Corporate Insurance and the Underinvestment Problem

TLDR

A casualty loss creates option-like characteristics in assets, and with risky debt, shareholders may forgo discretionary investment that has positive NPV, creating an incentive conflict between bondholders who want the investment and shareholders who do not. The study proposes controlling the incentive problem by including a covenant in the bond contract that requires insurance coverage. This is achieved by embedding a covenant that mandates insurance coverage in the bond contract. Full coverage is generally unnecessary, and the maximum deductible depends on the firm’s debt level and the feasible set of net casualty losses.

Abstract

A casualty loss produces option-like characteristics in assets because their value depends on further discretionary investment. With risky debt in the firm's capital structure, the shareholders can have incentives to forgo the discretionary investment, even though it has a positive net present value. Thus a potential incentive conflict exists between the bondholders who want the investment made and the shareholders who do not. The incentive problem can be controlled by including a covenant in the bond contract requiring insurance coverage. Full coverage is generally not required. The maximum deductible depends on the amount of debt in the firm's capital structure and the feasible set of net casualty losses.