Market Discipline in Property/casualty Insurance: Evidence from Premium Growth Surrounding Changes in Financial Strength Ratings

By Epermanis, Karen; Harrington, Scott E. | Journal of Money, Credit & Banking, September 2006 | Go to article overview

Market Discipline in Property/casualty Insurance: Evidence from Premium Growth Surrounding Changes in Financial Strength Ratings


Epermanis, Karen, Harrington, Scott E., Journal of Money, Credit & Banking


SINCE JENSEN AND MECKLING (1976), the agency cost literature emphasizes possible time-inconsistent incentives and attendant increased risk-taking associated with debt finance. With rational, risk-sensitive lenders, shareholders bear the expected costs of distorted incentives ex ante, thus motivating firms to accept restrictions on risk-taking and otherwise reduce agency costs. This result also applies to financial firms, such as banks and insurance companies. When customer demand is risk sensitive, financial firms with higher insolvency risk will receive less favorable terms of trade, such as having to offer higher yields on bank deposits, CDs, or subordinated debt, or having to accept lower prices on insurance contracts. Deterioration in an institution's financial condition and an attendant increase in its insolvency risk likewise should produce a loss of customers and adversely affect the terms of trade with customers that remain, thus reducing the institution's revenues and cash flows. Those consequences in turn should motivate financial firms to manage their risk ex ante. As a result, the risk sensitivity of demand for financial firms is an important factor influencing private incentives for safety and soundness.

If, on the other hand, customer demand is risk insensitive, the potential loss of intangible, firm-specific assets ("franchise value") that arise from investments in reputation and building a client base can nonetheless motivate risk management by value maximizing financial firms. Incentives to preserve franchise value can therefore offset, at least in part, disincentives for safety and soundness that flow from risk-insensitive demand. Although there is no sharp definition or consensus concerning the meaning of "market discipline" in the safety and soundness literature, the term often focuses on incentives provided by risk-sensitive customer demand. The term also can be used more broadly to encompass incentives for risk management provided by capital markets, including the goal of preserving franchise value to benefit equity-holders.

The banking and insurance literatures emphasize moral hazard and reduced risk sensitivity of demand that accompany risk-insensitive deposit insurance and insurance guaranty funds. The magnitude of market discipline provided by risk-sensitive demand and, more broadly, capital market incentives for safety and soundness, and the extent to which private incentives can substitute for or augment regulation of financial intermediaries remain of considerable interest and importance in the United States and abroad given the ongoing evolution of prudential supervision in general and capital regulation in particular.

This study analyzes the relationship between insurance premium growth and changes in A.M. Best Company financial strength ratings for a large sample of property/casualty insurers. We conduct control group comparisons of premium growth for firms with rating changes versus those without for a sample of 9,446 firm-year observations during 1992-99 and regression tests for 7,961 firm-year observations during 1993-99. We generally find economically and statistically significant premium declines in the year of and the year following rating downgrades. Premium declines were greater for firms with relatively low pre-downgrade ratings (Best's rating of either A- or B + + and below) and particularly pronounced for firms losing an A- rating. The results provide little evidence of moral hazard induced premium growth surrounding rating downgrades. Our results also provide some evidence that rating upgrades for relatively low-rated insurers were accompanied by increased premium growth.

Consistent with weaker guaranty fund protection and greater risk sensitivity of demand for commercial insurance compared with personal automobile and homeowners' insurance, we find that premium declines predominantly occurred for commercial insurance written by insurers with pre-downgrade ratings of A- and below, and were especially pronounced for insurers with a pre-downgrade rating of A-. …

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