Information Risk and the Cost of Equity Capital Revisited: Evidence from the U.S. Property-Casualty Insurance Industry

Opaque liabilities, learning, and the cost of equity capital for insurers

“…There is ample evidence that the underwriting side of the P/L insurance business is opaque (see, e.g., Chen et al, 2017; Eckles et al, 2014; Morgan, 2002; Pottier & Sommer, 2006; Zhang et al, 2009). By opacity, we mean that investors have uncertainty about the present value of expected underwriting claims, that is, the economic value of the insurer's liability.…”

“…Eckles et al (2014) results indicate that greater information quality does not affect the cost of equity capital but does increase the price that insurers charge customers (i.e., lowers the cost of debt capital). Chen et al (2017) present a model in which information quality (regardless of whether it is innate or discretionary) and the cost of equity capital are negatively related, holding insurers' real decisions (operating risk) constant. However, greater innate information quality also induces insurers to take more risk, which has a positive indirect effect on the cost of equity capital.…”

“…Empirically, they find evidence of both the direct and indirect effects, but that overall, the negative direct effect dominates the positive indirect effect. Compared with Eckles et al (2014) and Chen et al (2017), we take a different, but complementary approach. Instead of relating a measure of information quality (opaqueness) to the cost of equity capital, we examine a different implication of opacity—when assets or liabilities are opaque, investors will learn about the underlying value when new information is revealed (Pastor & Veronesi, 2009).…”

“…First, we contribute to the literature that highlights the opaqueness of insurer liabilities (e.g., Eckles et al, 2011; Kamiya & Milidonis, 2016; Morgan, 2002; Zhang et al 2009). Second, this paper relates to an extensive literature on understanding the firm‐ and market‐level determinants of insurers' cost of equity capital (e.g., Berry‐Stölzle & Xu, 2018; Chen et al, 2017; Cummins & Phillips, 2005; Eckles et al, 2014). The cost of equity capital is an important input for a variety of financial decisions, including capital budgeting, capital structure, valuation, and performance assessment.…”

“…Lambert et al (2007) present a model in which greater information quality refers to lower uncertainty about the true value of cash flows that will eventually be revealed. 7 Eckles et al (2014) and Chen et al (2017) use the standard deviation of loss reserve errors as a proxy for information quality and test whether information quality is related to the cost of equity capital. They also decompose information quality into innate and discretionary quality.…”