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Corporate insurance with optimal financial contracting

  • Bruno Jullien

    ()

    (IDEI and GREMAQ , UniversitÊ des Sciences Sociales Toulouse 1, Place Anatole France, 31042 Toulouse CÊdex, FRANCE)

  • Georges Dionne

    ()

    (Risk Management Chair, HEC-MontrÊal, 3000 Cote Ste Catherine, MontrÊal, CANADA H3T3A7, C.R.T.)

  • Bernard Caillaud

    ()

    (CERAS-ENPC , 28 rue des Saints PÉres, 75007 Paris, FRANCE)

This paper attemps to rationalize the use of insurance covenants in financial contracts, and shows how external financing generates a demand for insurance by risk-neutral entrepreneurs. In our model, the entrepreneur needs external financing for a risky project that can be affected by an accident during its realization. Accident losses and final returns are private information to the firm, but they can be evaluated by two costly auditing technologies. We derive the optimal financial contract: it is a bundle of a standard debt contract and an insurance contract with franchise, trading off bankruptcy costs vs auditing costs. We then analyze how this optimal contract can be achieved by decentralized trading on competitive markets when insurance and credit activities are exogenously separated. With additive risks, the insurance contract involves full coverage above a straight deductible. We interpret this result by showing how our results imply induced risk aversion for risk-neutral firms.

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Article provided by Springer in its journal Economic Theory.

Volume (Year): 16 (2000)
Issue (Month): 1 ()
Pages: 77-105

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Handle: RePEc:spr:joecth:v:16:y:2000:i:1:p:77-105
Note: Received: December 14, 1998; revised version: August 11, 1999
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  1. P. Picard, 1996. "On the Design of Optimal Insurance Policies under Manipulation of Audit Cost," THEMA Working Papers 96-20, THEMA (THéorie Economique, Modélisation et Applications), Université de Cergy-Pontoise.
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  3. Kenneth A. Froot & David S. Scharfstein & Jeremy C. Stein, 1992. "Risk Management: Coordinating Corporate Investment and Financing Policies," NBER Working Papers 4084, National Bureau of Economic Research, Inc.
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  6. Robert M. Townsend, 1979. "Optimal contracts and competitive markets with costly state verification," Staff Report 45, Federal Reserve Bank of Minneapolis.
  7. Campbell, Tim S. & Kracaw, William A., 1987. "Optimal Managerial Incentive Contracts and the Value of Corporate Insurance," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 22(03), pages 315-328, September.
  8. Hermalin, Benjamin E & Katz, Michael L, 1991. "Moral Hazard and Verifiability: The Effects of Renegotiation in Agency," Econometrica, Econometric Society, vol. 59(6), pages 1735-53, November.
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  10. EECKHOUDT, Louis & Christian GOLLIER & Harris SCHLESINGER, 1994. "Changes in Background Risk and Risk Taking Behavior," Working Papers 005, Risk and Insurance Archive.
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  12. Paul R. Milgrom, 1979. "Good Nevs and Bad News: Representation Theorems and Applications," Discussion Papers 407R, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
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  16. DeMarzo, Peter M. & Duffie, Darrell, 1991. "Corporate financial hedging with proprietary information," Journal of Economic Theory, Elsevier, vol. 53(2), pages 261-286, April.
  17. Mathias Dewatripont & Jean Tirole, 1994. "A Theory of Debt and Equity: Diversity of Securities and Manager-Shareholder Congruence," The Quarterly Journal of Economics, Oxford University Press, vol. 109(4), pages 1027-1054.
  18. Bengt Holmstrom & Roger B. Myerson, 1981. "Efficient and Durable Decision Rules with Incomplete Information," Discussion Papers 495, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  19. Stulz, René M., 1984. "Optimal Hedging Policies," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 19(02), pages 127-140, June.
  20. Mayers, David & Smith, Clifford W, Jr, 1990. "On the Corporate Demand for Insurance: Evidence from the Reinsurance Market," The Journal of Business, University of Chicago Press, vol. 63(1), pages 19-40, January.
  21. Philippe Aghion & Patrick Bolton, 1992. "An Incomplete Contracts Approach to Financial Contracting," Review of Economic Studies, Oxford University Press, vol. 59(3), pages 473-494.
  22. Gollier, Christian & Pratt, John W, 1996. "Risk Vulnerability and the Tempering Effect of Background Risk," Econometrica, Econometric Society, vol. 64(5), pages 1109-23, September.
  23. DeMarzo, Peter M & Duffie, Darrell, 1995. "Corporate Incentives for Hedging and Hedge Accounting," Review of Financial Studies, Society for Financial Studies, vol. 8(3), pages 743-71.
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