Market Pricing of Political Risk: Evidence from the Property-Liability Insurance Industry

Abstract

On September 14, 2005, a press report announced the Mississippi Attorney General’s intention to file a suit against the insurance industry forcing homeowners’ insurers to pay flood damage claims despite the standard water damage exclusion. This increase in uncertainty regarding whether insurance contracts would be upheld in Mississippi resulted in an increase in political risk. We use an event study methodology to measure the equity market’s reaction to this change in political risk. We find negative and significant average abnormal returns on the announcement date for insurers that wrote policies in Mississippi, amounting to an estimated average loss in market value of approximately $225 million. By contrast, insurers with no Mississippi exposure experienced insignificant abnormal returns. We do not, however, find a significant relationship between our continuous proxy for exposure extent and abnormal returns. Our results provide some evidence suggesting that political risk is rationally priced by equity market participants.

Keywords: Political risk, event study, Hurricane Katrina

JEL Classification: G14, G22, G28