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Choice of corporate risk management tools under moral hazard

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  • Bena, Jan

Abstract

This paper examines the choice of tools for managing a firm’s operational risks: cash reserves, insurance contracts, and financial assets under an optimal financing contract that solves moral hazard between insiders and outside investors. Risk management is valuable as it reduces the costs of raising external financing, increases debt capacity, lessens underinvestment, and improves welfare. I show that insurance is superior as it facilitates the outside financing relationship but leads to inefficient excessive continuation if used without coverage limits. When insurance against an operational risk is not available, the firm uses financial assets instead or resorts to holding cash reserves.

Suggested Citation

  • Bena, Jan, 2006. "Choice of corporate risk management tools under moral hazard," LSE Research Online Documents on Economics 24518, London School of Economics and Political Science, LSE Library.
    • Handle: RePEc:ehl:lserod:24518
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    File URL: http://eprints.lse.ac.uk/24518/
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    Keywords

    Risk management; Corporate insurance; Moral hazard; Optimal contracting;
    All these keywords.

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies

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