Director Networks and Credit Ratings of Insurance Companies

Previous finance literature has found that a firm’s credit rating is influenced by the connectedness of its board members. Due to the subjective nature of credit ratings, qualitative information like a board’s connections can influence a rating agency’s decision making. We investigate the impact of four dimensions of board connectedness on credit ratings in the highly-regulated insurance industry. We find mixed evidence regarding the relationship between board connectedness and credit ratings in the insurance industry. As is the case for non-financial companies, we find some evidence that board connectedness is positively related to credit ratings for property/casualty (P/C) insurers, in line with social capital theory. However, for life insurers, we find that board connectedness is negatively associated with credit ratings, which supports the “board-busyness” theory. We suggest that the differing relationships between board connectedness and credit ratings among insurers are due to the short-term and riskier nature of property insurers, and that the disconnect between life insurers and non-financial companies is explained by life insurers’ greater size, lower liquidity and higher leverage. 1 Journal of Insurance Regulation © 2019 National Association of Insurance Commissioners Introduction The insurance industry’s stability is increasingly vital to overall economic health (Das, Davies and Podpiera, 2003). Although traditionally stable, risk-taking within the sector has increased as insurance companies diversify into products traditionally offered by banks and wealth management firms. Investment losses within these products, along with miscalculations in underwriting, can befall an insurance company; and those risks can reverberate throughout the economy. As such, more stringent regulations, requiring increased financial reporting, have historically been required by state insurance regulators to strengthen insurers’ solvency (Klein, 1995). BarNiv and Hershbarger (1990) highlight the concerns the NAIC has in avoiding insurance company failures. Credit rating agencies (CRAs) assign scores based on the perceived likelihood of default and a firm’s perceived solvency. In their assessments, CRAs appropriately consider financial information relevant to a firm’s economic health. However, credit ratings are not assigned based on financial information alone. Acknowledging the presence of asymmetric information, CRAs attempt to close the information gap by relying on qualitative information (Frost, 2007). Recent research has shown that one mechanism that CRAs consider is director connections, both in the form of social capital (Benson, Iyer, Kemper and Zhao, 2018) and also the direct connections that boards have with a CRA (Khatami, Marchica and Mura, 2016). However, both of these papers exclude insurance companies from their sample, arguing that a tight regulatory environment in this sector might compromise their results. We revisit Benson et al. (2018) to examine how a tighter regulatory environment affects the need for qualitative information. Benson et al. argue that CRAs rely on the trustworthiness of the members of a firm’s board of directors to close the information gap and proxy for trustworthiness by examining the directors’ social capital. Their results show that firms which employ a highly connected board receive higher credit ratings. Following the work of Belliveau, O’Reilly and Wade (1996) and Paldam (2000), the authors relate the social capital of the board to trust. This social capital is built by expanding one’s personal network, which increases an individual’s reputation. Once earned, an individual is likely to behave in a manner that preserves that reputation. Due to regulatory agencies requiring insurance companies to disclose significant additional financial information, we argue that this sector warrants investigation to better understand the relationship between board connectedness and credit ratings. We are motivated to examine the role that stringent regulations play in CRA decision making in the presence of additional financial constraints. Using a global sample of 10,973 firm-year observations, including both insurers and noninsurers, we find mixed evidence regarding the relationship between board connectedness and credit ratings. Regarding P/C insurers, we find some evidence of results similar to Benson et al. (2018). Namely, we see a positive relationship between board connectedness and credit ratings in two of our four measures, suggesting that CRAs may value the social capital of highly connected board 2 Director Networks and Credit Ratings of Insurance Companies © 2019 National Association of Insurance Commissioners members. Given that property insurers face more claim volatility and a much higher potential for underwriting losses, this seems plausible. However, the same relationship does not exist regarding life insurers. In fact, when examining life insurers, we find evidence that board connectedness is associated with lower credit ratings. This result is consistent with the “board busyness” theory (Fich and Shivdasani, 2006). This theory posits that boards containing members with many commitments, which are more likely to be classified as highly-connected in our sample, actually result in weaker corporate governance. Taken in concert, our findings suggest that the impact of board connectedness is different for P/C firms and life insurance firms. Property insurers face more unpredictability, and thus risk, in their operations than life insurers, which could account for the opposite relationship between board connectedness and credit ratings seen in our results. In our sample, our results suggest that the connectedness of boards leads to lower credit rating for life insurers. One possible explanation for this result, which is the opposite found by Benson et al. (2018) for non-financial firms, is that the larger size, greater leverage and lower liquidity of life insurers (relative to both P/C firms and nonfinancial firms) explains why CRAs react differently to board connectedness for life insurers, because the detrimental effects of a “busy board” are greater at larger, more highly levered, and less liquid firms. The first contribution of our paper is to analyze the impact of board connectedness on CRA’s decision making in a highly regulated industry. State insurance regulators recognize the systemic importance of insurance companies and provide oversight. A natural question would be to examine whether the regulatory oversight of insurers negates the impact of board connectedness on CRAs found in prior studies. Specifically, if state insurance regulators trust the additional financial information required of insurers, they may not consider board connectedness. From our results, some evidence exists that CRAs appear to consider board connectedness at property insurers in a way similar to that of non-financial companies, meaning that higher board connectedness is positively associated with credit ratings. Our results suggest that CRAs consider highly connected boards negatively with respect to life insurers. This result stands in contrast to the work of Benson et al. (2018), while our results for P/C insurers tend to support it. Our second contribution is to add to the literature that focuses on understanding the rating process. Graham and Harvey (2001) illustrate the importance that firms place on their ratings as chief financial officers (CFOs) list a firm’s credit rating as a top priority. Dichev and Piotroski (2001) also show that credit ratings affect firm investment decisions. Additionally, both bond and equity markets react to changes in credit ratings (Hand, Holthausen and Leftwich, 1992). Because investment decisions are made with ratings in mind and stockholder wealth is affected by changes in ratings, the analysis of the rating process is valuable to managers and investors alike. However, the rating process is not fully transparent, nor does the rating process rely solely on firm financials (Frost, 2007). Therefore, this paper’s focus is on revealing another qualitative measure that CRAs likely consider. There also exists rating literature that is specific to insurers. Pottier and Sommer (1999) show the value that insurers place on their own ratings. Chen, Gaver and 3 Journal of Insurance Regulation © 2019 National Association of Insurance Commissioners Pottier (2018) highlight insurer stock return movements associated with changes in ratings. Halek and Eckles (2010) also highlight equity reactions to changes in insurance company ratings, confirming the effect that ratings have on stockholder wealth. Much research has hence been devoted to understanding the rating process. This paper adds to the evidence that the rating process is a function of the regulatory environment each industry faces. Hypothesis Development and Methodology CRAs create a numerical measure which attempts to quantify default probability. In the process, analysts rely on financial ratios and other quantitative information. However, financial information alone does not capture the entire process. Instead, the final credit rating reflects qualitative information (OddersWhite and Ready, 2006). Benson et al. (2018) introduce social capital into the equation and show that, in non-financial companies, CRAs consider the connectivity of the boards of directors in their assessment. The authors argue that CRAs expect a board that is well-connected to take steps to maintain its reputation and do its duty. As such, the credit rating for firms with well-connected boards is higher than the financial models would suggest, ceteris paribus. BarNiv and Hershbarger (1990) stress that the Insurance Regulatory Information System (IRIS), developed by the NAIC, will take immediate action when firm financials move outside preferred limits. Over time, the implementation of the NAIC’s Financial Analysis Solvency Tools (FAST) ratios and