Academic journal article Journal of Risk and Insurance

Information Risk and the Cost of Capital

Academic journal article Journal of Risk and Insurance

Information Risk and the Cost of Capital

Article excerpt

ABSTRACT

This article applies a unique accruals measure to empirically test whether accruals quality affects the cost of capital for property-liability insurers. We utilize insurer loss reserve errors to accurately measure the quality of accruals. This measure, as well as conventional accruals measures, is used to investigate the extent to which accruals quality is priced into both debt and equity capital. We find that accruals quality is priced into debt capital; however, we find virtually no evidence that accruals quality is priced into equity capital. Our results should be of particular interest to insurers as it affects pricing ability. Specifically, insurers who provide primary debt-holders (i.e., policyholders) less information risk are able to command higher prices. Furthermore, our results suggest that insurance is not a diversifiable asset.

INTRODUCTION

Information risk refers to the potential that inaccurate or incomplete firm information may be disseminated to those who are considering investment in the firm. Investment can come in various forms; two common examples are the purchase of a bond (debt) or the purchase of stock (equity). For insurers, a policyholder also invests in the firm when buying an insurance policy. Information related to this investment is therefore important to a potential policyholder just as information is valuable to a nonpolicyholder investor who may loan the insurer money or purchase stock in the insurer. Accounting results are a common vehicle for information dissemination to potential investors. Thus, if an investor is confident in the accounting results provided by the firm, the investor will accept a lower price on the capital being provided to the firm.

Recent research has attempted to address the degree to which information risk is priced into capital costs. (1) Utilizing accruals quality as a proxy for information risk, these studies have come to differing conclusions regarding the relation between information risk and the cost of capital. Our study contributes to this discussion by constructing an alternative, arguably more accurate measure of accruals quality utilizing insurer loss reserve errors. This measure allows us to directly observe the accuracy of the primary accrual used by insurance companies (loss reserves). Due to data limitations, prior research on accruals quality has relied on estimated accruals of firms. We then investigate the quality of accruals' relationship with the cost of debt capital and equity capital for insurers.

Francis et al. (2005) (FLOS) establish a link between a firm's accruals quality and its cost of capital. They argue that poor accruals quality weakens the mapping of accounting earnings into cash flows, and thus exposes investors to information risk. Ceteris paribus, investors will demand a risk premium by way of higher expected returns on capital for assuming this type of risk. Using a broad cross-section of publicly traded companies, FLOS show that poor accruals quality is positively related to (1) higher cost of equity, as computed using the firm's equity beta; (2) the firm's low price-to-earnings ratio; (3) a higher cost of debt; and (4) a high factor loading for accrual quality in one-factor (and three-factor) asset pricing models. Based on these results, FLOS conclude that when used as a proxy for information risk, accruals quality is a significant determinant of the cost of debt and equity capital.

Alternatively, Core, Guay, and Verdi (2008) (CGV) suggest that FLOS use a misspecified model to test the hypothesis that accruals quality is a priced risk factor. In fact, the models in CGV show no pricing of accruals quality in the cost of equity capital. FLOS and CGV exemplify the inconclusiveness of how information risk impacts a firm's cost of capital. We attempt to provide further evidence on this unresolved relationship by using a more precise estimate of accruals quality from the insurance industry. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.