Academic journal article Journal of Risk and Insurance

On the Demand for Corporate Property Insurance

Academic journal article Journal of Risk and Insurance

On the Demand for Corporate Property Insurance

Article excerpt

ABSTRACT

Since changes in the firm-specific or unsystematic risks faced by a corporation have no effect on firm value, corporate insurance purchases might seem unwarranted. However, more than 57 percent of insurance premiums are paid by businesses. This apparent contradiction has motivated researchers to suggest factors other than simple risk reduction that create corporate incentives to purchase insurance. This article tests the practical validity of most of the analytic arguments regarding corporate demand for insurance. In general, the empirical evidence from corporate property insurance purchases is consistent with the various theoretical arguments regarding corporate demand for insurance. The results suggest insurance helps to reduce various agency costs associated with stakeholder conflicts, provides real services, and reduces taxes. Finally, the less risky nature of regulated industries compared with unregulated industries is believed to lessen the various corporate incentives to purchase property insurance.

INTRODUCTION

This article tests the determinants of property insurance purchasing behavior of publicly traded corporations. Recognizing that risk aversion in an in adequate explanation for the insurance purchasing behavior of corporations, some authors (e.g., Main, 1982 and 1983; Mayers and Smith, 1982 and 1987; and Skogh, 1989) have sought to develop a positive theory of corporate insurance purchasing behavior. These studies argue that corporate insurance purchases are driven by (I)the under investment problem (interest conflicts between shareholders and debt holders); (ii) interest conflicts between owners and managers; (iii) the comparative advantage of insurers in providing risk-related services (also known as real services), such as claims handling or loss prevention); (iv) effects of the firm's expected tax liability; (v) the existence of bankruptcy costs; and (vi) the regulatory status of the firm. Smith and Sultz (1985) and Shapiro and Titman (1985) have extended some of these motivations to other forms of corpora te hedging.

Three prior studies (Mayers and Smith, 1990; Core, 1997; and Yamori, 1999) have tested some of these theories by using data on reinsurance purchases by U.S. property and liability insurers, directors' and officers' insurance purchases by Canadian firms, and aggregate insurance purchases by Japanese firms. However, due to differences in the data used we are able to extend these studies by testing arguments for corporate insurance demand that the prior studies either could not test (tax motivations and bondholder-shareholder conflicts) or could not consistently test (the impact of size, regulation, and growth opportunities).

The article is organized as follows: First, the hypotheses that have been advanced to explain corporate incentives for insurance purchases are presented. Second, the data used to test these hypotheses are discussed. Third, the specific variables chosen to represent these hypotheses are presented. This includes the dependent variable, which incorporates unique data on insurance purchases that are unavailable from public sources. Finally, the results are summarized and compared to the prior empirical studies of corporate insurance demand.

HYPOTHESIS DEVELOPMENT

Prior research provides several hypotheses regarding the relation between the amount of insurance purchased by a widely held firm and the firm's various operating characteristics. Each of these hypotheses is described more fully in this section.

Underinvestment Problem

The underinvestment problem arises out of conflicts between shareholders and debtholders. Myers (1977) argues that since limited liability conveys to shareholders a potentially valuable put option, shareholders of leveraged firms might find that future discretionary projects with positive net present values are actually disadvantageous to them since the project's benefits accrue to the bondholders. …

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