in the United States, corporations commonly purchase insurance contracts. For example, in 1994, Japanese non-financial incorporated enterprises as a whole paid [yen]1.3 trillion for non-life insurance premiums, which was equivalent to 2.3 percent of their total operating surplus ([yen]5 trillion).[1, 2] At first glance, the reasons why corporations purchase such significant amounts of insurance seem clear. Many people used to believe that corporate purchases of insurance protect stockholders against the risk of loss. However, modem financial theory has argued that investors can hedge against insurable risks through diversification. That is, while the importance of risk aversion in an individual's demand for insurance is obvious, the importance of risk aversion in the corporate demand for insurance is less obvious (Main, 1983; Mayers and Smith, 1987, 1990; and MacMinn, 1987). Therefore, it is necessary to find other reasons why corporations purchase significant amounts of insurance.

As previous studies have shown, each stockholder may have a diverse portfolio in order to offset firm-specific risks (i.e., the unsystematic risks in the terminology of finance theory). Therefore, if capital markets are perfect according to Modigliani and Miller's definition, there is no difference between purchasing insurance and purchasing a portfolio of securities. That is, corporate insurance is irrelevant.

Because many corporations do demand insurance, theories that can analyze corporate demand for insurance are necessary. In fact, previous studies show that once several market imperfections are introduced into a theoretical model, the corporate demand for insurance can be derived (e.g., Smith, 1986; Mayers and Smith, 1987; MacMinn and Han, 1990; and Han, 1996). For example, Grace and Rebello (1993) found that if firms suffered from the asymmetric information problem, they would demand insurance because the possession of insurance may be perceived as an indication of reliability. MacMinn (1987) incorporated costly bankruptcy and agency problems between corporate management and bondholders into a standard model. He found that the corporations purchase insurance to eliminate or reduce bankruptcy costs and agency costs. Skogh (1989) demonstrated that insurance may be purchased because of the impossibility of complete contingent claim contracts, in other words, the existence of the transaction costs.

Smith (1986, p. 704), among others, surveyed the theoretical studies and concluded that corporate insurance purchases will depend on the following factors. First, the corporate purchase will be greater if the company is closely held. As aforementioned, the owners of large, widely-held corporations, who can eliminate insurable risks by holding portfolios of securities, will find no need for the corporations to purchase insurance. On the other hand, if the owners of the closely held corporations are risk averse, they may ask the corporations to purchase the insurance contract to protect against the risk of loss.

Second, the corporate purchase will be greater if uninsured losses are likely to move the corporation into lower tax brackets. The progressive tax schedule allows corporations to raise their after-tax expected net cash flows by purchasing insurance. Thus, the corporations will purchase insurance to reduce the volatility of the taxable income, which in turn reduces the expected taxes.

Third, the corporate purchase will be greater if leverage in the firm's capital structure is high. For firms facing some degree of financial distress, the interests of bondholders and stockholders can diverge, and some actions that benefit stockholders will reduce the wealth of bondholders. Because the potential lenders anticipate the conflict of interests, they require higher interest rates or more restrictive covenants. Purchasing insurance eliminates or reduces the conflict of interest between bondholders and stockholders. …

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