Contagion Effects in the Insurance Industry

This article investigates the valuation effects of equity issuances by insurance companies on rival firms. The literature has documented the existence of contagion effects associated with the revelation of information in industries characterized by asymmetric information, i.e., both the banking and insurance industries (see, e.g., Slovin, Sushka, and Polonchek, 1992; Avila and Eastman, 1995; and Fenn and Cole, 1994). We argue that because of high monitoring costs investors holding insurance company securities are rationally uninformed about the quality of insurance company portfolios. In this environment characterized by asymmetric information, if the market interprets an equity issuance by an individual insurer as a signal regarding the quality of insurance company portfolios in general, then we would expect to observe cross-firm effects associated with insurance company equity issuance announcements.

Our results are consistent with the hypothesis that the announcement of an equity offering reveals information about the quality of both the announcing firm's portfolio and the quality of rival firms' portfolios. In addition, when we split the sample by industry grouping, we find that announcements by life insurance firms generate significant cross-firm effects. We argue that these results are a consequence of the different types of state-contingent contracts offered by insurers in different segments of the industry.

Investors holding securities of companies that issue short-term state-contingent contracts find it economically rational to be relatively well informed about the quality and riskiness of an insurance company. Equity issuance announcements by insurers that offer short-term state-contingent contracts do not produce cross-firm effects. Before the well-publicized asset quality problems in the life insurance industry in 1990, it appears that the perceived risk of holding insurance company securities was low and the perceived quality of insurance company assets was high. Because of these perceptions regarding asset quality and risk, investors were relatively uninformed. When we examine insurance company equity issuance announcements before and after 1990, we find that it is the announcement of equity offerings made by life insurance firms before January 1, 1990, which results in significant contagion effects.


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The Journal of Risk and Insurance
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John Polonchek and Ronald K. Miller
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ResourceID: 72472

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