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

Abstract

The paper analyzes how rating standards the affect risk-taking behavior of rated firms using the natural experiment of hurricane Katrina in 2005. In the aftermath of the hurricane, the major rating agencies required insurers exposed to catastrophic losses to hold more capital to maintain the same rating grade. We show empirically that the rating standards change prompted the best response adjustment of credit quality by insurers depending on the benefits and costs of maintaining the rating. In particular, a substantial number of insurers reduced their credit quality in response to the more stringent rating standards. The results demonstrate that rating standards are significant for the distribution of credit risk in the insurance industry, and affect its capacity to sustain catastrophic losses.