Market Discipline in Life Insurance: Insureds' Reaction to Rating Downgrades in the Context of Enterprise Risks
Social Science Research Network
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
... n 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 -consumers' discipline.