Information Risk and the Cost of Capital

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 debtholders (i.e., policyholders) less information risk are able to command higher prices. Furthermore, our results suggest that insurance is not a diversifiable asset.

Ratings: It's Accrual World

“…Second, we examine the role of accruals quality, as measured by reserve error volatility, as opposed to earnings management. To that end, we also extend the evolving literature examining the implications of the volatility of reserve errors, specifically (Eckles, Halek, and Zhang, ), and accruals, generally (Francis et al., ). Eckles, Halek, and Zhang () and Francis et al.…”

“…In this article, we examine whether accruals quality is related to a firm's financial strength rating. Eckles, Halek, and Zhang () provide evidence that insurers with higher reserve error volatility have greater information risk. We suggest that insurers with higher reserve error volatility have lower quality, or noisy, accruals.…”

“…As mentioned above, we measure accruals quality in terms of the volatility (the standard deviation) of loss reserve errors. We also decompose accruals quality into innate and discretionary accruals (Francis et al., ; Eckles, Halek, and Zhang, ) in an effort to examine differential ratings effects.…”

“…Second, we contribute to the literature on insurer loss reserve errors. While the majority of extant literature examines reserve manipulation in the context of earnings management (e.g., Petroni, ; Anthony and Petroni, ; Beaver, McNichols, and Nelson, ; Eckles and Halek, ; Grace and Leverty, ), we utilize the volatility of loss reserve errors as a measure of accruals quality (e.g., Eckles, Halek, and Zhang, ). A number of prior studies, such as Gaver and Paterson () and Grace and Leverty (), have examined the role of financial performance in reserve management.…”

Recent Research Developments Affecting Nonlife Insurance—The CAS Risk Premium Project 2014 Update

“…Eckles et al. () measure the impact of loss‐reserve accuracy on pricing ability. They find that the information risk is priced into debt capital (thus affecting policyholders) but not into equity capital.…”