Question

An article in the Economist notes that: “From an insurance perspective, the co-payments that patients must sometimes make when receiving treatment are a waste; it would be better for people to be able to insure fully.” Are restrictive covenants in loan agreements also a waste in this sense? If so, why do insurance companies use co-payments and why do lenders use restrictive covenants?

Answer 1

No, ideally speaking the restrictive covenants in loan agreements is not a waste in that sense. In fact restrictive covenants are used to ensure that the interest of the lender is protected as these covenants contain certain terms and conditions with regards to the financials of the borrower and hence ensures good financial health of the borrower.

Insurance companies use co-payments and lenders use restrictive covenants so as to ensure that interests of the person taking the insurance is aligned with the interest of the insurance company and the interest of the borrower is aligned with the interest of the lending company. For instance the co-payment clause that insurance company puts in ensures that people do not make unnecessary claims. In other words co-pay discourages people to misuse their health insurance policies and encourages people to make honest and judicious use of their health insurance policies. The same applies with restrictive covenants put in place by lenders who want to ensure that the borrower uses the loan for the right purpose and then keeps the financial condition in a proper shape so as to be able to timely service the loan and pay back the interest and principal amounts at the time when they become due.