Incentive incompatibilities and arbitrage opportunities

Purpose – The paper aims to examine the practical importance of the finding of Mayers and Smith, that underinvestment is a problem when debt exposed to bankruptcy is part of the financial structure. Design/methodology/approach – The paper examines critically the assumptions underlying the Mayers and Smith paper. Findings – The necessary assumption of deterministic arbitrage in the market for productive properties used by Mayers and Smith in their model is found to be unrealistic. Even if that assumption were valid, however, the result of Mayers and Smith establishes that raising exposed debt is a negative net present value project for the investor and hence that form of financing would not be found in practice. Practical implications – The existence of exposed debt does not explain the demand or commercial insurance. Originality/value – The paper challenges the results of Mayers and Smith that have been used to examine the effect of debt on insurance demand for almost 20 years with mixed results.