Insurance Covenants in Corporate Credit Agreements

• DOI: http://doi.org/10.1111/jori.12263
• Date: 01 March 2020
• Published date: 01 March 2020
• Author: Greg Nini

INSURANCE COVENANTS IN CORPORATE CREDIT

AGREEMENTS

Greg Nini

ABSTRACT

In a large sample of private credit agreements of publicly traded firms,

nearly all agreements contain at least a boilerplate provision requiring the

borrower to purchase insurance. In about 80 percent of the agreements,

the insurance covenant is more explicit. Four additional features of the

insurance covenant are quite common: requirements of coverage for

specific risks, naming the lender as a loss payee, mandating that any

insurance proceeds be used to repay the loan, and explicit permission for

the borrower to self-insure. Credit agreements contain more stringent

insurance requirements for borrowers that pose higher credit risk. The

insurance requirements are strongly positively correlated with the loan

being secured by collateral, which suggests that insurance creates value by

protecting lenders from unexpected changes in seniority that might

happen following the destruction of collateral. Insurance covenants are an

important ingredient of credit agreements designed to create a very safe

claim for senior, secured lenders.

INTRODUCTION

Corporate credit agreements frequently require the borrower to purchase

insurance, providing one answer to the long-debated question why publicly

traded corporations would demand insurance. Since the seminal work of Mayers

and Smith (1982) first highlighted that the corporate form provides maximal

diversification opportunities, researchers have looked for alternatives to risk

aversion to explain the corporate demand for insurance. Mayers and Smith (1987)

and others have pointed to covenants in lending agreements as one source of

corporate demand and have offered theories to identify the value that insurance

covenants can create.

The goal of this article is to provide large-sample evidence on the use and nature of

insurance covenants in credit agreements for publicly traded companies. I provide

Greg Nini is at LeBow College of Business, Drexel University. Nini can be contacted via e-mail:

gpn26@drexel.edu.

©2018 The Journal of Risk and Insurance. Vol. 9999, No. 9999, 1–21 (2018).

DOI: 10.1111/jori.12263

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evidence that loan contracts nearly always require that borrowers have some form of

insurance and in many cases tailor the requirements to the borrowers’ specific

situation. In addition to requirements to have insurance, credit agreements also

frequently include four additional provisions: (1) requirements that borrowers

purchase specific types of coverage, such as liability or property insurance; (2)

requirements that lenders be named as additional loss payees; (3) requirements that

the proceeds from any insurance payments be used to pay down outstanding loan

balances; and (4) explicit permission that borrowers may self-insure. Given that over

three-quarters of public firms use private credit agreements (Sufi, 2007), insurance

covenants are indeed an important source to explain the depth and variety of

corporate insurance seen in practice.

I establish these facts using a set of more than 4,000 credit agreements entered into by

publicly traded firms in the United States during the years 1996 through 2010. In each

of the agreements, I read the section related to insurance and code the presence or

absence of each of the four provisions.

Using these data, I show empirically that the provisions are related to a number of

borrower-specific characteristics. Consistent with prevailing theory, I find that the

credit quality of the borrowers is significantly related to the use of various insurance

provisions. Firms posing higher credit risk are significantly more likely to be required

to buy insurance for specific risks, more likely to name their lender as a loss payee,

and more likely to be required to use any insurance proceeds to pay down loan

balances. The estimated effects are quite large; compared to firms with an A credit

rating, B-rated firms are about twice as likely to have insurance covenants that require

specific coverage.

This result is consistent with existing theories that explain insurance covenants

as a means to avoid underinvestment problems created by risky debt. Myers

(1977) shows that management of levered firms may limit investment if some of

the returns to a project accrue to creditors in the form of reduced credit risk.

Since the underinvestment problem worsens as firms become more levered,

insurance can create value by reducing the probability of insolvency, as shown

in Garven and McMinn (1993). For firms with higher credit risk, the benefit of

insurance is larger, since it takes a smaller loss to move such firms closer to

insolvency.

I also find that stricter insurance covenants are considerably more common for

loans that are secured with collateral. Secured loans are much more likely to

require specific coverage, often insuring the assets serving as collateral, much

more likely to name the lender as an additional loss payee, and more likely to

require prepayment from insurance proceeds. I conjecture that the insurance

requirement creates value by limiting the possibility that secured lenders face an

unexpected change in priority following an insurable loss. For example, in the

event that a fire destroys a firm’s inventory that is pledged as collateral to a

secured lender, the secured lender loses its priority relative to the firm’s other

creditors. The risk of such an event weakens the value of providing collateral,

which recent empirical work (e.g., Rauh and Sufi, 2010) has shown is used

strategically by borrowers. If, however, the borrower were required to purchase

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