The role of insurance and limited liability on corporate insolvencies

Abstract

The current recession has been accompanied by an unprecedented rise in the incidence of default on loans and companies' insolvencies. This paper seeks to clarify the reasons for this level of default, relating them not only to the general economic conditions and the state of private sector balance sheets but also to a range of factors such as the role that limited liability and several forms of insurance contracts play in companies' failures. In particular, due to asymmetric information and 11 moral hazard 11 problems limited liability seems to favor insolvency. However, the use of credit insurance is likely to reduce the cost of capital and thus the probability of default, as insurance companies are better suited for screening and monitoring functions.