Reinstatement or Insurance Payment in Corporate Fire Insurance

Abstract

ABSTRACT This article characterizes the optimal corporate fire insurance contract when the insured firm has private information about the economic value of the damaged assets. It is shown that the indemnity should be lower when the firm receives insurance money than case of reinstatement, but there should be partial coverage even when reinstatement is chosen. When a risk of arson exists, the insurer may only reimburse reinstatement costs. Finally, the optimal contractual arrangement specifies that, order to discriminate among firms, the insurer may use a (randomly exercised) reinstatement option as a screening device. INTRODUCTION Following the accidental destruction of productive assets (e.g., buildings, plant, inventories), a firm must decide whether to repair or replace those assets. The reinvestment decision rule of the firm's manager usually rests on a net present value calculation (NPV). Future cash flows are estimated under the replacement arid abandonment strategies. After deducting the replacement cost one case and adding the salvage value of the damaged assets the other one, the manager will be a position to calculate the NPV of both strategies. The optimal strategy will be the one with the highest NPV. As an example, the absence of an efficient market for second-hand goods, a firm may have chosen to retain underproductive assets because expected discounted cash flows from continued use exceed the disposal value. In such a case, should the assets be accidentally destroyed, reinvestment will not be appropriate and the activity should be abandoned if the replacement cost is too high. Such circumstances are likely to prevail a period of declining demand. On the contrary, strong productive interdependencies would strengthen the case for the reinvestment, especially if a post-loss abandonment creates a bottleneck the production process. [1] Reinvestment decisions are also affected by the tax law. In particular, when the capital-gains tax rate is lower than the corporate profit tax rate, then a post-loss reinvestment is more likely to increase the value of the firm. [2] Reinvestment decisions may also be affected by specific provisions of the firm's insurance contract. This is particularly obvious corporate fire insurance. Indeed, when physical assets are destroyed by fire, the amount of the insurance coverage frequently depends on the reinstatement decision. In particular: 1. When the insured has the option to choose between insurance money or reinstatement, the indemnity is usually lower the first case than the second one. In case of reinstatement, the insurer pays for the replacement or repair of damaged capital, but a deductible applies when the insured chooses to receive insurance money. In fact, when there is no reinstatement, the insurance payment frequently corresponds to the accounting book value of the damaged assets, while there is full coverage (or at least a larger coverage) of the replacement cost case of reinstatement. [3] 2. Sometimes reinstatement is an option expressly given by the contract of insurance to the insurer rather than the insured. [4] For instance, Section 83 of the British Fire Prevention (Metropolis) Act 1774 provides that in order to deter and hinder ill-minded persons from wilfully setting their house or other buildings on fire view of gaining to themselves the insurance money,... fire insurers are authorized and required to expend the insurance money on the reinstatement of the house or building. However, this provision applies only to the extent that the insurer has grounds of suspicion that the insured has been guilty of fraud or wilfully setting the building on fire. 3. As emphasized by Clarke (1997), An initial offer of money by the insurer may be seen as a first move negotiations and does not rule out a later election to reinstate, if the initial offer is refused. …