Opaqueness in the Insurance Industry: Why Are Some Insurers Harder to Evaluate than Others?

ABSTRACT Many articles have investigated various tools used to evaluate the financial strength of insurers. This is the first study to investigate whether certain insurers are simply inherently more difficult to evaluate than others, regardless of the tool used. The article identifies certain specific insurer characteristics that are associated with greater difficulty in financial strength evaluation, as proxied for by the level of rating disagreement by Moody's and Standard and Poor's. Specifically, the empirical results indicate that insurers that exhibit the following characteristics are more difficult to assess in terms of financial strength: smaller insurers, stock insurers, insurers with a history of reserving errors, insurers that use less reinsurance, insurers with greater levels of investment in stocks and low-grade bonds, and insurers that are more geographically diversified. INTRODUCTION The financial assessment of insurers is vitally important. Regulators expend considerable resources trying to determine the financial condition of insurers, and have developed numerous tools to aid in that task. Insurance purchasers, especially large commercial clients (or their brokers) who cannot rely on the protection of guaranty funds if their insurers become insolvent, also attempt to judge the financial position of insurance companies. Insurer rating agencies exist primarily for the purpose of assessing the financial strength of insurers and disseminating their evaluations to interested parties. Because of the importance of insurer financial strength assessment, significant academic research has been directed at evaluating the various assessment tools and approaches. Most of these studies have taken the form of insolvency studies, in which the abilities of various tools or techniques to predict insurer insolvencies are analyzed. Various studies have looked at the insolvency prediction abilities of IRIS ratios (Barrese, 1990; Brockett et al., 1994), the NAIC Risk Based Capital ratio (Cummins, Harrington, and Klein, 1995; Grace, Harrington, and Klein, 1998, Pettier and Sommer, 2002), the NAIC FAST system (Grace, Harrington, and Klein, 1998, Pettier and Sommer, 2002), Best's ratings (Ambrose and Seward, 1988; Pottier and Sommer, 2002), or of large collections of financial ratios (Brockett et al., 1994). In all of the above studies that analyze the ability of various tools and techniques to predict insolvencies, one issue that has never been addressed is whether the financial strength of certain insurers is simply more difficult to accurately ascertain compared to that of other insurers, and if so, which characteristics make some insurers harder to evaluate. In other words, some insurers may simply be more "opaque" than others and inherently more difficult to assess in terms of financial strength. When an insurer's financial statements and other public information present a complete and unambiguous picture of the insurer's risks, the insurer would be considered transparent; when this is not the case, the insurer would be considered opaque to some degree. The importance of increased financial transparency has been growing, as exemplified by the Sarbanes-Oxley Act of 2002. While this particular law is only applicable to publicly traded companies, concerns about more reliable and understandable financial reports are likely to influence insurance regulators and rating agencies, among others, as they pursue their solvency monitoring agendas. Recent events have highlighted just how nontransparent property-liability insurers can be. In 2005, American International Group, Ace, and RenaissanceRe Holdings all restated multiple years of results after allegations of improper accounting of highly complex finite reinsurance transactions. The goal of this article is to determine whether, in fact, the financial strength of some insurers is more difficult to measure than the financial strength of other insurers, as well as to determine exactly which firm-specific characteristics are associated with difficulty in risk assessment. …