Corporate Insurance and the Underinvestment Problem

A casualty loss produces option-like characteristics in assets because their value depends on further discretionary investment. With risky debt in the firm's capital structure, the shareholders can have incentives to forgo the discretionary investment, even though it has a positive net present value. Thus a potential incentive conflict exists between the bondholders who want the investment made and the shareholders who do not. The incentive problem can be controlled by including a covenant in the bond contract requiring insurance coverage. Full coverage is generally not required. The maximum deductible depends on the amount of debt in the firm's capital structure and the feasible set of net casualty losses.