An Investigation of the Short‐Run and Long‐Run Stock Returns Surrounding Insurer Rating Changes

• Author: Jennifer J. Gaver,Leon Chen,Steven W. Pottier
• DOI: http://doi.org/10.1111/jori.12138
• Date: 01 March 2018
• Published date: 01 March 2018

© 2016 The Journal of Risk and Insurance. Vol. 85, No. 1, 35–67 (2018).

DOI: 10.1111/jori.12138

35

ANINVESTIGATION OF THE SHORT-RUN AND LONG-RUN

STOCK RETURNS SURROUNDING INSURER RATING

CHANGES

Leon Chen

Jennifer J. Gaver

Steven W. Pottier

ABSTRACT

We find that stock returns move in the direction of insurer rating changes in

the 12-month period prior to the announcement. There is an additional stock

price response following the announcement of a downgrade, but no

response to upgrade announcements. The reaction to a downgrade is more

pronounced when it involves a smaller insurer, when it spans multiple

levels, or when it is a threshold downgrade. Returns are significantly more

negative during the 12 months leading up to a downgrade announcement

during the financial crisis (2008 and 2009) compared to other sample years.

INTRODUCTION

Insurer financial strength ratings assess the ability of an insurer to pay future claims.

Unlike bond ratings, which gauge default risk for a specific debt security, financial

strength ratings are a summary measure of the insolvency risk of the insurance firm as

a whole (Pottier and Sommer, 2002). Rating agencies, such as A.M. Best Company Inc.

(Best), claim that their assessments are based on both publicly available information

about the rated insurer and private information from company managers. The

agencies perform extensive quantitative and qualitative analysis of an insurer’s

financial position, performance, and prospects, using proprietary models. The

question that we address in this study is whether and in what contexts insurer

financial strength ratings provide information that is relevant to equity valuation, as

well as the timing of the market response.

The standard means of measuring information content is to track stock price revisions

contemporaneous with an event that is hypothesized to be value relevant. In an

Leon Chen is at Minnesota State University at Mankato, Department of Finance, College of

Business, MN. Chen can be contacted via e-mail: yilin.chen@mnsu.edu. Jennifer J. Gaver is at

University of Georgia, Terry College of Business, J.M. Tull School of Accounting, Athens, GA.

Gaver can be contacted via e-mail: jgaver@uga.edu. Steven W. Pottier is at University of

Georgia, Terry College of Business, Department of Insurance, Legal Studies, and Real Estate,

Athens, GA. Pottier can be contacted via e-mail: spottier@.uga.edu.

36 THE JOURNAL OF RISK AND INSURANCE

efficient capital market, an entity’s stock price is the present value of its expected

future cash flows discounted for risk. In this context, a new or revised financial

strength rating would be value relevant if it prompts investors to change either their

assessment of the insurer’s future cash flows or the appropriate discount rate for those

cash flows. Sommer (1996) contends that policyholders view insurers with higher

ratings as having lower insolvency risk. Halek and Eckles (2010) observe that ratings

can impact an insurer’s future cash flows if brokers and other intermediaries base

their decisions on where to place business on insurer ratings.

1

This suggests that

changes in financial strength ratings potentially convey information about both an

insurer’s future cash flows and its risk.

The valuation impact of a ratings announcement—that is, whether it prompts a

change in expected cash flows or risk—depends on the information environment of

the insurer. The issue is whether the market for the insurer’s stock is primarily

characterized by previously uninformed investors who receive new information from

the ratings change announcement or if it is dominated by informed investors who

already had access to the information from alternative sources. If informed investors

dominate the market, then stock prices will not react to a rating change because it

simply confirms existing expectations. The converse is also true; if investors did not

previously have access to the information conveyed by the rating announcement, a

stock price reaction will occur.

Our study provides new evidence on the association between financial strength

ratings and equity values. We analyze a sample of 267 rating changes announced by

Best for a sample of 238 insurers during the 1996–2013 period. Using insurer stock

returns over a 25-month period centered on the month of the rating change, we assess

the abnormal stock price activity leading up to the announcement as well as the

immediate and longer term stock market response to this event. We find that for the

sample as a whole, stock returns move in the direction of the rating change (either

upgrade or downgrade) prior to the announcement. Abnormal performance is

apparent 12 months before the change is announced and continues into the days

leading up to the event. This suggests that, in general, public information supporting

the rating change is incorporated into stock price in a timely fashion as the

information becomes available. Thus, investors and rating agencies are responding to

a common set of publicly available information. There is an additional stock price

response following the announcement of a downgrade, but no response to upgrade

announcements. The market reaction to downgrades is short-lived, discernible only

in the month of the downgrade announcement and in the following few days. This

differs from the results for bond rating changes, where negative abnormal

performance can persist for up to a year (Dichev and Piotroski, 2001).

We also investigate the impact of the financialcrisis on the association between rating

changes and stock returns. Compared to other sample years, the market response to

rating downgrades in 2008 and 2009 is significantly more negative during the

12 months leading up to the announcement and significantly more positive in the

1

Supporting this, Epermanis and Harrington (2006) find that premium growth decreases

significantly in the year of and in the year following rating downgrades.

INVESTIGATION OF THE SHORT-RUN AND LONG-RUN STOCK 37

12 months thereafter. In nonfinancial crisis years, abnormal performance is negative

both before and after downgrade announcements. This suggests that market

participants were overly conservativein valuing insurance stocks during the financial

crisis years, leading to corrections after downgrade announcements. These findings

add to the growing literature on the response of insurers to the financial crisis (see

Harrington, 2009; Berry-Stolzle, Nini, and Wende, 2014; Cummins and Weiss, 2014).

Abnormal stock price performance around announced changes in financial strength

ratings is related to characteristics of both the insurer and of the rating change itself.

Abnormal returns prior to downgrades tend to be more negative among smaller

insurers and in cases where ratings cross an “acceptability threshold,” span multiple

levels, or follow a previous change earlier in the year.

2

Smaller insurers and cases

where ratings cross the acceptability threshold or span multiple levels also have more

negative abnormal performance in response to the downgrade announcement.

Cumulative abnormal returns prior to upgrades tend to be more positive among

smaller insurers and insurers in lower rating categories prior to the rating change.

They are also more positive in cases where ratings cross the acceptability threshold

and span multiple levels.

Although our study is not the first to examine the relation between insurer financial

strength ratings and equity valuation, it makes two important contributions to the

literature. First, we examine stock market returns over a substantially longer period

than has been attempted in previous work. Our analysis considers stock price

behavior for a full year before and a full year after a ratings change announcement.

Halek and Eckles (2010) and Eckles and Halek (2012) also examine the equity market

response associated with changes in insurer financial strength ratings, but their

analysis is limited to short-term price reactions around the event. Dichev and

Piotroski (2001) examine the long-term market response following changes in

corporate bond ratings but do not consider stock price changes prior to the

announcement. Our comprehensive time frame allows us to consider how

information about an insurer’s financial condition is disseminated to investors and

the degree to which ratings convey private information or simply confirm public

knowledge. The second contribution of our study is to investigate the degree to which

the hypothesized stock return behavior prior to and following the rating change

announcement is associated with the size of the equity reaction. We do this by

partitioning the sample according to firm characteristics that we expect to be

associated with the information environment and ratings characteristics that we

expect to be associated with the timing and magnitude of the information diffusion

process. Our results support the notion that insurer financial strength ratings are

value relevant to equity investors, although they are not always a timely source of

information.

The remainder of this article proceeds as follows. The “Prior Research” section

reviews relevant prior research. The “Hypotheses” section states the hypotheses

2

Ratings that cross an “acceptability threshold” reclassify the firm from below to above either

an Aor a Bþrating (in the case of upgrades) or from above to below either an Aor Bþrating

(in the case of downgrades).