Information and Insurer Financial Strength Ratings: Do Short Sellers Anticipate Ratings Changes?

• Published date: 01 June 2016
• Author: Andre Liebenberg,Benjamin M. Blau,Chip Wade
• Date: 01 June 2016
• DOI: http://doi.org/10.1111/jori.12063

INFORMATION AND INSURER FINANCIAL STRENGTH

RATINGS:DOSHORT SELLERS ANTICIPATE RATINGS

CHANGES?

Chip Wade

Andre Liebenberg

Benjamin M. Blau

ABSTRACT

Ratings of financial institutions have been shown to provide informational

value as stock prices generally decrease in response to ratings downgrades.

Moreover, insurer’s stock prices have been observed to decrease 2 days prior

to downgrades, suggesting that informed trading occurs during the

predowngrade period. This study examines the trading activity of short

sellers surrounding insurer financial strength ratings. We show that short

selling is abnormally high during the predowngrade period—indicating that

short sellers can predict rating downgrades. Interestingly, we find that

predowngrade short selling is driven by stocks of insurers with the most

transparent balance sheets. This result suggests that while short sellers can

predict rating downgrades generally, the opaqueness of an insurer’s assets

and liabilities can inhibit informed trading during the predowngrade period.

INTRODUCTION

Research regarding the insolvency risk of financial institutions has received

considerable attention, with good reason due to recent insolvencies in financial

institutions. Doherty and Phillips (2002) argue that insurers attempt to market their

financial strength (IFS) ratings as a signal of the firm’s financial strength. Pottier and

Sommer (1999) suggest that investors use these ratings to measure the risk of insurers,

while Parekh (2006) suggests that insurers with ratings above some specified

threshold are more popular than other insurers. Halek and Eckles (2010) find that

stock prices of insurance companies tend to move in the direction of ratings changes,

particularly for unfavorable changes, thus indicating that ratings provide informa-

tional value to the market. Further, Halek and Eckles (2010) show that returns during

the 2 days prior to downgrades are significantly negative, suggesting that the market

Chip Wade is at the Mississippi State University, 312 McCool Hall, MS 39762. Wade can be

contacted via e-mail: CWade@cobilan.msstate.edu. Andre Liebenberg is at the Department of

Finance, University of Mississippi, Oxford, MS. Benjamin M. Blau is at the Department of

Economics and Finance, Utah State University, Logan, UT.

© 2015 The Journal of Risk and Insurance. Vol. 83, No. 2, 475–500 (2016).

DOI: 10.1111/jori.12063

475

begins to move as informed investors begin to trade before the announcement of the

downgrade is made public.

The objective of this study is to examine a subset of arguably informed traders—short

sellers—around IFS ratings announcements. Specifically, we test whether the price

reaction precipitated by ratings downgrades, upgrades, and affirmed ratings are

anticipated by short sellers. Prior work generally finds that short-selling activity

contains information about future price movements as current short-selling activity

relates inversely to subsequent stock returns (Diamond and Verrecchia, 1987;

Senchack and Starks, 1993; Aitken et al., 1998; Desai et al., 2002; Boehmer, Jones, and

Zhang, 2008; Diether, Lee, and Werner, 2009). However, observing a negative relation

between short selling and subsequent returns is not tantamount to finding that short

sellers are privately informed, per se. In fact, Engelberg, Reed, and Ringgenberg (2012)

show that the negative relation between daily short selling and next-day returns is

driven by the ability of short sellers to process information that is already public.

The level of private information contained in short selling has been recently debated.

Some research indicates that short sellers are consistently able to predict negative

announcements, such as earnings announcements and analyst recommendations

(Christophe, Ferri, and Angel, 2004; Christophe, Ferri, and Hsieh, 2010). However,

other studies have shown that short-selling activity is not abnormally high prior to

negative news events as short sellers are generally reactive as opposed to being

proactive prior to firm-specific announcements (Daske, Richardson, and Tuna, 2005;

Blau and Pinegar, 2012; Blau and Wade, 2012; Engelberg, Reed, and Ringgenberg,

2012).

While our study is motivated by this debate in these foregoing studies, examining the

trades by short sellers around IFS rating announcements is particularly appealing for

two reasons. First, while insurers are often rated on an annual or quarterly basis, IFS

ratings are not usually announced on a fixed calendar date and are therefore less

predictable than other types of announcements such as earnings or analysts’

recommendations. Second, ratings are focused on insurance companies that vary in

their level of transparency as their asset and liability structure is focused in different

lines of insurance business and differs in the level of uncertainty (Ross, 1989; Baranoff

and Sager, 2002; Zhang, Cox, and Van Ness, 2009). The cross-sectional variation in

transparency of insurer liabilities and assets may adversely affect the ability of short

sellers to correctly predict upcoming ratings because of uncertainty in properly

evaluating the insurance company. Thus, the insurance industry and specifically IFS

rating announcements provide a robust framework for testing whether short sellers

trade on private information or have a superior ability to process already-public

information.

Using a sample of 165 A.M. Best ratings announcements between January 1, 2005 and

December 31, 2006, we test whether short selling is unusually high in the period

directly prior to IFS rating announcements. Our tests show abnormally high short

selling prior to downgrades, after controlling for other factors that might affect the

level of short selling. In additional tests, we find abnormally low short selling in the

days prior to the ratings upgrades and relatively normal short selling in the days prior

to announcements when ratings are affirmed (no change). Combined with our results

476 THE JOURNAL OF RISK AND INSURANCE