Title

Insurance, bond covenants, and under- or over-investment with risky asset reconstitution

Document Type

Journal article

Source Publication

Journal of Risk and Insurance

Publication Date

3-1-2007

Volume

74

Issue

1

First Page

3

Last Page

22

Abstract

Traditional theory predicts that the shareholders of a limited liability company financed partly by bonds may underinvest by not replacing damaged company assets. It also precludes the possibility of overinvestment. By relaxing the restrictive assumption maintained under traditional theory, namely, that the effects of reconstituting damaged assets are nonstochastic, this article shows that both over and underinvestment are possible. It is shown that these moral hazard problems can be mitigated by incorporating appropriate insurance requirements into bond covenants. Moreover, it is shown that the insurance requirements for alleviating underinvestment and overinvestment are quite different. Particularly, for underinvestment, the required insurance only needs to make the bonds riskless in the best asset reconstitution states of the loss states in which the company value falls short of the promised bond repayment; however, for overinvestment, the required insurance should make the bonds totally riskless. The difference in insurance requirements is especially important when insurance is actuarially unfavorable such that more-than-required insurance is always undesirable.

DOI

10.1111/j.1539-6975.2007.00200.x

Print ISSN

00224367

Funding Information

Financial support from the University Academic Programme Research Grants (reference: DB05A5) of Lingnan University. {DB05A5}

Publisher Statement

Copyright © The Journal of Risk and Insurance, 2007. Access to external full text or publisher's version may require subscription.

Full-text Version

Publisher’s Version

Language

English

Recommended Citation

Hau, A. (2007). Insurance, bond covenants, and under- or over-investment with risky asset reconstitution. Journal of Risk and Insurance, 74(1), 3-22. doi: 10.1111/j.1539-6975.2007.00200.x

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