The Liquidity Demand for Corporate Property Insurance

Author: Hau, Arthur

Source: Journal of Risk & Insurance, Volume 73, Number 2, June 2006 , pp. 261-278(18)

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Abstract:

This article suggests that liquidity may be an important reason for a corporation to purchase property insurance. A model of a risk-neutral producer facing an endogenously determined risk of property damage under an output contract that penalizes underproduction is formulated to exemplify such a real need of liquidity. Under the output contract, the producer may purchase full unfavorable property insurance even when postloss financing is available. Surprisingly, the conclusion may still hold when the cost of postloss financing equals that of long-term capital, provided that the rate of underproduction penalty is sufficiently high. Similar conclusions apply when postloss financing is replaced by planned internal reserve (self-insurance) that may be invested in the short run at an interest rate that is lower than the long-term cost of capital. When the capital market is perfect, however, the holding of planned internal reserve eliminates the purchase of actuarially unfavorable property insurance.

Document Type: Research article

DOI: http://dx.doi.org/10.1111/j.1539-6975.2006.00173.x

Affiliations: 1: Arthur Hau is Associate Professor at the Department of Finance and Insurance, Lingnan University, Tuen Mun, N.T., Hong Kong, People's Republic of China; , Email: ahau@ln.edu.hk.

Publication date: 2006-06-01