Corporate insurance with optimal financial contracting

This paper attemps to rationalize the use of insurance covenants in financi al contracts, and shows how external financing generates a demand for insur ance by risk-neutral entrepreneurs. In our model, the entrepreneur needs ex ternal financing for a risky project that can be affected by an accident du ring its realization. Accident losses and final returns are private informa tion to the firm, but they can be evaluated by two costly auditing technolo gies. We derive the optimal financial contract: it is a bundle of a standar d debt contract and an insurance contract with franchise, trading off bankr uptcy costs vs auditing costs. We then analyze how this optimal contract ca n be achieved by decentralized trading on competitive markets when insuranc e and credit activities are exogenously separated. With additive risks, the insurance contract involves full coverage above a straight deductible. We interpret this result by showing how our results imply induced risk aversio n for risk-neutral firms.