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Corporate insurance with optimal financial contracting

Bruno Jullien (), Georges Dionne and Bernard Caillaud ()

Economic Theory, 2000, vol. 16, issue 1, 77-105

Abstract: 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.

Keywords: Corporate insurance; Credit; Contract; Audit. (search for similar items in EconPapers)
JEL-codes: D82 G14 G22 (search for similar items in EconPapers)
Date: 2000-04-14
Note: Received: December 14, 1998; revised version: August 11, 1999
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