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Journal of Financial Economics 90 (2008) 298312

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Volume 88, Issue 1, April 2008 ISSN 0304-405X

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Why rms purchase property insurance$

Daniel Aunon-Nerin a, Paul Ehling b,
a b

Business Development Financial Industry Assets, UBS AG, Gessneralle 3-5 P.O. Box, Zurich CH-8098, Switzerland Norwegian School of Management (BI), Nydalsveien 37, Oslo 0442, Norway

a r t i c l e i n f o
Article history: Received 21 May 2007 Received in revised form 26 December 2007 Accepted 7 January 2008 Available online 20 September 2008 JEL classication: G22 G32 G33 G35 Keywords: Corporate risk management Property insurance

abstract
We investigate whether corporate nance incentives affect the extent of corporate hedging with property insurance. Using a database that contains detailed insurance information, we document a positive relation between the expected costs of distress and property insurance coverage. We also show that the dividend payout ratio is negatively associated with property insurance coverage, consistent with the view that rms with high payout ratios insure a smaller fraction of properties due to cash ows in excess of investment needs, easy access to capital markets, or both. Different incentives are important for the insurance deductible and limit of coverage, and the deductible and limit of coverage are substitutes. & 2008 Elsevier B.V. All rights reserved.

1. Introduction This paper exploits detailed property insurance data from SwissRe to help establish which theoretical incentives and imperfections lead to corporate risk management with insurance. Our tests consist of a simultaneousequations model that recognizes the simultaneity of the

$ We would like to thank an anonymous referee, Alessandro Beber, Guido Bollinger, Michael Brennan, Didier Cossin, Ilan Cooper, Jean-Pierre Danthine, Kurt Falk, Michel Habib, Radomir Haiker, David Haushalter, Manuel Kast, Bill Kracaw, Henri Louberge, Alessandra Luzzi, Alex Murmann, yvind Norli, Richard Priestley, Samuel Scherling, Werner Schlapfer, Enrique Schroth, Henri Servaes, Alex Stomper, Rene Stulz, Elu von Thadden, Kjetil Welle, and seminar participants at FAME Doctoral Workshops, the First Swiss Doctoral Workshop in Finance in Ascona (NCCR FinRisk), SwissRe, the Rosen Huebner McCahan Seminar at The Wharton School, and the EFA Meetings in Maastricht for comments; SwissRe for providing us with the data; and, in particular, Kurt Falk for his invaluable help. Both authors acknowledge nancial support from The International Center for Financial Asset Management and Engineering (FAME) and SwissRe. The usual disclaimer applies. Corresponding author. E-mail address: paulehling@gmail.com (P. Ehling).

deductible and limit of coverage determination problem and a simultaneous-equations analysis that, additionally, recognizes that capital choice is endogenous. We nd that different incentives are important for the insurance deductible and limit of coverage and that rms use the deductible and limit of coverage as substitutes. Our data suggest a positive relation between the expected costs of distress and property insurance coverage. Further, we nd a negative association between the dividend payout ratio and property insurance coverage. Empirical literature on derivative use, on the one hand, presents sensible results that are generally consistent with theoretical predictions (Nance, Smith, and Smithson, 1993; Gezcy, Minton, and Schrand, 1997; Graham and Rogers, 2002). On the other hand, it has been argued that hedging is correlated with managerial quality and the results in the literature are therefore spurious. Additionally, measuring a rms exposure to a risk factor is notoriously difcult, and it is thus not clear whether rms can determine their exposure a priori. Without knowing their exposure, rms cannot pursue a successful risk-management strategy. As a consequence of rms

0304-405X/$ - see front matter & 2008 Elsevier B.V. All rights reserved. doi:10.1016/j.jneco.2008.01.003

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difculty in resolving their risk exposure, it is difcult to determine whether rms hedge or speculate. An additional criticism of the literature on this theme is that the typical derivative exposure is too small to offset cash ow variability (Guay and Kothari, 2003).1 By focusing on insurance use rather than on derivative use, we avoid the problems noted above. Managerial sophistication is not a prerequisite for a successful riskmanagement strategy. Further, measuring the exposure of properties in place to left-tail risk is straightforward. Since investing in insurance for gains would require fraud, it is not feasible to consider that rms speculate using insurance contracts. Finally, in our data, the level of insurance coverage is not too low to be considered ineffective. We provide evidence on corporate risk management that complements the derivative-use literature. It has been argued that corporate risk management aims at reducing cash-ow variability (Froot, Scharfstein, and Stein, 1993) or the probability of left-tail outcomes (Stulz, 1996). According to Leland (1998), hedging with derivatives has a direct effect on cash ows and exerts an indirect effect on left-tail outcomes. We show that left-tail outcomes help explain hedging with property insurance contracts, and that insurance can inuence cash-ow variability through the choice of the deductible. This paper contributes to the corporate risk-management literature by employing both the insurance deductible and the level of insurance coverage as dependent variables. This is an important matter because the existing literature on corporate insurance use relies on insurance premiums to distinguish among theoretical incentives.2 However, rms choose the deductible and coverage limit according to a schedule of prices offered by a syndicate of insurance rms (or offered by an insurer if it is a small rm). Using both the deductible and the limit of coverage enables us to isolate the importance of various rm characteristics for these choices. Our empirical results conrm the general intuition that the deductible and the limit of coverage are determined simultaneously. While this is not surprising, a more important result is that different incentives are important for our dependent variables. For instance, industry dummy variables play an important role in the deductible, most likely due to captive insurance at the industry level, but do not appear to explain the choice of coverage limit. We also show that rm size impacts the choice of coverage limit, but no such relation exists for the deductible. By and large, we nd that rms use the deductible and the coverage limit as substitutes. That is, the deductible has a positive inuence on the limit of coverage, and the extent of the coverage also exerts a

1 Brown (2001) and Petersen and Thiagarajan (2000) and the literature therein offer more arguments and evidence as to why successful risk management is not evident. For further discussion on whether rms use derivatives primarily for hedging or for speculative purposes, see Hentschel and Kothari (2001) and Allayannis and Ofek (2001). 2 See Hoyt and Kang (2000), Mayers and Smith (1990), Yamori (1999), and Zou, Adams, and Buckle (2003).

positive inuence on the deductible. Further, we provide supportive evidence for the Graham and Rogers (2002) result that rms insure (hedge) to increase debt capacity. Our results indicate a positive (negative) relation between the long-term debt ratio (a proxy for the probability of default) and insurance coverage (deductible). Again, this is not entirely surprising since many bond contracts stipulate insurance. Supplier, employment, and customer contracts also stipulate levels of insurance coverage (Smith, 1995). Our contribution, however, goes beyond merely conrming the argument in Stulz (1996) that rms should hedge left-tail outcomes. We show that a variable that interacts rm size with the long-term debt ratio helps in explaining insurance use. This result is consistent with the scale effect in that the ratio of direct bankruptcy costs to size is smaller for large rms than for small rms, as reported in Warner (1977). Our results also indicate a negative (positive) relation between the dividend yield (or, alternatively, the dividend payout ratio) and the coverage limit (deductible). This result is consistent with the view that rms with higher payout ratios insure a smaller fraction of properties because of cash ows in excess of investment needs, easy access to capital markets, or both.3 In particular, if high dividends imply greater free cash ow, a rm is less likely to fail to rebuild when a casualty loss occurs (Smith and Watts, 1992), i.e., the underinvestment problem is small due to the negative relation between dividends and the opportunity set. Our result is also consistent with the survey on payout policy by Allen and Michaely (2003), who show that dividends are typically paid by large, protable rms and rms with less information asymmetry. Obviously, these are precisely the rms that can afford to forgo insurance. Clearly, many of our explanatory variables are at least partially endogenous. For example, dividend policy and capital structure can be determined simultaneously with property insurance. While we can and do control for simultaneity between capital structure and property insurance, we cannot control for all possible sources of endogeneity. To attempt to further address endogeneity problems, we conduct a series of tests. For example, all our stock data originate in the balance sheet prior to the insurance contract and are thus predetermined. Even the ow data, such as dividends, are partially predetermined, as our insurance data do not perfectly overlap with the balance sheet data. Further, our results are essentially unchanged when we only use predetermined data. Overall, we think that our empirical methods help reduce simultaneous-equation problems. Finally, to further verify the robustness of our results, we explain credit ratings from Standard and Poors with the dividend payout ratio, deductible, limit of coverage, and other variables. We then nd a positive relation between the payout ratio and the debt rating. If rms with higher dividends are indeed less risky, they are then more
3 Nance, Smith, and Smithson (1993), Gezcy, Minton, and Schrand (1997), and Graham and Rogers (2002) interpret the dividend ratio as an inverse measure of liquidity and predict a positive relation with derivative use.

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likely to receive a high rating. With a higher rating, the rm is more likely to purchase low insurance coverage, which is consistent with our result on the relation between the dividend yield and the coverage limit. This is also consistent with Allen and Michaely (2003), who argue that rms tend to be riskier if they do not pay dividends or substitute repurchases for dividends. We proceed as follows. In Section 2, we describe our data. In Section 3, we illustrate our empirical analysis. Section 4 contains our robustness checks, and our conclusions are provided in Section 5. Appendix A provides a detailed description of our data and sign predictions.

2. The data sample Our data are property insurance contracts from SwissRe. The data correspond to direct insurance transactions over the period January 1991 through September 2002. The rm-year coverage for such contracts is as high as $44 billion dollars. Coverage for the largest contract in our nal sample is over $17 billion dollars. Insurance coverage limits are typically divided into limits per occurrence and annual aggregates. In particular cases, when a longstanding relation exists between the insurance company (syndicate) and the insured, and when loss history is adequate in the opinion of the insurer, there is no annual aggregate, which in theory implies no limit. In these cases, the insurance company tends to substitute the assets of the insured for the annual aggregate, although their expectation for the limit is certainly much lower. We analyze 183 rm-year observations from 73 U.S. rms. To be included in the analysis, an observation must meet several criteria. In particular, an insurance contract for a particular rm-year must represent a complete

description of a companys property insurance purchases. A detailed account of the selection procedure is in Appendix A. The database includes, among other items, the rm name, the location of the rm, the type of participation of SwissRe, the starting date of the contract, the termination date of the contract, the deductible of the insurance policy, the limit of coverage, the premium paid to SwissRe, and SwissRes share of total rm insurance. The insurance deductible is the maximum amount that an insured rm must pay towards its own losses. Limit of coverage corresponds to the highest possible payment the client can receive from all involved insurance rms (syndicates) when a major event occurs. Note that the limit of coverage is expected to be much lower than the value of assets. This is, in part, because one can think of the coverage as a value that corresponds to the maximum possible payment for a major event, an event upon which the company and all the insurance companies that participate in an insurance policy contractually agree. Clearly, even in a major event, not everything will be destroyed. Note that liabilities are not included in property insurance contracts. For liabilities occurring during a casualty loss, rms need a liability insurance contract, which is not in our data. Fig. 1 is an illustration of the insurance coverage as a fraction of insured assets. Insurance coverage starts at the deductible and provides a shield against losses until reaching the limit of coverage, which is smaller than the expected maximum loss. Table 1, Panel A, shows our sample rms insurance data in descriptive statistics. The mean (median) for the insurance deductible is $35.08 million ($5.00 million). We observe a wide variation across rms as evidenced by the difference between the minimum ($0.03 million) and maximum ($260.00 million) observation. Table 1 also shows that limit of coverage has a mean (median) of

Value of Assets (Total property) Maximum possible loss

Limit of coverage

Insurance coverage Deductibles

Fig. 1. Insurance coverage as a fraction of total assets. This gure illustrates the three main features of property insurance contracts with respect to total insurable property (assets). Consider a rm with property at two locations (A and B). If A and B are sufciently far away from each other, the maximum possible loss from a catastrophic event is either A or B (or smaller than that) and, therefore, the maximum possible loss is strictly smaller than the value of assets. Standard features of insurance contracts are (to reduce moral hazard) the deductible is strictly larger than zero and the limit of coverage is smaller than the maximum possible loss.

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Table 1 Insurance data The table summarizes descriptive statistics of the insurance variable characteristics for 73 publicly traded U.S. rms. The sample consists of 183 rm-year observations ranging from January 1991 to September 2002. Panel A reports the original data. The deductible is the uninsured lower part of the loss distribution. The limit of coverage is the highest payment a rm can receive. Total premium is the estimated premium a company pays for an insurance policy, estimated by linear extrapolation from the premiums paid to SwissRe. The mean (median) duration of the contracts is 1.05 years (1.00 year). Of the 183 contracts, 164 have a duration of one year. The premiums of all other contracts are annualized. Panel B reports statistics for insurance variables scaled by property, plant and equipment plus inventory. The insurance data are from SwissRe, while rm data are from COMPUSTAT. Variable N Mean Std. Dev. Minimum Median Maximum

2.1. Financial data and hypotheses We now introduce hypotheses that are associated with motives for corporate risk management, along with the rm-specic variables that serve as proxies for the hypotheses. Our nancial data are from COMPUSTAT, the Compact Discloser disc of the Securities and Exchange Commission (SEC) lings, the Standard and Poors ExecuComp database (CEO compensation), and IBES (earnings forecasts). Graham kindly supplied corporate marginal tax rates (MTRs). Many of the explanatory variables introduced below are endogenous. In the empirical analysis, we control for simultaneity between the deductible and the limit of coverage and between the deductible, limit of coverage, and capital structure. Neither our data nor nancial theory allow for controlling for other sources of potential simultaneous-equation bias. Although our empirical methods help reduce simultaneous-equation biases, they might not sufciently reduce these problems. For example, employing lagged data does not perfectly address the time-series dependency in some of our explanatory variables. Another potential problem is that the insurance policies should depend on forecasted rm characteristics instead of current or lagged characteristics. Bearing in mind that the theoretical literature on corporate hedging with derivatives has outgrown the work on corporate insurance use, we opted for the following strategy: for each of the corporate motives that could induce either insurance purchases or hedging, we rst introduce the insurance argument. Only when substantial differences between hedging with derivatives and hedging with insurance are at work do we point them out explicitly. Because we use standard variables for the theoretical incentives, we do not further elaborate on the proxies or their sign predictions except when they are not standard. Appendix A contains the various sign predictions. We assume that the higher is the relative deductible, the lower is the insurance coverage. This assumption is, of course, a simplication. It is possible that, for two otherwise identical rms, one of the rms has a higher deductible for property insurance and higher coverage. However, we believe that our assumption is sensible, due to the fact that a rms limit of coverage has a natural upper limit. Moreover, this assumption lets us use the opposing predictions of corporate nance theory on the limits of coverage given the deductible. This second point is important, in part because present theory has not yet addressed the joint choice of the deductible and limit of coverage for an insurance policy. Note that by estimating simultaneous equations in the following analysis, we address whether such a simplication can be regarded as useful. According to existing theories, the deductible is the variable of choice while the limit of coverage should be equal to the value of the insured object. We could, in principle, use predictions from existing theory on the deductible for a xed limit of coverage and then select the opposite predictions for the limit of coverage. Because the deductible is affected by exogenous forces such as industry captives as well as unobservable behavior like

Panel A: Insurance variables Deductibles ($MM) 183 35.08 70.16 Limit of coverage 183 765.45 1980.43 ($MM) Total premium 183 5.21 6.28 ($MM) Panel B: Normalized insurance variables Deductibles/PP&E+I 183 0.01 0.02 Limit of coverage/ 183 0.22 0.51 PP&E+I Total premium/ 183 0.00 0.00 PP&E+I

0.03 15.00 0.18

5.00 260.00 400.00 17247.36 3.62 55.00

0.00 0.00 0.00

0.00 0.05 0.00

0.09 3.61 0.01

$765.45 million ($400.00 million), and coverage for the largest contract is above $17 billion. Similarly, the insurance variable is skewed and exhibits wide variation. The mean (median) premium for property insurance is $5.21 million ($3.62 million). The range of roughly $55 million between the minimum and maximum premium suggests that premiums vary widely as well. Most of the contracts have a duration of one year. The mean is 1.05 years, while the median is exactly one year. The shortest contract lasts 0.08 years and the maximum length is three years. Of 183 contracts, 164 have a duration of approximately one year with deviations of only a few days. For the analysis that follows, we annualize all insurance contracts with durations different from one year. Since companies differ in their demand for property insurance, we scale the insurance variables by property, plant and equipment plus inventory PP&E I. Hence, the normalized insurance variables (see Panel B in Table 1) represent the percentage of a meaningful maximum insurance. We generally do not expect normalized coverage to exceed one. Notice, however, that a few of the normalized coverage variables exceed one. Recall that book values are expected to represent at most historical costs. Further, the value of assets, and especially tangible assets, is reported net of amortization. This is one reason why the limit is occasionally higher than PP&E+I. Another reason is that our data cover business interruption insurance. As for absolute values, the scaled insurance data vary widely. Furthermore, distributions are skewed (medians are always smaller than the means).

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self-insurance, we opt to focus our attention on the limit of coverage. 2.1.1. Incentives for corporate insurance use Bondholders. Mayers and Smith (1982) suggest that rms with above-average expected bankruptcy costs are expected to purchase more insurance than other companies. Similarly, Smith and Stulz (1985) show that expected bankruptcy costs can induce bondholders to support or even demand hedging (Shapiro and Titman, 1986; Stulz, 1996). Indeed, bond covenants can require insurance and, hence, guarantee the hedging strategy ex ante. We use two measures to address the inuence of expected default costs on insurance: the interest coverage ratio (COV) and the long-term debt ratio (LTD). Warner (1977) argues that bankruptcy costs fall with size due to xed costs and scale economies in the bankruptcy process. Hence, we also use size-adjusted versions of our proxies. We create proxies for this hypothesis by multiplying COV and LTD by the logarithm of rm size (LOGSIZE). It is often argued that corporate insurance (Mayers and Smith, 1987) or corporate hedging (Shapiro and Titman, 1986; Lessard, 1990; Stulz, 1990, Froot, Scharfstein, and Stein, 1993) can help to reduce the underinvestment problems discussed in Myers (1977). The Froot, Scharfstein, and Stein (1993) argument relies upon reducing cash-ow variability. Clearly, property insurance is more important for assets in place than for growth opportunities. Because the deductible can inuence cash-ow variability, we employ proxies for growth opportunities such as a rms book-to-market (BM) ratio, price-earnings ratio, capital expenditures for property, plant, and equipment scaled by total assets (PP&E), and expenditures for research and development scaled by sales (R&D). We also employ interactive terms for these variables with the debt-equity (DE) ratio and LTD. Since convertible debt and preferred stock can potentially mitigate the dependence of a rm on external nancing, Nance, Smith, and Smithson (1993) argue that these nancial instruments will decrease corporate hedging. In contrast, Gezcy, Minton, and Schrand (1997) predict a positive relation (Froot, Scharfstein, and Stein, 1993) based on the observation that both convertible debt and preferred stock increase leverage, making additional external funding more difcult to obtain. We use both the ratio of convertible debt to total assets (CONV) and preferred shares to total assets (PS) in our analysis, but make no prediction about their relation with the dependent variables. Maintaining high liquidity can offset the impact of agency as well as distress costs. We measure the inuence of liquidity through the ratio of cash and short-term investments to current liabilities (QUICK). According to Nance, Smith, and Smithson (1993), Gezcy, Minton, and Schrand (1997), and Graham and Rogers (2002),4 the dividend yield (DIV) is a measure of
4 Graham and Rogers (2002, p. 822) contains a typo: Dividend yields (Nance, Smith, and Smithson) and ... have been shown to be negatively related to derivative usages. Nance, Smith, and Smithson predict and nd a positive relation.

negative liquidity. Thus, in their work, a positive relation between the dividend yield and derivative use is hypothesized. However, only Nance, Smith, and Smithson (1993) report a positive and signicant coefcient estimate. In Gezcy, Minton, and Schrand (1997), the tables show only regressions with the variable QUICK as a measure for liquidity. Graham and Rogers (2002) do not include measures for liquidity in their regressions. Haushalter (2000) argues that liquidity-constrained rms pay little or no dividends. Moreover, Allen and Michaely (2003) summarize the evidence on dividend policy by stating that dividends are typically paid by large, protable rms and rms with less information asymmetry; they also note that rms with high dividend yields tend to be less risky. It appears that rms with these characteristics need to hedge less rather than more. This should be the case independently of whether a hedge is carried out with derivatives or insurance. Consequently, we predict a negative relation between dividend yield and insurance coverage. We also employ the dividend payout ratio (PAYOUT) to proxy for less risky rms. This measure better reects the payout policy as a fraction of available cash ows. We predict that the higher is the dividend payout ratio, the lower (higher) is the limit of coverage (deductible) per unit of property. Equityholders. Main (1983) reports large estimates of the tax benets for equityholders stemming from insurance purchases. In Smith and Stulz (1985), equityholders benet from hedging when a progressive tax schedule affects prots. Chen and PonArul (1989) show, to the contrary, that the benets associated with insurance purchases are rather small. Graham and Rogers (2002) also argue that rms do not hedge in response to tax convexity. To measure tax incentives, we use MTRs following Graham (1996) as well as the book value of outstanding net operating loss carryforwards divided by total assets (NOL).5 A potential measurement problem arises because multinationals do not le unied tax returns. Hence it is possible that an uninsured casualty loss is small relative to assets and cash ows, but is large relative to taxable income. Our data, however, do not allow us to control for this measurement problem. We also construct a variable that measures the potential tax savings (TAXSAVE) from a 5% reduction in the volatility of taxable income following Graham and Smith (1999, Eq. 1). The 5% assumption can be justied by the ndings in Guay (1999), who shows that new users of derivatives experience a 5% reduction of their risk. Further, Graham and Rogers (2002) argue that their results are not sensitive with respect to volatility. They also use a rened version of the TAXSAVE variable in Graham and Smith (1999) with sales revenue instead of taxable earnings. We can only use the functional form of Graham and Smith (1999). Note that Graham and Rogers (2002) argue that the original version of the TAXSAVE variable produces similar results as the rened version. In addition, Dionne and Garand (2003) also rely on Graham and Smith (1999) and obtain sensible results. In any case we do not expect TAXSAVE to

We thank Graham for sharing his data with us.

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be of considerable importance in our regressions, since insurance use seems less important than derivative use as a means of altering the volatility of income. Informational asymmetries can also motivate hedging. Grace and Rebello (1993) argue that favorable (unfavorable) information can be signaled through a high (low) level of insurance coverage. If a rms capital requirements are relatively large, it is optimal to insure all possible losses. DeMarzo and Dufe (1991, 1995) argue that shareholders benet from hedging because it reduces unobservable uncertainty and therefore improves the precision of their portfolio optimization problem. Breeden and Viswanathan (1998) assume that managers hedge to signal their skill. We use the standard deviation of analysts earnings forecasts (STDEV) as a proxy for informational asymmetries. We also identify institutional ownership (INSTOWN) since rms with high institutional ownership could have less informational asymmetry. Managers. Clearly, managers might or might not have the same incentives as owners.6 Therefore, the greater is the divergence in interests, the greater is the degree to which managerial incentives such as risk aversion inuence corporate insurance demand (Mayers and Smith, 1982; Stulz, 1984, 1990). On the other hand, compensation schemes such as stock ownership and stock options should, in principle, help to align the interests of managers with outside owners (Campbell and Kracaw, 1987, 1990; Han, 1996; Smith and Stulz, 1985; Stulz, 1984). However, the higher is a managers stock ownership, the less likely it is that they can maintain a well-diversied portfolio. This, in turn, will induce an increased use of insurance to decrease managers exposure to the rms unsystematic risk. Such behavior will decrease rm value and also decrease potential income for the manager from rm value. Therefore, the inuence of managerial stock and option holding is ambiguous. We measure managerial wealth invested in shares as a percentage of outstanding shares (INSIDERS), and CEO wealth invested in shares as a percentage of outstanding shares (CEOINSIDER). Unfortunately, we cannot obtain share value as a percentage of managers wealth. Both variables exclude options. We employ two measures, DELTA and VEGA, associated with a CEOs exposure to rm risk via unexercised options and managerial equity. DELTA and VEGA are partial derivatives of the dividend-adjusted Black and Scholes value of managerial option ownership plus managerial equity. Industry, regulatory, size, and year effects. We include dummy variables for industries to avoid contamination of our results from industry-specic insurance use. We group the data into ve industries: automotive (Auto), food and pharmaceuticals (FoodPharm), mining and energy (MinEn), oil and chemicals (OilChem), and telecommunications (Tel). This is the industry classication of SwissRe. This classication is similar to one-digit SIC codes. For example, rms classied as OilChem in our
6 We experiment with the percentage share of 5%-owners (OWNFIVE) since these block-owners, or owners of larger blocks of rm stock, might be active in controlling management and hence could affect riskmanagement strategies.

sample have either 1 or 2 as a SIC code. A more detailed industry classication would be desirable but our small sample size prevents it. We also include a dummy for regulated rms (SIC codes between 4900 and 4939). To our knowledge, nancial theory does not make a clear prediction as to whether regulation has any effect on insurance policy. Hoyt and Kang (2000) argue that contradictory hypotheses exist. According to SwissRe, regulated rms such as utilities tend to have few large losses but experience small losses with high frequency. This would imply that utilities should purchase property contracts with both lower deductibles and lower coverage than other comparable but unregulated rms. In fact, SwissRe seems to recommend such a policy. Thus, we predict a negative sign for the dummy variable in both regressions (for deductible and limit of coverage). We also control for size. In general, one would expect that insurance plays a more prominent role for small rms than for large rms. For example, large rms tend to be better diversied and might thus need less insurance. This argument is similar to the argument that smaller rms should rely more on hedging than larger rms. However, setting up a derivative trading desk is costly so that in the data it appears that large rms hedge more with derivatives than do small rms. Insurers might also provide additional (real) services to their clients on top of their expertise in pooling low-probability high-loss events in an efcient way. In general, one would expect that real services play a more prominent role for small rms. This argument is consistent with the more common argument that large rms should hedge less because of natural diversication. Finally, because the price for property insurance has skyrocketed over the last few years (within the last two years of our sample, partially because of September 11, 2001, property insurance premiums increased by up to 300%), we include a dummy variable for all rm-year observations starting with the year 2001 (42001). A positive impact on the deductible and a negative impact on the limit of coverage is expected. Because of the small sample size, we cannot estimate regressions with a complete set of year dummies. 2.1.2. Financial data Table 2 summarizes the descriptive statistics (mean, standard deviation, minimum, median, and maximum) of the corporate variables that motivate the purchase of insurance for the 73 publicly traded rms in our sample. The distribution of many variables is skewed, i.e., the median is smaller than the mean. Notice the rather large standard deviation for the BM ratio of the sample rms (Gezcy, Minton, and Schrand, 1997; Johnson, 2003). This fact and the potential problems associated with it (Rajan and Zingales, 1995) lead us to use PP&E, price-earnings ratios, and R&D as additional variables to proxy for growth opportunities. All nancial stock data in Table 2, such as, the book value of debt associated with an observation, are from the scal year before the insurance contract is initiated. In other words, if a contract starts in January 1996,

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Table 2 Summary of explanatory variables This table summarizes descriptive statistics of nancial characteristics for 73 publicly traded U.S. rms. The sample consists of 183 rm-year observations ranging from January 1991 to September 2002. The variables are proxies related to incentives for corporate insurance use. CEO, managerial, and institutional ownership and 5%-owner (OWNFIVE) data are in percentages. CEO delta is the dollar change in the CEOs option portfolio value from a 1% increase in the stock price, scaled by salary and bonus. CEO vega is the dollar change in the CEOs option portfolio value from a 1% increase in the standard deviation of the rms equity returns, scaled by salary and bonus. MB times LTD is the market-to-book ratio times the long-term debt ratio. MTR is the corporate marginal tax rate before nancing. RATING is S&P debt rating (AAA: 2, AA: 4, AA: 5, AA: 6, A: 7, A: 8, A: 9, BBB: 10, BBB: 11, BBB: 12, BB: 13, BB: 14, BB: 15, B: 16, B: 17, B : 18, CCC: 19, CCC or CC: 20, 23, C: 21, 24, D or SD: 27, 29, 90) from COMPUSTAT. SG&A is selling, general, and administrative expenses scaled by net sales revenue. The TAXSAVE variable is constructed from Graham and Smith (1999, Eq. 1). Flow nancial data are measured as of scal year-ends after the starting date of the insurance contract, while stock data are measured as of scal year-ends before the starting date of the insurance contract. The data are from COMPUSTAT, IBES, the SEC disclosure disc, Standard and Poors ExecuComp database, and our own calculations. Corporate marginal tax rates (MTR) are from Graham. See Appendix A for all variable denitions. Variable Book-to-market ratio CEO delta CEO ownership CEO vega Convertible debt/SIZE Interest coverage ratio Debt-equity ratio Dividend payout ratio Dividend yield Institutional ownership Logarithm of SIZE Long-term debt ratio Managerialownership MB LTD MTR before interest payments Price-earnings ratio PP&E investment expenditures/Size Preferred stock/SIZE RATING Quick ratio R&D expenses/Sales SG&A expenses/Sales Std. Dev. of earnings forecasts Tax-loss carryforwards/SIZE TAXSAVE Z-SCORE 5% owners N 175 117 117 99 165 181 178 175 176 151 175 175 151 175 143 177 170 175 130 180 84 152 157 121 178 176 151 Mean 0.38 406.88 0.55 0.94 0.01 9.73 0.12 0.12 0.02 58.09 3.64 0.67 8.94 0.16 0.32 9.65 0.13 0.01 9.98 0.25 0.03 0.11 0.18 0.02 4.11 7.63 29.81 Std. Dev. 2.03 1451.77 1.08 0.72 0.03 33.37 0.19 0.14 0.02 19.94 0.72 1.29 18.54 11.92 0.08 31.57 0.13 0.04 4.16 0.38 0.04 0.09 0.26 0.06 3.15 16.47 29.21 Minimum 24.98 1.17 0.00 0.07 0.00 73.14 0.00 0.15 0.00 0.00 1.84 0.00 0.00 123.84 0.02 7.79 0.00 0.00 2.00 0.00 0.00 0.05 0.00 0.00 1.33 0.55 0.00 Median 0.42 67.21 0.13 0.78 0.00 3.72 0.06 0.09 0.02 60.64 3.64 0.42 0.85 0.76 0.35 4.94 0.09 0.00 11.00 0.10 0.01 0.09 0.10 0.00 3.65 3.35 21.86 Maximum 2.83 13972.68 7.45 5.16 0.32 361.50 1.27 1.19 0.08 99.99 5.44 13.79 99.99 21.30 0.38 391.21 0.94 0.39 27.00 2.44 0.22 0.44 2.14 0.34 13.66 141.73 99.99

the nancial data matched to this contract are from the 1995 scal year-end (e.g., December 1995). Flow data such as earnings, however, are from the same scal year as the insurance contract. This specication assumes that management relies on past stock data but has good estimates available for current ow data. Gezcy, Minton, and Schrand (1997) also use the procedure noted here.

available upon request. The results are presented in two subsections: the rst subsection studies the insurance decision, and the second subsection addresses whether rms insure to increase debt capacity (Graham and Rogers, 2002).

3.1. The insurance decision In untabulated 2SLS simultaneous-equation regressions, the coefcients of the variables measuring interest coverage, institutional ownership, and marginal tax rates are insignicant in either the rst-stage regressions or the second-stage regressions, or both. These variables are also insignicant in the linear GMM simultaneous equations. Therefore, we exclude them from the analysis. Also, many of the introduced variables, such as convertible debt and preferred shares, measure the same incentives, so we focus on only one of the variables and use the others for robustness tests. The main results of the paper are not affected by excluding the mentioned variables. Some of the standard variables in the literature, such as R&D or

3. Empirical ndings To infer whether insurance purchases are indeed motivated by the introduced variables, we undertake a sequence of regressions. Pearson correlation coefcients, conventional ordinary least squares (OLS) regressions, and various other regression models are available upon request. We focus our discussion on the results of linear generalized method of moments (GMM) simultaneous equations. The p-values are heteroskedasticity and autocorrelation consistent. Results with a two-stage estimation technique (2SLS) are qualitatively similar and also

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Table 3 Simultaneous analysis of the deductible and the limit of coverage This table reports linear GMM coefcient estimates from a simultaneous-equations model for the insurance decision (deductible and limit). The p-values are heteroskedasticity-consistent. The insurance data consist of 73 publicly traded U.S. rms with 183 rm-year observations ranging from January 1991 to September 2002. DEDUCTIBLE is the ratio of deductibles to property, plant and equipment plus inventory. Deductible is the uninsured lower part of the loss distribution. LIMIT is the ratio of limit of coverage to property, plant and equipment plus inventory. Limit of coverage represents the highest possible payment a rm can receive. BM is the book-to-market ratio. CONV is the ratio of convertible debt to SIZE. INSIDERS is the managerial ownership in percentage points. LOGSIZE is the logarithm of rm size (SIZE). LTD is the long-term debt ratio. MB times LTD is the market-to-book ratio times the long-term debt ratio. PAYOUT is the dividend payout ratio. QUICK is the quick ratio. TAXSAVE is constructed from Graham and Smith (1999, Eq. 1). OWNFIVE is 5% block owners data in percentage. Flow nancial data are measured as of scal year-ends after the starting date of the insurance contract while stock data are measured as of scal year-ends before the starting date of the insurance contract. Regulated rms have SIC (standard industrial classication) codes between 4900 and 4939. Industries are the automotive industry (Auto), food and pharmaceuticals (FoodPharm), mining and energy (MinEn), oil and chemicals (OilChem), and telecommunications (Tel). The year 2001 dummy denotes a dummy variable indicating contracts ranging from 2001 to September 2002. The insurance data are from SwissRe, and the nancial data are from COMPUSTAT, IBES, the SEC disclosure disc, Standard and Poors ExecuComp database, and our own calculations. See Appendix A for all variable denitions. Variable Deductible Coeff. Constant BM CONV INSIDERS LOGSIZE LTD LTD LOGSIZE MB LTD PAYOUT QUICK TAXSAVE OWNFIVE DEDUCTIBLE LIMIT Dummy variables: REGULATED 42001 Auto FoodPharm MinEn OilChem Tel Sample size 0.0108 0.0102 0.0251 0.0001 0.0056 0.0005 0.0482 0.0044 0.0004 p-Value 0.01 0.01 0.22 0.35 0.09 0.00 0.01 0.06 0.41 Model 1 Limit Coeff. 1.3338 0.4729 1.0252 0.0020 0.2506 0.1665 0.0076 0.8486 0.1640 0.0123 12.7679 0.0244 0.0067 0.0025 0.0041 0.0045 0.0069 0.0049 148 0.00 0.01 0.14 0.08 0.02 0.02 0.02 148 p-Value 0.00 0.00 0.23 0.28 0.00 0.08 0.03 0.00 0.01 0.28 0.01 0.0237 0.0081 0.0029 0.0008 0.0035 0.0058 0.0049 151 0.00 0.00 0.13 0.67 0.07 0.03 0.02 151 Deductible Coeff. 0.0155 0.0080 p-Value 0.00 0.01 Coeff. 1.2937 0.4095 Model 2 Limit p-Value 0.00 0.00

0.0248 0.0082 0.0005 0.0522 0.0029 0.0001

0.01 0.00 0.00 0.00 0.15 0.01

0.2117 0.7222 0.2221 0.0083 0.8414 0.0638 0.0023 12.0428

0.00 0.01 0.01 0.01 0.02 0.16 0.05 0.00

managerial option holdings, substantially reduce the sample size. Since we use several proxies for the underinvestment problem, excluding R&D from the main analysis seems plausible. However, excluding the variable DELTA or VEGA could affect some of our conclusions. Table 3 presents our central results. The dependent variables are the deductible and the limit of coverage (both scaled by PP&E+I). The table contains two models, Models 1 and 2. Model 2 excludes all the insignicant variables from Model 1, with the exception of the dummy variables, and also uses an additional and rened defaultrelated measure: LTD LOGSIZE. The LTD LOGSIZE variable helps to capture the notion that large rms have smaller default costs. We predict a negative relation between LTD LOGSIZE and insurance coverage. We note rst that both Models 1 and 2 support our assumption that theories that help explain corporate risk management exert an opposing inuence on the insurance deductible and limit of coverage. In other words, the

coefcient estimates for explanatory variables in the regressions with the deductible as a dependent variable always show the opposite sign to the coefcients in the regressions with the limit of coverage as the dependent variable. Obviously, our assumption is motivated by the fact that more hedging implies a lower deductible but a higher limit of coverage. Further, Table 3 illustrates that the signs of the coefcient estimates are consistent with the theory. Only the variables TAXSAVE and QUICK, in both equations of Model 1, show a sign not consistent with standard predictions. Another important result is that different incentives are important for our dependent variables. In particular, we nd that LOGSIZE is insignicant as an explanatory variable in the deductible equation and we thus exclude it from the models. Additionally, we nd that all dummy variables, and in particular the industry dummies, are unimportant in explaining the corporate choice of

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coverage limit and we thus exclude them from the analysis as well.7 The variables BM and MB LTD always appear with the correct (and signicant) coefcient estimates. This result is consistent with ndings in the derivative-use literature. We also note that CONV, INSIDERS, and TAXSAVE are insignicant in Model 1, and we thus exclude them from Model 2. The variable LOGSIZE shows predicted signs and signicant coefcient estimates in both models for the regressions using the coverage limit as a dependent variable. Next, note that the variable OWNFIVE shows a signicant coefcient estimate in the deductible regression and a slightly insignicant coefcient in the limit regression in Model 2. Interestingly, the variable INSIDERS shows the same sign. In addition, in the following subsection, INSIDERS appears in the deductible equation with a signicant coefcient estimate. Dummy variables are important in the deductible equations for both models. The regulated rm dummy variables are signicant and show the predicted sign. The 2001 year-dummy variables are insignicant and show a negative sign. Also, many of the industry variables are signicant, suggesting that the nature of the industrial sector is an important factor in the choice of the insurance deductible. Since hedging with property insurance eliminates lefttail outcomes, one would expect variables related to default to help explain insurance use. Moreover, many bond contracts require insurance and, therefore, it seems natural to expect that debt ratios are helpful in explaining insurance. Indeed, our results for Model 1 unequivocally support the view that insurance coverage is positively related to the probability of default. Employing the NOL variable affects the signicance of the LTD variable (untabulated), supporting the view of Graham and Rogers (2002) that tax-loss carryforwards proxy for default risk. Interestingly, our second result related to default risk in Model 2 is that a variable that interacts rm size with the long-term debt ratio can help to explain insurance use. Further, this result is related to the scale effect, such that the ratio of direct bankruptcy costs to size is smaller for larger rms than for smaller rms, as in Warner (1977). The increase in the coefcient estimate of LTD from Models 1 to 2 suggests that it can be important to capture the scale effect in order to show the importance of expected default costs for property insurance use. In addition, the coefcient estimate for LTD LOGSIZE is signicant. As pointed out above, it is conventional in the riskmanagement literature to interpret dividends as negative liquidity. However, dividends are typically paid by large

and protable rms and rms with less information asymmetry (Allen and Michaely, 2003). Obviously, these are precisely the rms that can afford to forgo insurance. Our results support this latter view. In particular, the variable PAYOUT shows for both models and both equations a signicant coefcient estimate: the highest p-value is 0:02, and the relation in the limit equations is negative, while we observe positive coefcients in the deductible equation. These results also hold when we replace PAYOUT with DIV (untabulated). The latter nding shows that our interpretation of the inuence of dividends on risk management is not dependent on the specication of the payout variable. What can we say about the inuence of deductibles on limits and vice versa? Table 3 sheds light on this issue. We notice that both Models 1 and 2 suggest a simultaneous determination of the deductible and the limit of coverage, since both insurance variables always appear with signicant coefcient estimates. These results suggest that it is important to capture simultaneity, and also underscore the nding that coefcient estimates for explanatory variables always show opposite signs for the insurance deductible and limit of coverage. More importantly, the coefcient estimates for both dependent variables are always positive. This implies that rms use the insurance deductible and limit of coverage as substitutes. In other words, when a rm increases its deductible, say due to captive insurance, we can also observe an increase in the limit of coverage. The opposite is also true, in that an increase in the limit of coverage leads to an increase in the deductible.

3.2. Firm insurance regarding debt capacity Table 4 provides the results of a linear GMM simultaneous equation. The dependent variables are LTD, deductible scaled by PP&E+I, and limit of coverage scaled by PP&E+I. The specication of the LTD regression is motivated by Graham and Rogers (2002). This system of equations recognizes the simultaneity of the deductible and limit of coverage determination problem and additionally recognizes that capital choice is endogenous. Note that here we use contemporaneous rather than lagged values of LTD. Two key ndings of this paper, aside from the simultaneity of the insurance variables, are a negative relation between the payout ratio and insurance coverage and a positive relation between the long-term debt ratio and insurance coverage. Also, because one of the most interesting ndings in recent literature is that rms hedge to increase debt capacity (Graham and Rogers, 2002), it is useful to assess whether this feature of derivative data also plays a role in explaining insurance data, and whether our two key results survive such an extension. Table 4 provides the rst evidence regarding these relations. We observe that the variable LIMIT exerts a positive and statistically signicant effect on LTD. The opposite is likewise true: the variable LTD exerts a positive and signicant inuence on LIMIT. Furthermore, LIMIT shows a positive and signicant coefcient estimate in the

7 The main reason why we always include the industry dummies in the deductible equations is the following: Companies can, and in general do, insure the lower part of the loss spectrum with a captive insurer. For instance in the oil-industry rms purchase insurance from an oilindustry mutual called O.I.L. Not surprisingly, some of our insurance excess values for rms which are joint owner of O.I.L. represent nothing more than the maximum amount which can be insured with the industry mutual. Hence, the industry dummy variables help to pick up the industry motivated choice of deductible.

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Table 4 Simultaneous analysis of debt ratio and insurance This table reports linear GMM coefcient estimates from a simultaneous-equations model for debt (LTD) and the insurance decision (deductible and limit). The p-values are heteroskedasticity consistent. The insurance data consist of 73 publicly traded U.S. rms with 183 rmyear observations ranging from January 1991 to September 2002. DEDUCTIBLE is the ratio of the deductible to property, plant and equipment plus inventory. Deductible is the uninsured lower part of the loss distribution. LIMIT is the ratio of the limit of coverage to property, plant and equipment plus inventory. Limit of coverage represents the highest possible payment a rm can receive. LTD is the (contemporaneous) long-term debt ratio. BM is the book-to-market ratio. INSIDERS is the managerial ownership in percentage points. LOGSIZE is the logarithm of rm size (SIZE). MB times LTD is the market-to-book ratio times the long-term debt ratio. PAYOUT is the dividend payout ratio. PP&E is property, plant, and equipment by total assets. QUICK is the quick ratio. SG&A is selling, general, and administrative expenses scaled by net sales revenue. TAXSAVE is constructed from Graham and Smith (1999, Eq. 1). Flow nancial data are measured as of scal year-ends after the starting date of the insurance contract while stock data are measured as of scal year-ends before the starting date of the insurance contract. Regulated rms have SIC (Standard Industrial Classication) codes between 4900 and 4939. Industries are the automotive industry (Auto), food and pharmaceuticals (FoodPharm), mining and energy (MinEn), oil and chemicals (OilChem), and telecommunications (Tel). The year 2001 dummy denotes a dummy variable indicating contracts ranging from 2001 to September 2002. The insurance data are from SwissRe, and the nancial data are from COMPUSTAT, IBES, the SEC disclosure disc, Standard and Poors ExecuComp database, and our own calculations. See Appendix A for all variable denitions. Variables LTD Coeff. pValue 0.08 Deductible Coeff. pValue 0.00 0.00 0.05 0.00 0.00 0.00 0.20 0.50 0.00 0.41 0.00 0.06 0.00 0.01 127 Limit Coeff. pValue 0.00 0.00 0.10 0.00 0.00 0.00 0.00 0.00 0.14 0.00

4. Robustness We argue above that our data offer advantages over derivative-use data. However, our database has its own shortcomings. In this section, we address, three main issues: the robustness of the results, selection bias at several levels, and whether the presented results are representative.8 First, our results are robust to exclusion of the annualized contracts. We allow for deviations of 5% and 10% from one-year duration. We also note that annualizing affects only the premium, not the deductible or coverage.9 We then scale both the deductible and the coverage limit by PP&E and the valuation of property in the SwissRe data instead of by PP&E+I. Further, as in Hoyt and Kang (2000), we subtract land and capitalized leases from PP&E+I. Our results are robust to all of these normalizations. The nancial stock data in Table 2 are from the nancial year before the insurance contract is initiated. Flow data are from the same year as the insurance contract. This specication assumes that management relies on past stock data but has good estimates available for current ow data. Gezcy, Minton, and Schrand (1997) also use this procedure. However, their derivative data match perfectly with their accounting data, while our insurance data are almost never synchronic with accounting data. Therefore, we construct two additional samples of the explanatory variables, one using all data from the scal year ending prior to the insurance policy and the other using all data from the scal year starting after the insurance policy is initiated. In untabulated results, we nd that our qualitative results are unaffected by changes in the matching criteria between the insurance data and these explanatory variables. The largest group of rms belongs to the oil and chemical industry (OilChem), with 67 observations. We form a separate sample that excludes the OilChem data points. Again, our qualitative results remain unchanged. Some of the explanatory variables in Table 2 include extreme values. To better understand the inuence of outliers on our results, we exclude them, observation by observation, from our regressions. We nd that our results are unaffected by outliers. We also conduct a bootstrap analysis to further conrm the robustness of our analyses. Furthermore, we address problems related to selection bias. Firms self-select whether they wish to insure within the syndicate of which SwissRe is a partner. Moreover, SwissRe might in some years choose not to insure a rm it has insured in other years. In principle, we cannot address these issues in any other way than to argue that our
8 It is important to note that insurance addresses one-sided risk and thus relates to underinvestment problems only. Financial derivatives, on the other hand, allow for addressing two-sided risk and can thus control both underinvestment and free cash ow problems (Morellec and Smith, 2007). 9 However, seasonal effects can play a role for the deductible and coverage. For example, the structure of contracts, including the deductible and limit can, in a hurricane season, be very different from contracts in a non-hurricane season for property that is in an endangered region.

Constant 0.1767 BM INSIDERS LOGSIZE LTD MB LTD PAYOUT PP&E 2.9684 QUICK SGA 0.7435 TAXSAVE 0.0246 DEDUCTIBLE 10.6596 LIMIT 0.5913 Dummyvariables: 42001 Auto 0.4714 FoodPharm 0.3597 MinEn OilChem 0.3055 Tel 0.1625 Sample size 127

0.0106 0.0119 0.0002 0.0068 0.0006 0.0249

1.5403 0.5520 0.0026 0.3005 0.2287 0.0086 0.6306 0.1635 0.0152 10.9833

0.00 0.0029 0.17 0.11 0.07 0.00 0.003 0.0157 0.0015 0.0068 0.0040 0.0108 0.0064 127

0.00 0.01 0.01 0.21

regression with DEDUCTIBLE as a dependent variable. These results simply reinforce our ndings for both models, as shown in Table 3. Next, we note that the inuence of DEDUCTIBLE on LIMIT and LTD is also signicant. Finally, we note that essentially all our ndings, and the role of the PAYOUT variable in particular, remain unchanged in the regressions of Table 4. To summarize, rms insure to increase debt capacity or need to insure to be able to increase debt capacity and to prevent left-tail outcomes.

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Table 5 Credit rating, dividend payout, and insurance This table reports OLS coefcient estimates of the logarithm of RATING and proxies for insurance, debt, and dividends. RATING is S&P debt rating (AAA: 2, AA: 4, AA: 5, AA: 6, A: 7, A: 8, AA: 9, BBB : 10, BBB: 11, BBB: 12, BB: 13, BB: 14, BB: 15, A: 16, B: 17, B: 18, CCC: 19, CCC or CC: 20, 23, C: 21, 24, D or SD: 27, 29, 90) from COMPUSTAT. The insurance data consist of 73 publicly traded U.S. rms with 183 rm-year observations ranging from January 1991 to September 2002. DEDUCTIBLE is the ratio of the deductible to property, plant and equipment plus inventory. Deductible is the uninsured lower part of the loss distribution. LIMIT is the ratio of the limit of coverage to property, plant and equipment plus inventory. Limit of coverage represents the highest possible payment a rm can receive. BM is the book-to-market ratio. DE is the debt-to-equity ratio. LIQUIDITY is cash divided by SIZE. LOGSIZE is the logarithm of rm size. PAYOUT is the dividend payout ratio. QUICK is the quick ratio. Flow nancial data are measured as of scal year-ends after the starting date of the insurance contract while stock data are measured as of scal year-ends before the starting date of the insurance contract. Industries are the automotive industry (Auto), food and pharmaceuticals (FoodPharm), mining and energy (MinEn), oil and chemicals (OilChem), and telecommunications (Tel). The insurance data are from SwissRe, and the nancial data are from COMPUSTAT and our own calculations. See Appendix A for all variable denitions. Variable Model 1 Coeff. Constant BM DE LIQUIDITY LOGSIZE PAYOUT QUICK DEDUCTIBLE LIMIT Indicator variables: Auto FoodPharm MinEn OilChem Tel AdjustedR-squared Sample size 4.2956 0.0196 0.2237 0.0010 0.5423 1.0161 5.8619 0.0531 0.1249 0.0844 0.1113 0.0944 0.53 129 p-Value 0.00 0.01 0.09 0.29 0.00 0.02 0.01 0.23 0.22 0.35 0.19 0.64 Model 2 Coeff. 4.2491 0.0242 0.2760 0.5645 1.0083 0.4976 4.7488 0.0987 0.1887 0.1528 0.0263 0.3517 0.59 129 p-Value 0.00 0.00 0.04 0.00 0.00 0.00 0.02 0.01 0.10 0.16 0.79 0.07

show very different deductible and limit structures. In an untabulated analysis, we nd that most of our ndings hold in regressions with the premium as an exogenous variable, with the exception of the PAYOUT variable. We interpret this as supportive of our view that the premium variable cannot entirely explain insurance buying behavior. Another robustness check is shown in Table 5. This table reports OLS coefcient estimates of the logarithm of S&P ratings and proxies for insurance, debt, and dividends. The coefcient estimate for the PAYOUT variable is highly signicant and the relation between PAYOUT and rating is negative. That is, the higher the dividend payout ratio, the better is the S&P rating. This conrms our intuition that corporations with high dividend yields are less risky and thus receive a higher rating and do not need to hedge (insure) as much. Again, this is consistent with Allen and Michaely (2003), who argue that rms tend to embrace riskier behavior if they do not pay dividends or substitute repurchases for dividends. It is also consistent with the Jensen (1986) and Smith and Watts (1992) argument that rms with more assets in place have higher payouts to control for free cash ow problems. Note also that assets in place are less risky than growth options because of underinvestment effects. Although, this regression is independent from our analysis above, it nevertheless conrms our ndings. The deductible and limit of coverage variables are signicant, with the exception of LIMIT in Model 1, and have signs consistent with our previous analysis.10 While our rather small sample size is a source of concern, the results of our robustness tests help us to conclude that our primary results are not an artifact of the data. 5. Conclusions We exploit data from SwissRe to help establish the inuence of demand-side corporate nance theories on property insurance use. Our tests consist of a simultaneous-equations analysis that recognizes the simultaneity of the deductible and limit of coverage determination problem, and a simultaneous-equations analysis that additionally recognizes that capital choice is endogenous. Our rst result establishes a positive relation between expected distress costs and property insurance coverage. We further show that a variable that interacts rm size with the long-term debt ratio (a proxy for the probability of default) helps to explain insurance use. This result is consistent with the scale effect, i.e., that the ratio of direct bankruptcy costs to rm size is smaller for large rms than for small rms.
10 The variable QUICK consistently shows the wrong sign in Model 2 of Table 5 and in all other tables. We experiment with an alternative measure of liquidity (LIQUIDITY) and nd that it does not affect the other coefcients. Overall, LIQUIDITY does not outperform QUICK, except maybe in Table 5, Model 1. In Table 5 we use the same matching criteria as above. Again, the qualitative results are unaffected when only lagged explanatory variables are employed. Note, however, that the insurance data cannot be lagged.

sample is representative, which we further address below. However, it is possible that we introduce a selection bias when choosing rms from the data. To address this issue, we employ a larger sample in which we use a less strict selection process with 695 observations (see Appendix A). Once more, untabulated results strongly support our general ndings. To show that our sample is representative, we compare the descriptive statistics of our data to all COMPUSTAT data for the relevant years. Overall, we do not nd our sample signicantly different. In particular, excluding a few outliers from our sample helps reduce any difference between our data and COMPUSTAT. The previous literature on corporate insurance use relies entirely on premium data. While it is possible that premiums incorporate all relevant information driving corporate insurance choices, we argue that rms choose insurance based on deductibles and coverage limits. Moreover, two rms can pay identical premiums but

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Importantly, the dividend yield (or, alternatively, the dividend payout ratio) is negatively associated with insurance coverage. This result is consistent with the view that rms with higher payouts insure a smaller fraction of their property simply because they have lots of cash, easy access to capital markets, or both. In the simultaneous-equations analysis, we nd that different incentives are important for the insurance deductible and limit of coverage, and that rms use the deductible and limit of coverage as substitutes. We also provide evidence that rms insure (hedge) to increase debt capacity. Finally, we undertake an extensive analysis to address issues including robustness and the risks of selection bias. Overall, we nd that our results stand up to these checks. In closing, we note at least one clear implication of our paper for future work. Ideally, we would like to test theories of corporate nance in a manner that permits unambiguous predictions. Current models, however, say very little about risk management through insurance. Apparently, risk management through insurance is simple and of rst-order importance. It is thus much easier to test the relevance of risk-management theories on insurance data than on derivatives data.

Appendix A. Data description A.1. The insurance data Our data are property insurance contracts from SwissRe over the period January 1991 to September 2002. They cover a total of nearly 10,000 contracts with U.S. companies. An insurance policy of a rm is usually cut into coverage layers to diversify potential losses across participating insurance companies. Coverage is divided into a number of sections starting, for example, at a deductible of $300 million. The next layer might cover

losses from $300 million to $600 million, and this goes on until the limit of coverage is reached. Layers as well as sections of a layer can be contracted with different insurers. SwissRe can participate in an insurance policy proportionally, non-proportionally, or both. A proportional contract is across layers. Non-proportional participation is in only one layer of the losses of a company, say between $800 million and $1.2 billion of a contract with a $100 million deductible. Fig. A1 illustrates the difference between proportional and non-proportional insurance contracts. The gray shaded area represents a proportional contract and thus ranges from layer one to layer two. The black area, a non-proportional contract, covers only a rectangular area in layer two and does not cover layer one. Whenever an insurance contract with SwissRe is of the non-proportional type and there exists no other proportional contract for the same year, we only observe the deductible and limit of coverage that are relevant for SwissRe. In the above example, the deductible is $800 million and the coverage limit is $400 million instead of $100 million and $1.2 billion, respectively. Clearly, the data on non-proportional insurance contracts are not useful to studying overall corporate insurance purchasing behavior. Therefore, our analysis focuses only on contracts in which SwissRe participates in the overall insurance policy of a rm. We restrict our data in the following way. We eliminate all erroneous data, such as contracts that do not represent property insurance. We also eliminate pure business interruption contracts and re-insurance contracts. To ensure that we consider only contracts that represent a signicant portion of a rms insurance activity, we exclude all data where the difference between the limit of coverage and the deductible is negative, noting the positivity test hereafter. For example, when the limit of coverage equals the difference between $800 million and $1.2 billion and the deductible is $800 million, the difference between the limit of coverage and the deductible

Insurance contract Layer 2

Limit of coverage, $1.2 billion U.S. dollars Non proportional $800 million U.S. dollars

Layer 1

Proportional

Deductible, $100 million U.S. dollars

Fig. A1. Proportional versus non-proportional insurance contracts. This gure provides a simple example of the information about the deductible and the limit of coverage for proportional and non-proportional insurance contracts. For proportional contracts (gray shaded area), our data provider participates in losses above the deductible until the limit of coverage. Participation is proportional to the total loss of a rm, e.g., in the worst-case scenario it is the complete gray shaded area. For these contracts, our data contain the deductible and limit of coverage of the rms insurance policy. Non-proportional contracts, the black rectangular area in layer 2, cover only losses within a layer. A layer is a section of an insurance contract (policy) in which coverage is divided into a number of layers starting at the deductible up to the limit of coverage. Layers and parts of a layer can be contracted with different insurance corporations. Frequently, SwissRe sells parts of proportional and non-proportional contracts to its reinsurance division. In the data, non-proportional contracts contain only the relevant numbers for SwissRe: US$800 million deductible and US$400 million coverage. Thus, the reported deductible is the value where layer 2 starts and the maximum loss covered by layer 2, or US$400 million (US$1.2 billion minus US$800 million).

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is $400 million. This procedure leaves us with 1,558 rm-year observations (see large sample below). Only then do we delete all observations classied as nonproportional. While the data are classied as proportional and non-proportional, we observe some cases in which SwissRe clearly participates proportionally and has, in addition to the proportional contract, several non-proportional contracts. Sometimes contracts are erroneously classied. In other words, for one rm for a specic year, an obviously proportional contract is classied as nonproportional and a non-proportional contract for the same year is classied as proportional. We perform the following additional steps to eliminate erroneous data.11 We remove all construction projects and the like. These contracts are treated separately, in general, and hence are of the proportional type. They also pass our positivity test. This leaves us with 882 rm-year observations. Finally, we select rm-year observations included on the COMPUSTAT database. We then eliminate all nancial rms (SIC codes between 6000 and 6999). This further reduces the sample to 183 observations across 73 rms. Thus, we cannot utilize standard panel data analysis. There are two reasons for the small sample size. First, a rm can opt, in some years, to select another insurer (or syndicate). Second, SwissRe decides on a yearly basis whether to participate in the insurance policy of a rm and to what extent. In general, the smaller the participation of SwissRe in the corporate insurance policy, or in an insurance syndicate, the more likely it is that we do not observe the corporate-wide deductible and limit of coverage but, rather, only a part of the companys property insurance policy. Hence, the time series for any one rm might typically contain observations for 1996, 1997, and 2001, for example, but not for other years. A.1.1. Large sample We also employ a larger control sample with 695 observations. In this sample, we do not eliminate observations classied as non-proportional. This is motivated by the following two issues. First, as noted above, some contracts are clearly misclassied. Second, when a contract passes the positivity test, it is by denition a quite substantial insurance contract. Therefore, this sample can help to show whether our results are robust and whether we lose information by being too selective. A.2. Firm and ownership data BM ratio: Total assets minus total liabilities minus outstanding preferred stock (COMPUSTAT items 6, 181, and 130, respectively) divided by the market value of equity (COMPUSTAT item 199 times COMPUSTAT item 25). MB is the inverse of BM. CEO delta (DELTA): Sensitivity of the Black-ScholesMerton option value to a 1% change in the stock price. The
11 We essentially analyzed each single case in detail. We are grateful to Kurt Falk for his help with the data and his patience with our many questions.

delta calculation follows Guay (1999), Core and Guay (2002), and Coles, Daniel, and Naveen (2006). CEO ownership (CEOINSIDER): CEO ownership as a percentage of total ownership (ExecuComp item SHROWNPC). CEO vega (VEGA): Sensitivity of the Black-ScholesMerton option value to a 1% change in the stock return volatility. The vega calculation follows Guay (1999), Core and Guay (2002), and Coles, Daniel, and Naveen (2006). Convertible debt/SIZE (CONV): The book value of convertible debt (COMPUSTAT item 79) divided by SIZE. DE ratio: Debt (COMPUSTAT items 10 and 34) divided by the market value of equity (COMPUSTAT item 199 times COMPUSTAT item 25). Dividend payout ratio (PAYOUT): Dividends per share (COMPUSTAT item 26) divided by earnings per share (COMPUSTAT item 13 divided by COMPUSTAT item 25). Dividend yield (DIV): Dividends per share (COMPUSTAT item 26) divided by scal year-end price per share (COMPUSTAT item 199). Institutional ownership (INSTOWN): Institutional ownership in percentage (SEC disclosure disc). Interest coverage ratio (COV): Pretax income (COMPUSTAT item 170) plus interest expense (COMPUSTAT item 15) divided by interest expense plus capitalized interest (COMPUSTAT item 239). Long-term debt ratio (LTD): Book value of long-term debt (COMPUSTAT items 9 and 34) divided by SIZE. Managerial ownership (INSIDERS): Managerial ownership in percentage (SEC disclosure disc). MTR before interest payments: Corporate MTRs before interest payments (Graham). Tax-loss carryforwards/SIZE (NOL): Net operating loss carryforwards (COMPUSTAT item 52) to total assets (COMPUSTAT item 6). Price-earnings ratio (PE): Price (COMPUSTAT item 199) divided by earnings per share (COMPUSTAT item 13 divided by COMPUSTAT item 25). PPE investment expenditures/SIZE (PPE): Expenditures for property, plant, and equipment (COMPUSTAT item 30) divided by SIZE. Preferred stock/SIZE (PS): Ratio of total preferred shares (COMPUSTAT item 130) divided by SIZE. Quick-ratio (QUICK): Ratio of cash and short-term investments (COMPUSTAT item 1) to current liabilities (COMPUSTAT items 34, 70, 71, and 72). R&D expenses/sales (R&D): R&D expenses (COMPUSTAT item 46) divided by sales (COMPUSTAT item 12). RATING: Standard and Poors debt rating (COMPUSTAT item 280). SIZE: Market value of equity (COMPUSTAT item 199 times COMPUSTAT item 25) plus book value of long-term debt (COMPUSTAT items 9 and 34) plus book value of preferred stock (COMPUSTAT item 130). LOGSIZE is the logarithm of SIZE. Std. Dev. of earnings forecasts (STDEV): Standard deviation of analysts earnings-per-share forecasts (IBES item STDEV). TAXSAVE: The tax save variable is constructed using Eq. (1) from Graham and Smith (1999).

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Z-score: Altman Z-score is 3.3 data178/data6 + 1.2 (data4 data5)/data6 + data12/data6 + 0.6 data199 data25/(data9 + data34) + 1.4 data36/data6 (all data items are from COMPUSTAT). 5% owners (OWNFIVE): Percentage share of 5% (and above) owners (SEC disclosure disc).

A.3. Sign predictions In the analysis, we assume that the higher is the (relative) deductible, the lower will be the (relative) insurance coverage. Thus, predictions for deductible and coverage always show the opposite sign. We state only the prediction for the coverage variable. BM: negative inuence on insurance coverage. CEOINSIDER: no prediction. CONV: no prediction. COV: negative inuence on insurance coverage. DE: positive inuence on insurance coverage. DELTA: no prediction. DIV: negative inuence on insurance coverage. INSIDERS: no prediction. INSTOWN: negative inuence on insurance coverage. LOGSIZE: negative inuence on insurance coverage. LTD: positive inuence on insurance coverage. MB LTD: negative inuence on insurance coverage. MTR: negative inuence on insurance coverage. NOL: positive inuence on insurance coverage. OWNFIVE: no prediction. PE: positive inuence on insurance coverage. PPE: positive inuence on insurance coverage. PS: no prediction. QUICK: negative inuence on insurance coverage. R&D: positive inuence on insurance coverage. RATING: negative inuence on insurance coverage. REGULATED: negative inuence on insurance coverage and deductible. STDEV: positive inuence on insurance coverage. TAXSAVE: positive inuence on insurance coverage. VEGA: no prediction. Z-SCORE: negative inuence on insurance coverage. 42001: negative inuence on insurance coverage.

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