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«July 7, 2015 World Risk and Insurance Economics Congress Munich, Germany Leon Chen Assistant Professor, Minnesota State University at Mankato Phone: ...»

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The Impact of Rating Agency’s Private Information and Disclosed Causes of Rating

Downgrades on Insurer Stock Returns

July 7, 2015

World Risk and Insurance Economics Congress

Munich, Germany

Leon Chen

Assistant Professor, Minnesota State University at Mankato

Phone: (507) 389-5336

Email: yilin.chen@mnsu.edu

Department of Finance, College of Business

150 Morris Hall

Mankato, MN 56001

Steven W. Pottier*

Associate Professor, University of Georgia

Office: (706) 542-3786

Fax (706) 542-4295 Email: spottier@uga.edu Address: Terry College of Business Department of Insurance, Legal Studies, and Real Estate 206 Brooks Hall Athens, GA 30602 *Corresponding Author JEL Classification: G14, G22 The Impact of Rating Agency’s Private Information and Disclosed Causes of Rating Downgrades on Insurer Stock Returns Abstract Existing studies document that bond and insurer rating downgrades are associated with negative abnormal returns, but generally do not consider the disclosed reasons for the downgrade and none has distinguished between rating downgrades based on private information or public information, or both. Using hand-collected press release news of A.M. Best Company (Best) rating downgrade actions for a sample of publicly-traded insurance firms during the period of 1996-2012, we classify and analyze rating downgrades based on the disclosed causes of the downgrades and whether the rating agency has relied upon private information. We then use an industry-benchmark model to calculate the short-run abnormal stock returns during the 21-day period surrounding the downgrade events. We find that during the three-day event window (-1, +1), rating downgrades overall generate statistically significant negative cumulative average abnormal returns (CAAR) of -7.76 percent. Significantly more negative CAAR of -11.46 percent is found for “financial-prospects-deterioration” downgrades with the presence of Best’s private information or opinion. For downgrades without any indication of Best’s private information or opinion, the CAAR is -3.35 percent which is significantly different from zero, but significantly less negative than the CAAR of downgrades where private information or opinion is indicated.

Downgrades with reported causes other than deterioration of a firm’s fundamental financial performance or condition, such as increases in financial leverage and increased business risk taking, produced significantly negative CAAR of -3.19 percent during the (-1, +1) 3-day event window, which is also significantly less negative than the CAAR of downgrades where private information or opinion is indicated. Our results provide evidence that downgrades where private information is likely and downgrades due to insurers’ fundamental financial profiles contain more information useful for investors than other types of downgrades.

1. Introduction The finance literature has examined the impact of a change in the firm’s debt rating on its common stock returns. The general consensus is that a rating upgrade is associated with an insignificant stock reaction, but a rating downgrade is associated with negative stock returns. 1 Credit rating agencies claim to receive private information for purposes of forming a rating opinion. When credit rating agencies announce a rating change, they also give a reason for the rating change. Capital market efficiency implies that all publicly available information is rapidly reflected in share prices and that any stock market response to rating changes should be due to new information (Fama, 1970 and 1991). Unless credit rating agencies possess a superior ability to evaluate public information, the stock market response to rating changes should be due to the private information contained in the rating change. Existing studies on rating changes generally do not consider the disclosed causes of downgrades and whether the rating agencies have used private information, public information, or both. In contrast to other studies on rating changes, Goh and Ederington (1993) examine the reasons for a bond rating downgrade and find that negative stock returns follow a downgrade due to a change in the firm’s financial performance or prospects, but not a downgrade due to the change of financial leverage, since increasing financial leverage may transfer wealth from bondholders to shareholders and thus can actually be good news to shareholders. Thus, a key point of their study is that rating downgrades do not necessarily have negative implications for stockholders as other studies implicitly assume when all rating downgrades are grouped and evaluated together.

Our study both extends and applies the analysis of Goh and Ederington (1993) to insurance firms. We further extend their analysis by hypothesizing that shareholders should only See Griffin and Sanvicente (1982), Hand, Holthausen and Leftwich (1992), Dichev and Piotroski (2001), Halek and Eckles (2010).

react negatively to a downgrade that conveys rating agencies’ incremental private information or opinion other than the publicly available information. Finding support for this hypothesis is important in understanding whether rating agencies provide incrementally useful information to market participants. If shareholders react negatively to all types of downgrades in a similar way, then the information set used and the causes of the rating downgrade may not be relevant to investors. Such a response tends to imply that the private information contained in the rating action news, if any, is of little value. We also apply the basic notion in Goh and Ederington (1993) that the particular reason for the rating downgrade is likely to determine whether the market responds negatively, positively, or not at all to a rating downgrade. For instance, we argue that a downgrade due to managerial decisions to increase business risk may not necessarily be bad news to shareholders, regardless of whether private or public information is used by the rating agency. These situations include not only financial leverage increases, a reason considered in Goh and Ederington (1993), but also aggressive business strategies, such as new product launching, business expansion, increased investment/asset risk, aggressive pricing, increased business concentration, and acquisitions or spin-offs. We argue that the increasing business risk due to managerial decisions does not usually decrease firm value and may represent wealth transfer from policyholders (or bondholders) to shareholders, and that can potentially be good news to shareholders.

This is the first paper to analyze the content of private information embedded in rating action news. Also, this is the first paper to apply the general approach of Goh and Ederington (1993) to insurer rating downgrades. We use hand-collected press release news of A.M. Best Company (Best) rating downgrade actions, for a sample of publicly-traded insurance firms during the period of 1996-2012. Best is the rating agency that specializes in rating insurance firms and its ratings are considered the most authoritative in the insurance industry. We determine whether private information may be used from each press release reporting a rating downgrade, and typically look for key words or phrases such as “A.M. Best remains concerned that…,” “it is A.M. Best’s opinion that…,” “believes,” and “expects.” We further read each downgrade news story after identifying those key words, to confirm the reasonableness of assuming the presence of some level of Best’s private information or opinion as one of the determining factors of rating downgrades. We then categorize them as the group where suspected Best’s private information or opinion (other than or in addition to public information) is being used in determining the rating downgrade.

Goh and Ederington (1993) differentiate “contaminated” and “uncontaminated” samples where the “uncontaminated” sample excludes observations when other firm-specific information is publicly released in the short-run event window. However, the nature of their “uncontaminated” sample is essentially quite different from that of the sample with suspected private information under our grouping method. For example, following their definition of “uncontaminated,” the rating downgrade may be partially due to public information announced several months ago which is outside of the event window, and it would be categorized as both “uncontaminated” and “no suspected private information.” In addition, the rating downgrade may be due to Best’s quantitative analysis of the public information released during the event window, and thus can be both “contaminated” and “no suspected private information.” Further, Best may issue a rating downgrade soon following a publicly known event after combining its own private information and/or opinion, and thus such downgrade can be categorized as both “contaminated” and “suspected private information.” In short, we are mainly concerned about whether Best may potentially use its own private information in making the rating downgrade decision. Goh and Ederington (1993) do not find meaningful differences in short-run abnormal returns between their full sample and “uncontaminated” sample. Our key empirical finding is that private information does make a statistically significant difference in shareholders’ responses to rating downgrade events, as implied by the generally accepted understanding of market efficiency in the finance literature.

Focusing on insurance firms offers three advantages relative to other industries generally.

First, it eliminates factors influencing cross-industry differences, such as accounting, taxation and regulatory differences. Second, Best’s financial strength ratings (FSRs) pertain to the entire firm rather than a particular security issued by the firm. Bond ratings of the same firm may be different because each rating is related to a particular security issued by the firm. Unlike bond ratings, the FSRs assigned by Best are related to the entire firm’s financial prospects, and specifically the ability of the insurer to meets its obligations to policyholders. The policyholder claim is the most senior debt or “debt-like” claim of insurance firms. Thus, we suggest that the FSR ratings are more uniform than the ratings used in studies of bond rating changes. Third, insurers are widely thought to be especially complicated to evaluate, mainly because of the opaque nature of their business operations (Fan et al., 2006). The amount, timing and uncertainty of cash flows with respect to “policyholder debt” are unique characteristics since premiums are generally fixed in advance, but the policyholder claim is not fixed.

We find that rating downgrades in general produce statistically significant negative cumulative average abnormal returns (CAAR) of -7.76 percent in the three-day (-1,+1) event window. 2 More negative CAAR of -11.46 percent during that event window is found for downgrades with both suspected Best’s private information or opinion and deterioration of The magnitude of the average abnormal return is similar to other studies. For instance, Halek and Eckles (2010, p.

817) report an abnormal return of -4.6 percent in the same window; Chen and Pottier (2014) report an abnormal return of -8.7.

fundamental financial prospects as related causes of downgrades. In general, abnormal returns, even when significantly different from zero, are significantly less negative for rating downgrades where there is not any indication of private information, and/or downgrades where the disclosed cause of the rating downgrade is something other than deterioration in the insurer’s fundamental financial performance/condition. The relatively larger (in absolute value) market reaction to rating downgrades where private information is indicated and/or where the disclosed cause is deterioration in financial prospects is consistent with capital markets that rapidly reflect valuerelevant public information, but do not generally reflect value-relevant private information. Any additional capital market response to rating downgrades based on previously released public information is likely due to the impact of the rating downgrade itself on the insurer’s future profitability and premium growth (see Epermanis and Harrington, 2006). Rating downgrades based on causes other than deterioration in a firm’s fundamental financial prospects, such as an increase in leverage, reduced liquidity, new products, among other causes, generally do not have unambiguous impacts on equity value, as Goh and Ederington (1993) also argue.

The remainder of the paper is organized as follows. We begin by describing the data and sample in Section 2, and then discuss our event study research method in Section 3. Section 4 presents the empirical results and Section 5 concludes.

2. Data and sample We first identify public insurers from CRSP (Center for Research in Security Prices) database narrowing SIC codes between “6311” and “6411” representing firms in the insurance industry, for the period of 1996-2012. Next, we obtain insurers’ financial strength ratings from Best’s Key Rating Guide for the same period, and match the rating information with the public insurers we have initially identified from CRSP database. Our sample creation process is then briefly illustrated in Figure 1.

We initially have identified 176 downgrades for public insurers during the period of 01/1996-06/2012. We then try to locate Best’s press release news for each of the 176 downgrades we have identified. Out of the 176 downgrades, we find press release news for 110 downgrades, and most of them are identified from A.M. Best’s web site, while a few are identified through “Google” search. Out of those 110 downgrades, CRSP daily data is available during the (-10, +10) 21-day event window for 95 downgrades. For those 66 downgrades with no press release news found, CRSP daily data is available for 63 downgrades during the 21-day event window. Our final sample consists of 158 total downgrades (95 with press release news and 63 without news) for the period of 01/1996-06/2012, and that represents 92 total firms that experienced downgrades during this time period.

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