Limited Liability, Corporate Value, and the Demand for Liability Insurance

Abstract

Limited Liability, Corporate Value, and the Demand for Liability Insurance Introduction Limited liability plays an important role in financial markets by enabling corporations to raise a sufficient amount of money to finance risky investments. It may, however, also create some difficulties for the operation of a competitive financial market system. If there is a positive probability that the firm will become insolvent, even in the absence of a risky bond issue, then limited liability protects shareholders but it also separates the private from the social costs of the firm's operations. Limited liability allows stockholders to walk away from corporate liabilities when earnings are insufficient to cover those liabilities. Hence, the stockholders may be viewed as holding a put option which allows them to put the firm to the liability claimants (1) and other general creditors in the event of insolvency. (2) The general creditors become the owners and share the liquidation value. The loss to liability claimants generates a social cost for the economy. This problem can be dealt with through public measures or through the creation of market institutions such as insurance companies. The purpose of this article is first, to analyze the impact of liability insurance on the value of the stakeholders positions in the firm and second, to demonstrate the conditions under which this insurance is demanded. The claim that limited liability can separate the private from the social cost of corporate operations has been made by Easterbrook and Fischel (1985). According to Easterbrook and Fischel, When corporations must pay for the right to engage in risky activities, they will tend to undertake projects only where social benefits equal social costs at the margin. Where high transactions costs prohibit those affected by risky activities from charging an appropriate risk premium, however, the probability that firms with limited liability will undertake projects with an inefficiently high level of risk increases. Firms capture the benefits from such activities while bearing only some of the costs; other costs are shifted to involuntary creditors. This is a real cost of limited liability, but its magnitude is reduced by corporation's incentives to insure. (see p. 107). The involuntary creditors are victims of torts, and, as Easterbrook and Fischel note, cannot negotiate with the firm in advance. There is apparently no model in the literature which establishes either the claim that a negative externality (3) exists or that it is reduced due to the firm's incentive to insure. The analysis here shows that, given no change in the investment level, purchasing liability insurance will not create value but will shift value between claimholders and may appear to change value because the financial market value of the corporation does not fully reflect the value of all the stakeholders' claims. This follows because the costs shifted to involuntary creditors are represented, in part, by the value of the stockholders' put option. (4) The incentive to insure is more problematic. The analysis, however, shows that in some cases corporate management has an incentive to purchase liability insurance and that the insurance provides management with the incentive to select efficient investment levels. (5) Equivalently, the corporate liability insurance eliminates the effects of the negative externality. Hence, the analysis here provides a proof of the claims made by Easterbrook and Fischel. Easterbrook and Fischel also expand the menu of contracts included in the nexus of contracts which defines the corporation. (6) In a similar vein, Cornell and Shapiro (1987) expand the set of contracts. Cornell and Shapiro introduce stakeholders. The group of stakeholders includes not only stockholders and bondholders but also other agents who have explicit or implicit contractual relationships with the corporation. …