Impact of Rating Standards on Risk-Taking of Financial Institutions: Evidence from Catastrophe Risks in Insurance

Abstract

We analyze how financial institutions adjust their risk-taking in response to stricter rating standards. Building on the premise that the demand for financial institutions services depends on their financial strength which is communicated by a rating, we argue that a more stringent rating standard induces a differential response. Financial institutions facing high (low) elasticity of demand to ratings and moderate (high) cost of raising capital improve (weaken) their financial strength in response to a stricter rating standard. We empirically assess the response to stricter standards using a significant change of the rating methodology for catastrophe risk exposures of insurers in the aftermath of hurricane Katrina. We find the differential response, revealing that lower financial strength insurers serving customers with low elasticity of demand to financial strength became more risky in response to the standard change.

Keywords: credit rating agencies, rating standards, insurance, catastrophic risk

JEL Classification: G22, G24, G31