On Corporate Risk Management and Insurance

Insurance contracts provide the corporation with an instrument to manage risk and create value. Insurance is designed to manage pure risk; a pure risk only yields a loss unlike speculative risks that may yield a gain or loss. Received theory does not provide the necessary distinction between pure and speculative risks that would allow the role of insurance to be investigated. Pure and speculative risks are modeled here as independent random variables. The role that insurance plays in determining an optimal capital structure and otherwise managing risk is investigated. This analysis is a generalization of a classic financial market model and it shows that earlier results such as the use of insurance to control the risk-shifting problem continue to hold. This role, however, can be duplicated by a variety of other instruments including convertible bonds and futures. In an attempt to provide a distinction the analysis is extended. It provides a tax result in which the corporation creates value by substituting a safe tax shelter for a risky tax shelter; this is accomplished by issuing debt to purchase insurance so that the random deduction due to the pure loss is replaced by a known deduction due to the debt. Hence, the analysis reveals a role that insurance can play in developing an optimal capital structure. The analysis also provides the basis for comparing the use of financial futures with that of insurance in managing risk. The analysis shows the conditions under which the corporation may create value for its shareholders by using both insurance and futures contracts to hedge the pure and speculative risks.