Creditor Mandated Purchases of Corporate Insurance

In our paper, Creditor Mandated Purchases of Corporate Insurance, which was recently made publicly available on SSRN, we provide the first large-sample evidence on the use and nature of insurance requirements in credit agreements for publicly-traded companies. We show that lenders nearly always mandate that borrowers have some form of insurance and in many cases tailor the requirement to the borrower’s specific situation. In addition to a requirement simply to have insurance, credit agreements also frequently include four additional provisions: (1) a requirement that the borrower purchase specific types of coverage, such as liability or property insurance; (2) a requirement that the lender be named as an additional loss payee; (3) a requirement that any proceeds from insurance payments be used to pay down loan balances; and (4) explicit permission that the borrower may self-insure. Given that over three-quarters of public firms use credit agreements of the type we study (Sufi, 2007), creditor mandated purchases of insurance are indeed an important source to explain the depth and variety of corporate insurance that we see in practice.

We code the insurance requirements in a sample of 3,106 private credit agreements to publicly-traded firms in the U.S. and show empirically that they are related to a number of borrower specific characteristics. We find that the size and credit quality of the borrower are significantly related to the use of various insurance provisions. Larger firms are less likely to be required to buy insurance and more likely to be permitted to self-insure. Firms posing higher credit risk are more likely to be required to buy insurance for specific risks, more likely to have to name the lender as a loss payee, and more likely to be required to use any insurance proceeds to pay down loan balances.

These correlations are consistent with existing theories that explain insurance covenants as a means to avoid underinvestment problems created by risky debt. Myers (1977) shows that managers of a levered firm may limit the scale of investment if some of the returns to a profitable project accrue to creditors in the form of reduced credit risk. Since the underinvestment problem worsens as firms become more levered, insurance may create value by reducing the probability of insolvency, as shown in Garven and MacMinn (1993). For firms with higher ex-ante credit risk, the benefit of insurance is larger, since it takes a smaller loss to move the firm closer to insolvency. We find a very strong correlation between the credit risk of the borrower and the stringency of the insurance requirement; for example, about one-quarter of loans to firms with investment-grade credit ratings require specific insurance coverage, but more than three-quarters of loans to speculative-grade borrowers have a similar provision.

We also find that the use of insurance covenants is highly correlated with other features of the loan contract, particularly the presence of collateral and the use of a borrowing base. Loans that are secured by collateral are much more likely to require specific coverage – often insuring the asset serving as collateral – and much more likely to name the lender as an additional loss payee or require prepayment from insurance proceeds. We conjecture that the insurance requirement creates value by limiting the possibility that senior, secured lenders face a change in priority following an insurable loss. For example, consider a firm with a large amount of secured debt that is exposed to the risk of being sued. As we describe in more detail below, a borrowing base limits the amount of borrowing to a fraction of an asset owned by the borrower, such as inventory or accounts receivable. The potential lawsuit creates the risk that a new claimant to the borrower’s assets – namely, plaintiffs in a lawsuit – may alter the priority of the secured lenders in the case of a bankruptcy. Such a risk weakens the value of providing collateral in the first place, which recent empirical work (Rauh and Sufi, 2010) has shown is used strategically by lenders. However, if the borrower were required to purchase liability insurance, secured lenders would be more confident that their claim to the borrower’s assets will remain intact. A similar argument can be made to justify why firms would purchase property insurance to replace damaged assets.

Existing theories of corporate capital structure identify several reasons why some loans are secured by collateral, which in a world with no frictions would create no value, based on a Modigliani and Miller (1958) argument. The distinguishing feature of a collateralized loan is priority in bankruptcy, which Carey and Gordy (2008) have shown leads to higher recovery rates following a default. Existing theories, such as Park (2000) and DeMarzo and Fishman (2007), point to priority in bankruptcy as generating valuable ex-ante benefits. If the cost of liquidating a failing firm is high, granting a secured claim gives a lender incentive to force a borrower into bankruptcy, which can limit borrower moral hazard problems.

Given that there are economic benefits from using collateral, mandated insurance strengthens these benefits by limiting the risk to changes in priority created by a secured claim. We surmise that the same underlying friction that makes collateral beneficial also creates the demand for insurance. Empirically, we document that controlling for the presence of collateral in the loan – an admittedly endogenous variable – reduces the correlation between most firm characteristics and insurance requirements.

The full paper is available for download here.