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