Summary
In perfect capital markets, there is no theoretical reason for the purchase of insurance by firms if shareholders can hold well-diversified portfolios of stocks. However, when transaction and agency costs are introduced, motives for insurance demand can be derived. Insurance purchases may be driven by the structure of the tax code, bankruptcy costs or bankruptcy probability, real services provided by insurers that are valued by shareholders, or differences in ownership structure or regulation across firms. Because of the difficulty in gathering data related to insurance purchases, there have been relatively few empirical tests of these theories. However, because Korean firms report insurance premiums paid on their financial statements, it is possible to analyze a large sample of Korean firms over an 11-year time period.
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Extract
On the Corporate Demand for Insurance: The Case of Korean Nonfinancial Firms
Introduction
Risk aversion as a motive for the purchase of insurance by individuals is well supported. However, the motive for the purchase of insurance by large, publicly traded corporations is less well understood. Mayers and Smith (1982) and Main (1983) argue that since individual shareholders can diversify firm-specific insurable risk by holding a portfolio of stocks, insurance does not increase the value of the firm because insurance premiums contain loading factors. Thus, even though they might be risk averse as individuals, well-diversified shareholders would not choose to reduce their wealth by authorizing the firm to purchase insurance against its own idiosyncratic risk. Contrary to this theoretical prediction, however, evidence indicates that corporations purchase substantial amounts of insurance. For example, commercial property and liability insurance in the U.S. market accounts for just over 50 percent of the approximately $350 billion in insurance premiums collected in 2002 (Hartwig, 2003).Several theories have emerged to explain this seemingly irrational behavior. One argument is that convexity in the tax code encourages insurance purchases as a way to decrease expected tax liabilities (see, e.g., Main, 1982,1983; Mayers and Smith, 1982). Mayers and Smith (1982) also argue that insurance allows firms to reduce expected bankruptcy costs by shifting the cost of high-severity events to an insurer. In addition, regulators might require the purchase of some forms of insurance, such as workers compensation insurance in the U.S. market. Furthermore, insurers provide services such as claims settlement and safety recommendations that might be valuable to the firm.Agency theory provides additional reasons for the corporate purchase of insurance. Myers (1977) argues that shareholders might forego potentially profitable investments if the benefits accrue to bondholders. In this case, insurance can be used to bond investment decisions (see, e.g., Smith, 1986; MacMinn, 1987; Mayers and Smith, 1987; Schnabel and Rouimi, 1989; Garven and MacMinn, 1993). Han (1996) examines the link between optimal managerial compensation contracts and the purchase of insurance when managers are risk averse. Insurance can signal reliability (Main, 1982; Grace and Rebello, 1993) and act as a monitor of firm quality for the firm's shareholders and...See the full content of this document
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