Debt Capacity, Cost of Debt, and Corporate Insurance

Abstract

Using a unique insurance dataset for a sample of Chinese publicly listed companies for the period 1997 through 2003, this study tests the simultaneous linkages between debt capacity, cost of debt, and corporate property insurance. Our results suggest that, on the one hand, a higher cost of debt appears to motivate the use of more property insurance, but high leverage alone does not lead to the purchase of more property insurance. The latter finding might reflect the unique institutional setting of China, for example, where there is a low chanceof legally enforced company liquidation. Also, there is evidence that leverage can interact with tangible assets intensity and exert a positive conjoint effect on the corporate purchase ofproperty insurance. On the other hand, we find evidence that supports that property insurance helps expand insuring firms' debt capacity and helps lower their borrowing costs. However, themoderate evidence on the cost reduction effect suggests that lowering the borrowing cost is likely to be a concern secondary to facilitating corporate borrowing and thereby expanding debt capacity in corporate property insurance decisions in China. Overall, we conclude that debt capacity, cost of debt, and corporate insurance appear to be simultaneously related.

Insurance and ownership structure in India’s corporate sector

“…Insurance is also a potentially better corporate hedging measure than the use of derivatives in that as an indemnity contract it cannot be used for speculative purposes (Aunon-Nerin & Ehling, 2008). Moreover, in contrast to previous corporate insurance studies from the Asia Pacific region (e.g., China) that focus on publicly listed companies (PLCs) (e.g., Zou & Adams, 2006, 2008aZou et al, 2003) most firms (approximately 90%) examined in the present study are small and medium-sized firms (SMEs) where roughly one-third do not insure their assets. We argue that this feature is potentially advantageous in that a more balanced cross-sectional mix of insurance users and insurance non-users reduces the risk of self-selection bias and provides a potentially cleaner test of the corporate insurance participation decision than has been carried out previously in other Asia Pacific emerging economies (such as China).…”

“…6 As noted previously in footnote 1, MacMinn and Garven (2000) and Mayers and Smith (1982), among others, argue that insurance is an integral part of corporate financial policy and thus an important strategic issue for board-level managers. Indeed, several prior academic studies (e.g., Froot et al, 1993;Hoyt & Khang, 2000;Mayers & Smith, 1982;Zou & Adams, 2006, 2008aZou et al, 2003) suggest that property insurance can be an effective strategic post-loss investment financing mechanism that can help reduce information asymmetries and financial distress/bankruptcy and other (e.g., agency) costs for firms. In this regard, managers may be motivated to purchase property insurance in order to protect and promote their job security.…”

“…Companies operating in emerging economies are also susceptible to acute unforeseen losses resulting from environmental perils (e.g., fire and flooding), accidents, fraud, and a host of other business risks (Freeman & Kunreuther, 2002;Sarker & Sarker, 2000;Sinha, 2004). 2 Exposure to such risks therefore underpins the need for Indian firms to have sound systems of risk management in order to ensure that operating, finance, and investment plans are not disrupted by a lack of liquidity following unexpectedly acute mishaps to corporate assets (e.g., see Froot, Scharfstein, & Stein, 1993;Zou & Adams, 2006, 2008a.…”

“…Zou and Adams (2008b) add that, as a corporate governance mechanism, ownership structure can shape corporate strategies and influence how management are monitored and compensated in order to reduce agency incentive conflicts in firms. Therefore, ownership structure 1 The view that the purchase of insurance is a key strategic issue for companies is well established in the literature (e.g., see Aunon-Nerin & Ehling, 2008;MacMinn & Garven, 2000;Mayers & Smith, 1982;Zou & Adams, 2006, 2008a. For example, MacMinn and Garven (2000) report that in the US corporate sector annual property insurance premiums consistently exceed the value of dividends by a factor of 30-40% per annum.…”

“…In the present study, we focus on analyzing separately the participation and volume of insurance decisions in India's corporate sector (utilizing a two-stage probit-Cragg estimation procedure) because such an approach could yield interesting insights into the factors that influence the ex-ante and ex-post aspects of the corporate insurance decision (Zou & Adams, 2006, 2008aZou, Adams, & Buckle, 2003). Insurance is also a potentially better corporate hedging measure than the use of derivatives in that as an indemnity contract it cannot be used for speculative purposes (Aunon-Nerin & Ehling, 2008).…”