Market Discipline in Life Insurance: Insureds' Reaction to Rating Downgrades in the Context of Enterprise Risks

21 Pages Posted: 21 Mar 2007 Last revised: 4 Mar 2010

See all articles by Etti G. Baranoff

Etti G. Baranoff

Virginia Commonwealth University (VCU) - Department of Finance, Insurance & Real Estate

Thomas W. Sager

University of Texas at Austin - Red McCombs School of Business

Date Written: February 15, 2007

Abstract

There is serious debate about the effectiveness of the market to discipline regulated industries like banks and insurance. In this paper, we examine empirically the reaction of consumers to changes in the financial ratings of life insurers. We find that downgraded life insurers in the period 1994-2003 experience a decline in demand for life insurance policies in the year after a downgrade. This occurs in spite of mitigation strategies like adjusting premium rates. It occurs in the context of a spectrum of enterprise risk measures and other controls such as financial risk (leverage), product risk (premiums written in various lines), asset risk (a proxy called opportunity asset risk), operational risks (use of derivatives, organizational structure and distribution system), regulatory risk (risk-based capital ratio), and size (total assets). Our findings comport with similar research in banking on the reactions of depositors to changes in the risk taking of banks. Moreover, our model is able to estimate the magnitude of the decline in demand for individual insurers. Using the notion of Granger causality, we are also able to demonstrate that the direction of the relationship flows from ratings downgrade to decline in demand, rather than the reverse. These findings have potentially strong impacts on the issue of appropriateness of risk models that regulators and the industry are developing in parallel: The parallel tracks may need to align with a third rail.

Keywords: market discipline, rating upgrades and downgrades, life insurance, Granger causality

JEL Classification: C23, C51, G22, D21

Suggested Citation

Baranoff, Etti G. and Sager, Thomas W., Market Discipline in Life Insurance: Insureds' Reaction to Rating Downgrades in the Context of Enterprise Risks (February 15, 2007). Available at SSRN: https://ssrn.com/abstract=971200 or http://dx.doi.org/10.2139/ssrn.971200

Etti G. Baranoff

Virginia Commonwealth University (VCU) - Department of Finance, Insurance & Real Estate ( email )

Richmond, VA 23284
United States

Thomas W. Sager (Contact Author)

University of Texas at Austin - Red McCombs School of Business ( email )

Austin, TX 78712
United States