A novel insurance system for associated loans: the realization of reducing bankruptcy cost

The assets of bankrupt firms are usually sold to unsuitable buyers at an extremely discounted price. Aiming to reduce the bankruptcy cost, the purpose of this paper is to propose a novel insurance system for associated loans.

In this insurance system, the joined firms are from the same industry and have a responsibility to buy the assets of potentially bankrupt firms at a relatively high price, because they could make better use of the assets than the buyers outside the industry. Further, the authors use the Shapley value to address the problem of bankruptcy cost allocation and additionally employ the method of Monte Carlo simulation to derive the numerical solution of the insurance premium of bankruptcy cost.

First, the relatively healthy and solvent firms in the insurance system could gain a larger proportion of benefits derived from the reduced cost of default, interestingly, the more so when the external cost of default is larger. Second, given the positive relationship between bankruptcy cost and asset correlation in practice, lenders and insurers face a trade-off to balance the cost against the benefit of asset correlation. Third, insurance premiums and bankruptcy costs decrease with the number of firms participating in this insurance system.

This paper proposes a novel insurance for associated loans, in which joined firms can pay a relatively low insurance premium due to the realization of reducing bankruptcy cost.