Information effect of entry into credit ratings market: The case of insurers' ratings

Abstract

The paper analyzes the effect of competition between credit rating agencies (CRAs) on the information content of ratings. We show that a monopolistic CRA pools sellers into multiple rating classes and has partial market coverage. This provides an opportunity for market entry. The entrant designs a rating scale distinct from that of the incumbent. It targets higher-than-average companies in each rating grade of the incumbent's rating scale and employs more stringent rating standards. We use Standard and Poor's (S&P) entry into the market for insurance ratings previously covered by a monopolist, A.M. Best, to empirically test the impact of entry on the information content of ratings. The empirical analysis reveals that S&P required higher standards to assign a rating similar to the one assigned by A.M. Best and that higher-than-average quality insurers in each rating category of A.M. Best chose to receive a second rating from S&P. Keywords ratings, competition, information disclosure, insurance Disciplines Economics | FinanceThis journal article is available at ScholarlyCommons: http://repository.upenn.edu/bepp_papers/121Electronic copy available at: http://ssrn.com/abstract=1101700Electronic copy available at: http://ssrn.com/abstract=1101700Information effect of entry into credit ratings market:The case of insurers' ratings * Neil A. Doherty † Anastasia V. Kartasheva ‡ Richard D. Phillips § August 21, 2011Abstract This paper analyzes the optimal entry strategy of a credit rating agency (CRA) to a market served by the incumbent. We show that a monopolistic CRA pools sellers into multiple rating classes and has partial market coverage. This provides an opportunity for market entry. The entrant targets higher-than-average companies in each rating class of the incumbent's rating scale and employs more stringent rating standards. We use Standard and Poor's entry into the market for insurance ratings previously covered by a monopolist, A.M. Best, to empirically test the impact of entry on the information content of ratings.Keywords: rating agency, entry, competition, precision and disclosure of information, insurance. 1Electronic copy available at: http://ssrn.com/abstract=1101700Electronic copy available at: http://ssrn.com/abstract=1101700Significant debate exists regarding the role that competition should play in the market for credit ratings. Representatives from the credit rating agencies (CRAs) themselves argue that reducing barriers to entry would eventually lead to reduced disclosure of information as the new entrants engage in "race to the bottom" strategies in order to sell Considering the unique dynamics of our market, historically new market entrants and marginal participants have sought to make their products more attractive to issuers by offering higher ratings than do more established market participants. Some new entrants might be inclined to try to compete in this manner because of the ease with which such a strategy could be implemented and the short-term benefits that might accrue to the en...

Reinsurance and Systemic Risk: The Impact of Reinsurer Downgrading on Property–Casualty Insurers

“…In addition to reinsurance arrangements, a primary insurer's rating may be downgraded due to a host of other factors that affect the firm's financial strength. We follow the insurance rating literature to select control variables X it (Cummins, Harrington, and Klein, ; Doherty and Phillips, ; Kartasheva and Park, ; Doherty, Kartasheva, and Phillips, ). To control asset‐side risks, we include investment yield and percentage of junk bond holdings.…”

“…We follow the insurance rating literature to select control variables X it (Cummins, Harrington, and Klein, 1995;Doherty and Phillips, 2002;Kartasheva and Park, 2011;Doherty, Kartasheva, and Phillips, 2012). To control asset-side risks, we include investment yield and percentage of junk bond holdings.…”

Information Opacity and Fitch Bond Ratings

“…Lizzeri () and Doherty, Kartasheva, and Phillips () argue that without sufficient competition, an incumbent rating agency may fail to distinguish between different issuers of bonds and will pool them into the same rating category. Doherty, Kartasheve, and Phillips () examine the entry of S&P into rating insurance companies to compete with A.M. Best and find improvement in the rating process because of the competition from S&P. Xia () examines the impact of the initiation of Egan–Jones ratings on the quality of S&P ratings. The author finds that the S&P ratings are more responsive to credit risk and become richer in their information content after increased competition from Egan–Jones.…”

“…Some models of the bond market indicate that additional rating agencies are able to increase the information available to investors. Lizzeri (1999) and Doherty, Kartasheva, and Phillips (2012) argue that without sufficient competition, an incumbent rating agency may fail to distinguish between different issuers of bonds and will pool them into the same rating category. Doherty, Kartasheve, and Phillips (2012) examine the entry of S&P into rating insurance companies to compete with A.M. Best and find improvement in the rating process because of the competition from S&P. Xia (2014) examines the impact of the initiation of Egan-Jones ratings on the quality of S&P ratings.…”

Product Ratings as a Market Reaction to Deregulation: Evidence From the German Insurance Market

“…When rated companies solicit and pay for ratings, theory demonstrates that a monopoly rater will earn higher profits if ratings do not cover all companies in the market and are structured to provide only coarse indicators of quality (Lizzeri, 1999;Doherty et al, 2012). This provides incentives for entry, and a new entrant into the market will compete by adopting a more precise rating scale and stricter rating standards (Doherty et al, 2012;Jiang et al, 2012). Competition over rating criteria will improve the quality of ratings.…”