The Underinvestment Problem, Bond Covenants and Insurance

An important yet often overlooked economic function of insurance is its role in resolving pervasive moral hazard problems that exist in credit markets. Bankruptcy statutes convey to both corporations and households liability limitations associated with borrowing money. Although such limitations provide important economic benefits, they also have their costs, the most obvious being the moral hazard associated with rewarding debtors with all of the benefits of risky activities while penalizing them with only a portion of the costs. By requiring the purchase of insurance as a loan covenant, the moral hazard problem can be mitigated. Essentially, insurance reallocates the costs and benefits of risky activities in such a way that otherwise divergent debtor-creditor incentives become realigned. As we show in the case of a corporation’s decision to purchase insurance, this result obtains irrespective of the nature of risk preferences; i.e., limited liability constitutes a sufficient condition for the existence of an insurance market, regardless of whether economic agents are risk loving, risk neutral or risk averse.

The Underinvestment Problem, Bond Covenants and Insurance“, (with Richard D. MacMinn), Journal of Risk and Insurance, Vol. 60, No. 4, December 1993, pp. 635-646. (Awarded the Journal of Risk and Insurance Outstanding Shorter Article Award in 1993 and the Robert I. Mehr award in 2003).

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