Information Risk and the Cost of Capital

• Published date: 01 December 2014
• Author: Martin Halek,David L. Eckles,Rongrong Zhang
• DOI: http://doi.org/10.1111/j.1539-6975.2013.01526.x
• Date: 01 December 2014

INFORMATION RISK AND THE COST OF CAPITAL

David L. Eckles

Martin Halek

Rongrong Zhang

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 there-

fore 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.

David L. Eckles is with the Terry College of Business, University of Georgia. Martin Halek is

with the School of Business, University of Wisconsin. Rongrong Zhang is with the College

of Business Administration, Georgia Southern University. David Eckles can be reached via

e-mail: deckles@uga.edu.

DOI: 10.1111/j.1539-6975.2013.01526.x

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© The Journal of Risk and Insurance, 2013, 81, No. 4, 861–881

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.

Our article empirically te sts whether accruals quality affects the cost of capital of

insurance companies. This rela tionship is particularly important to insurers since

the primary source of their bor rowed funds comes from their customers

(i.e., policyholders). S pecifically, we examine the extent to which accruals quality

is priced into debt capital (p olicyholder debt) and equity capital using insurer

reserve errors as well as acco unting accruals measures use d in prior research.

Consistent with FLOS, we find a negat ive relationship between the quality of

accruals and the cost of debt capital to insure rs. Our results are the same whe n

using both observed and estim ated accounting errors. When examining insurers

within publicly traded entit ies, we see no evidence that infor mation risk is a

positively priced risk fac tor in equity capital (via the firm’s beta) which suppo rts

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These studies, detailed below, do not consider the mechanism by which the information is

disseminated. For example, for policyholders of an insurer, information may come from a

rating agency, an agent, a broker, etc.

862 THE JOURNAL OF RISK AND INSURANCE