WHAT DO WE KNOW ABOUT
MARKET DISCIPLINE IN INSURANCE?
M
ARTIN ELING
W
ORKING PAPERS ON RISK MANAGEMENT AND INSURANCE NO. 101
E
DITED BY HATO SCHMEISER
CHAIR FOR RISK MANAGEMENT AND INSURANCE
N
OVEMBER 2011
WORKING PAPERS ON RISK MANAGEMENT AND INSURANCE, NO. 101 – NOVEMBER 2011
1
What Do We Know about Market Discipline in Insurance?
Martin Eling
Abstract
The aim of this paper is to summarize the knowledge on market discipline in insurance and other
financial service sectors. Market discipline can be defined as the ability of customers, investors, inter-
mediaries (agents, brokers), and evaluators (analysts, auditors, rating agencies) to monitor and influ-
ence a company’s management. Looking at banking is especially interesting, since market discipline
in this field has been studied extensively. Based on existing knowledge, we develop a framework for
researching market discipline in insurance that includes its most important drivers and impediments.
The results highlight a significant need for continuing research. The findings are of relevance not only
for European insurers and regulators, but for institutions outside Europe.
1 Introduction
An important new dimension of the regulatory environment in banking and insurance is ex-
plicit reliance on market discipline. Market discipline—the influence of customers, investors,
intermediaries (e.g., agents), and evaluators (e.g., rating agencies) on firm behavior—is a cen-
tral element of both Basel II and Solvency II. Market discipline has been a perennial topic of
research in the financial services sector since the 1970s (see Flannery, 2001). Likely due to
the fact that Basel II has been in force for several years, most research into market discipline’s
ability to regulate financial services has focused on banking (see, e.g., Martinez Peria and
Schmukler, 2001; King, 2008), but some research has also been conducted for the insurance
sector.
1
Solvency II should add even more impetus to the study of market discipline. It is thus
Martin Eling is professor of insurance management and director at the Institute of Insurance Economics
at the University of St. Gallen, Kirchlistrasse 2, 9010 St. Gallen, Switzerland ([email protected]). The
author is grateful to Christian Biener, Dieter Kiesenbauer, Sebastian Marek, and Jan-Philipp Schmidt for
helpful comments and suggestions. Special thanks to Peter Schlosser for his excellent research assistance.
1
Related papers, such as Harrington (2004, 2005) and Nocera (2005), will be discussed in detail throughout
this paper. Another excellent introduction to market discipline in the German language is Hartung (2005).
Furthermore, Solvency II’s approaching effective date has resulted in several recent empirical studies on
market discipline in insurance (e.g., Eling and Schmit, 2011). Also, experimental evidence from behavioral
insurance (Wakker, Thaler, and Tversky, 1997; Albrecht and Maurer, 2000; Zimmer, Schade, and Gründl,
2009; Zimmer, Gründl, and Schade, 2009) is relevant for market discipline. Furthermore, the European
Commission conducted research when designing Solvency II (see CEIOPS, 2009 and other information on
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important to consider what is already known about market discipline in the insurance and re-
lated sectors.
To that end, this paper summarizes extant knowledge on market discipline in insurance and
other financial services sectors. Looking at banking is especially interesting, since market
discipline has been studied extensively in this field and much can be learned from that work.
Based on existing knowledge, we develop a framework for researching market discipline in
insurance that includes its most significant drivers and impediments. Our results also highlight
a significant need for future research.
The results provide a clearer understanding of how market discipline works as a direct and
indirect mechanism for monitoring and influencing by customers, investors, intermediaries,
and evaluators. There are significant differences between banking and insurance with regard
to market discipline. We also identify important differences between lines of business and
legal forms in the insurance industry, which reveal that market discipline might be weak in
some areas (e.g., in personal lines with complex products or with mutuals) and strong in oth-
ers (e.g., in commercial lines or with stocks). We thus find a number of reasons why a “one-
model-fits-all” approach might be inappropriate for market discipline in the insurance indus-
try. The results of this analysis will be useful for insurers, regulators, and policymakers in-
volved in revising regulatory standards both in Europe and in other markets. The article is not
meant as an argument in favor of any particular type of regulation, but as an outline of poten-
tial impediments regulators may face in their efforts to enhance market discipline.
This paper is organized as follows. In Section 2 we review definitions and characteristics of
market discipline that highlight differences between insurance and other financial services
sectors. In Section 3 we take a look at the extant literature, especially that involving the bank-
ing field, and derive drivers of and impediments to market discipline in insurance. Section 4
concludes with potential policy implications and a summary of future research needs.
2
2 Definition and measurement of market discipline
2.1. Definition of market discipline
There are several definitions of market discipline currently in use. For example, in the bank-
ing literature, there is widespread agreement that market discipline involves two distinct com-
ponents (see Flannery, 2001;
Bliss and Flannery, 2002, Forssbæck, 2009): (1) the ability of
the Commission’s Internet pages). Finally, there is a long research tradition in the field of theory of competi-
tion, which is related to this topic (see, e.g., Stigler, 1971; Joskow, 1973; Posner, 1974; Munch and Small-
wood, 1981; Stiglitz, 1984).
2
Throughout this work, we analyze the role of both investors and customers in market discipline, instead of
focusing on just one of these stakeholders; we also do not focus on any specific country. It is, however, im-
portant to keep in mind that differences across countries, such as governance mechanisms, insolvency experi-
ences, and cultural norms, will affect the level of market discipline.
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market participants to accurately assess the condition of a firm (monitoring) and (2) their abil-
ity to impact management action in a way that reflects that assessment (influencing). Market
discipline thus has both an indirect and direct dimension (see Forssbæck, 2009). Monitoring
captures the information aspect of market discipline, i.e., current and prospective bank claim-
ants inform themselves about the bank’s condition and set prices for their claims accordingly.
Influence refers to the mechanism by which banks, in order to avoid the adverse consequences
of stronger discipline (such as higher financing costs and, ultimately, liquidity problems) de-
crease their risk exposure or avoid increasing it in the first place.
3
In the insurance field and with regard to the first component (monitoring), intermediaries
(agents, brokers), evaluators (auditors, analysts, rating agencies), and regulators assess the
financial strength and service quality of insurers. Due to the post-insolvency assessment fund-
ing mechanism of many guaranty funds and potential contagion effects of financial problems
among insurers, insurers in selected lines also have an incentive to monitor each other (see
Downs and Sommer, 1999). Overall, it thus seems that there are enough market participants
willing to monitor risk taking in insurance. Guarantee schemes and the opaqueness of some
insurers, however, could limit the willingness and ability to observe insurer behavior (see Lee,
Mayers, and Smith, 1997; Babbel and Merril, 2005; Pottier and Sommer, 2006; Zhang, Cox,
and Van Ness, 2009).
The second component, influencing, is difficult to evaluate. The finance literature contains
numerous reasons why we should be skeptical about the ability of market participants to in-
fluence managers (see Bliss and Flannery, 2002), including asymmetric information, costly
monitoring, principal-agent problems, and conflicts of interest among stakeholders. Another
impediment to market discipline is a legal environment that makes shareholder activism, e.g.,
a hostile takeover, difficult. From the shareholders’ perspective, monitoring and incentive
contracts can be combined to mitigate the agency problem, and there are also other mecha-
nisms that may induce managers to act in the shareholders’ best interests, such as reputational
concerns, competitive labor markets, and the threat of takeover, dismissal, or bankruptcy (see
Aggarwal and Samwick, 1999). The insurance sector has a number of characteristics that
might limit the influencing component. For example, there is a relatively small risk of a bank
run, at least in selected lines.
4
Furthermore, especially in personal lines, individual policy-
3
Compared to the neoclassical definition of market discipline in a complete and frictional market with sym-
metric information (leading to different willingness to pay depending on the default put option value; see
Doherty and Garven, 1986), these definitions typically emphasize the aspect of asymmetric information,
which is reduced by increasing market transparency.
4
In non-life insurance, payments are linked to claim events and insurers are funded in advance. In life insur-
ance, surrendering a contract has disadvantages, such as lapse costs, and thus the policyholder has an incen-
tive not to terminate the contract. See Eling and Schmeiser (2010). In countries with low lapse costs and
higher mobility of capital, there could be a risk of an “insurance run,” at least in selected insurance sectors.
WORKING PAPERS ON RISK MANAGEMENT AND INSURANCE, NO. 101 – NOVEMBER 2011
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holders are relatively small in terms of contract volume, which limits their ability to affect
decisions. It thus seems that the influencing component of insurance sector market discipline
is not without difficulties and needs more study.
While most definitions of market discipline in the banking context include the monitoring and
influencing components, Harrington (2004) and Nocera (2005) add another interesting dimen-
sion that is especially relevant in the insurance context. They differentiate between investor-
driven market discipline, i.e. financial market discipline, and customer-driven market disci-
pline, i.e. the extent to which demand by policyholders is sensitive to insolvency risk and
thereby motivates insurers to manage their risk. In creating an insurance-specific definition of
market discipline, it is also important to recognize the other monitoring and influencing ele-
ments (in addition to customers and investors), i.e., intermediaries (agents, brokers) and eval-
uators (analyst, auditors, rating agencies) that are involved in the buying decision. We thus
define market discipline in the insurance sector as the ability of customers, investors, interme-
diaries, and evaluators to monitor and influence the management of insurance companies.
2.2. Measurement of market discipline
Table 1 contains a review of the different facets of market discipline and derives measures for
quantifying it. Based on the definition developed in the last section, we distinguish between
“direct” and “indirect” monitoring and influencing. While in theory, customers and investors
directly influence management decisions, intermediaries and evaluators have both a direct and
an indirect influence. For example, customers or investors react to market signals set by eval-
uators (e.g., changes in ratings)—a direct influence by customers; an indirect influence by
evaluators. However, given that evaluators’ indirect influence can lead to direct influence by
customers and investors, they might also have an opportunity to exert a direct influence them-
selves if, for instance, managers are keen to do anything possible to avoid a rating downgrade.
Who? Customers and investors (direct monitor-
ing and influencing)
Intermediaries and evaluators (direct and
indirect monitoring and influencing)
Customers Investors-
stockholders
Investors-
bondhold-
ers
Rating
agencies
Auditors/
analysts
Agents/
brokers
How? Risk-sensitive
customer
demand
Risk-
sensitive
stock prices
Risk-
sensitive
bond yields
Product and
company
ratings
Recommen-
dations to
investors
Recommen-
dations to
customers
Measure-
ment
Growth in
premiums and
policies/lapse
Equity prices Debt yields Rating
changes
New recom-
mendation
New recom-
mendation
Relevance
in insurance
High Limited Limited High Limited High
Table 1: Facets of market discipline
In the banking literature, investor-driven market discipline is usually studied either by analyz-
ing stock prices or yields on debt instruments (see, e.g., Martinez Peria and Schmukler, 2001;
See DeAngelo, DeAngelo, and Gilson (1994) with regard to the collapse of First Executive in the United
States in the early 1990s.
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King, 2008). However, the insurance sector is different from the banking sector, especially as
to business models and financing. Regarding legal form, in banking and insurance both, many
companies are mutuals and many stock companies are not traded on the capital market. Fur-
thermore, for many of the insurance companies that are traded on the stock exchange, there
are no liquid markets, since only a small fraction of the stocks are in free float. Stock prices
are thus of only limited use when evaluating risk sensitivity in insurance.
5
Furthermore, the
financing of insurers is different from that of other providers in the financial sector in that
debt instruments typically are not traded (the reserves of the policyholders are the major debt
instruments). The debenture spreads typically considered as market elements disciplining
management behavior for the banking industry thus, for the most part, do not exist in the in-
surance industry.
6/7
An alternative way to measure market discipline is by looking at it as customer-driven. To
this end, the studies on market discipline in insurance consider premium growth and lapse.
Epermanis and Harrington (2006) and Eling and Schmit (2011) analyze premium growth
around rating changes as a proxy for market discipline. Zanjani (2002) considers changes in
lapse rates following rating changes. But there are also limitations in measuring customer-
driven market discipline. For example, premiums are not the price of insurance, but the price
times quantity. Typically, we cannot observe insurance prices, i.e., the premium rates per unit
of coverage, and even if such information were available, it would be very difficult to com-
pare insurers since the underlying expectations of claims costs used for calculating rates might
be very different and are not observable (see Harrington, 2004). A proxy for insurance prices
sometimes used in literature is the relation of insurer premiums to realized claims (see Som-
mer, 1996; Phillips, Cummins, and Allen, 1998).
From the above discussion, we conclude that in the insurance sector, market discipline focus-
es on the risk sensitivity of customer demand (for insurance coverage) and investor willing-
ness to pay (for equity and debt). To measure market discipline, we thus need to identify mar-
ket signals that affect the risk sensitivity of customers or investors. The second step is then to
evaluate whether this signal has a significant impact on our measures of market discipline,
i.e., demand and willingness to pay. Table 2 reviews a selection of potential signals.
5
Reinsurers are different from insurers in that many of them have stocks traded on capital markets. Further-
more, many large holdings, such as Allianz SE, are listed on the capital market. Overall, however, the num-
ber of liquid stocks is very limited. A broad empirical analysis based on stock prices is thus difficult.
6
There are some debt instruments, for example, credit-default swaps or hybrid instruments (e.g., participating
certificates), but the number of observable instruments and the number of companies involved in such trans-
actions is, again, very small. Catastrophe bonds or other forms of alternative risk transfer are not suitable
since these are issued in special purpose vehicles and thus are not linked to the default risk of the sponsor.
7
There are other important differences between insurance and banking. For example, the insurer’s assets and
liabilities are stochastic, particularly in the non-life sector. In banking, questions of duration (which do not
play a large role in non-life insurance) and asset risk are the main risk factors. In life insurance, duration is
also of high importance; additionally, insurers’ liabilities often embed many options and guarantees.
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Market signal with regard to risk situation
(input variable)
Signal given by Market reaction
(output variable)
Investor-driven market discipline
Annual and interim reports with outlook Company
Investors’ willingness to pay reflected in
Stock prices
Bond yields
Ad-hoc disclosure Company
Director´s dealings Company
Analysts’ comments Analysts
Company financial strength ratings Rating agencies
Takeover bids Competitor
Customer-driven market discipline
Product ratings Rating agencies
Customer demand reflected in
Premium growth
Lapse
Surplus participation Company
Complaint statistics Regulator
Statistics published by associations Insurance associations
Table 2: Measuring market discipline
Table 2 can be used to formulate hypotheses with regard to the disciplining impact. For ex-
ample, we might expect that a better company rating has a positive influence on equity prices
(i.e., an increase in price) and a negative influence on the debt yields (i.e., the spread over the
risk-free interest rate decreases).
8
We consider three main sources of market signals: the com-
pany, the evaluators (analysts, rating agencies), and the regulator (other sources of infor-
mation such as consumer protection institutions or recommendations by friends are also im-
portant, but are not discussed in this paper). Table 2 also allows us to identify elements unique
to the insurance sector that might be used to measure market discipline. Among these are
product ratings, surplus participation, complaints, and other published statistics.
2.3. Discussion of market discipline in the context of other regulatory measures
Basel II and Solvency II are two examples of how market discipline research is relevant to
regulatory problems. In both systems, market discipline is the third fundamental pillar. The
expectation is that a transparent market will require less overt intervention by regulators as
market participants themselves force appropriate firm behavior. The third pillar of Solvency II
will be composed of public disclosure and reporting requirements that are intended to facili-
tate more rigorous and uniform analysis of capital adequacy across firms and across national
borders. Improved market discipline is the hoped-for result. The extent to which market disci-
pline can be relied on for successful regulation, however, depends on the strength of its influ-
ence.
Different mechanisms have been employed during the last decades in an effort to limit default
probability in the financial services sector. Historically, solvency regulation focused on dif-
ferent types of safety nets, including deposit insurance schemes in banking (such as the Fed-
eral Deposit Insurance Corporation (FDIC) in the United States after the Great Depression)
and guarantee funds in insurance. Until the early 1990s, many countries in the European Un-
8
As we will discuss below, typically the downside risk of a bad market signal is greater than the upside poten-
tial of a good market signal. See, e.g., Hong, Lim, and Stein (2000) and Halek and Eckles (2010). The direc-
tion of impact also depends on the signal. For example, a takeover bid might be a signal that the stock is un-
derpriced because of poor management.
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ion addressed default risk by limiting competition via market entry restrictions and price and
product regulation (see Eling, Klein, and Schmit, 2009). Rules for capital adequacy—
imposing certain minimum capital requirements—on either an absolute or a risk-adjusted ba-
sis (e.g., Solvency I, U.S. RBC Standards) have also been introduced (see Eling, Schmeiser,
and Schmit, 2007, for an overview).
None of these market interventions is without disadvantages. Safety nets can create moral
hazard since the risk reduction the parties face leads them to take riskier actions or fail to take
precautionary measures (see Demirgüç-Kunt and Detragiache 2002; De Ceuster and Massche-
lein, 2003). Distortions of competition, such as price and product regulation, decrease effi-
ciency and limit innovation. Capital adequacy rules might be subject to adverse incentives, as
illustrated in the recent financial crisis, e.g., by AIG and its credit default swap business,
which was motivated by regulatory and rating arbitrage (see Eling and Schmeiser, 2010).
Recently, regulators have begun to incorporate a new market-based element into regulatory
regimes by increasing transparency and disclosure requirements. Basel II’s inclusion of “mar-
ket discipline” among its three regulatory pillars is the most notable example. Regulators see
two main advantages to market discipline, which is, theoretically, brought into play by greater
disclosure requirements. First, stakeholder monitoring should improve due to the availability
of more information and, second, this improved monitoring is expected to influence insurer
behavior, i.e., the stakeholders are expected to use their market power to influence manage-
ment decisions with regard to risk taking.
Which of the different regulatory mechanisms is best is a question yet to be answered. In the
case of Solvency II, regulators advocate a combination of capital adequacy (Pillar 1) and mar-
ket discipline (Pillar 3). This provides the opportunity to integrate different approaches, but
has several disadvantages too, one of which is cost: requiring insurers to employ extensive
financial models (Pillar 1), as well as increased reporting requirements (Pillar 3), are both
going to impose a substantial financial burden on insurers. The cost of regulation might out-
weigh its benefits.
9
This argument is especially relevant for small insurers that might be
pushed out of the market by requirements too costly to meet.
Market discipline cannot completely replace regulation. In a perfect and arbitrage-free market,
where providers and policyholders have perfect information, one might argue that policyhold-
ers should be free to purchase insurance with a lower safety level as long as the contract pric-
ing is fair, i.e., the net present value is zero (see Doherty and Garven, 1986; Gatzert and
9
There is no clear evidence as to whether the costs of Solvency II are higher than its benefits. The EU Com-
mission demands an assessment of the costs of regulation for each new tool, including Solvency II. See, e.g.,
CEA (2007) for estimations of the administrative costs. Problems that arise are: (1) only direct costs (compa-
nies’ costs of implementation and future use) are considered and no indirect costs (inefficiency, effects on
premiums and their result on other markets that depend on the insurance sector) and (2) potential benefits are
described, but not quantified in any way.
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Schmeiser, 2008). In this world, the policyholder, being fully informed, could choose to ac-
cept the default risk and hence there would be no need for capital regulation. However, in the
insurance context, there is a “third-party problem”, i.e., the policyholder may cause an injury
to a third party. This third party has no ex-ante contractual relationship with either the insurer
or the policyholder, and hence cannot agree to some possibly low safety level in regard to the
insurer’s default, with a consequent lower premium. In this situation, there is still a need for
solvency requirements and regulation that cannot be replaced by enhanced market discipline
per se.
Furthermore, there are interactions between the different pillars of Solvency II that need to be
kept in mind when designing the regulation, especially regarding incentives. One important
interaction is between the risk-based capital requirements in Pillar 1 and market discipline in
Pillar 3. Under Pillar 3, insurance companies must publish their solvency testing results, thus
informing the stakeholders and making the insurer’s safety level a competitive factor in the
market. However, since internal risk models can be used for this purpose (as long as they are
approved by the regulator), insurance companies may have an incentive to use internal models
that “make them look safe” instead of models that would more accurately reflect their true
risk situation (for a more detailed discussion on the pros and cons of internal models, see
Eling, Schmeiser, and Schmit, 2007).
3 Evidence for market discipline (including facilitators and impediments)
We consider 62 peer-reviewed empirical studies on market discipline in financial services.
For the field of insurance, we also include recent material presented at peer-reviewed confer-
ences so as to increase the number of studies. Twenty of the 62 studies address the insurance
industry; the other 42 studies are from the banking literature, reflecting the fact that, at least in
terms of research questions and countries analyzed, more work has been done in banking
field. However, as we highlight in the following discussion, some of the insights from the
banking studies might be transferable to the insurance industry, e.g., with regard to safety
nets.
10
3.1. Evidence for market discipline in banking
There is a vast literature on market discipline, especially for the banking industry; research on
the topic in this field dates back to the 1980s (see Table 3). The motivation for all this work is
that innovation, e.g., in financial engineering, enabled financial intermediaries to become in-
10
The 16 oldest papers in banking are also summarized in Gilbert (1990). We also identified studies in other
sectors of financial services, such as mutual funds (see, e.g., Dangl, Wu, and Zechner, 2008), but to reduce
the complexity of the review, did not include them. Given the broadness of literature on market discipline in
banking, we also cannot claim that our collection of 62 studies is complete, but we believe that the most im-
portant studies are included. Also note that experimental evidence, such as Wakker, Thaler, and Tversky
(1997), is mentioned in our paper but is not included in the tables.
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volved in complex financial operations that were very costly to monitor. Furthermore, exces-
sive risk taking in the 1980s resulted in the failure of some depository institutions, which
raised concern over safety and prompted calls for stricter regulation. Thus, by the 1980s,
banking regulators had market discipline on the policy agenda (see Park and Peristiani, 1988).
Research in this area was given another boost when market discipline was made one of the
three pillars of Basel II.
There are two main empirical results in regard to market discipline found in the banking liter-
ature. First, there is evidence of market discipline in banking over the last decades across a
variety of measures and countries, i.e., with regard to stock prices (e.g., Baer and Brewer,
1986), debt (Avery, Belton, and Goldberg, 1988; Sironi, 2003), and deposit growth (Park and
Peristiani, 1998).
11
Second, investors in bank stocks have the strongest incentives to be risk
sensitive,
12
while market discipline in debt is often hampered by safety nets. Safety nets of all
kinds create moral hazard and reduce market discipline (Billett, Garfinkel, and O’Neal, 1998;
Demirgüç-Kunt and Huizinga, 2004; Nier and Baumann, 2006). There is evidence that reduc-
ing safety nets increases market discipline (Flannery and Sorescu, 1996). A potential policy
implication is that regulators should enforce modifications of existing guarantee schemes to
bring market discipline into play. In this context, a number of authors (e.g., Benink and
Wihlborg, 2002) advocate for banks to issue a substantial amount of uninsured deposits in
order to enhance market discipline.
In addition to these two main results, we identify four other aspects from the banking litera-
ture that might be of relevance to the insurance industry. First, the strength of market disci-
pline depends on the line of business. Morgan and Stiroh (2001), e.g., show differences for
credit card, commercial, and industrial lending, all of which carry a penalty in terms of higher
spreads. Second, Sironi (2003) found differences depending on ownership structure, i.e., less
discipline was found for government-owned institutions. This is an important finding in light
of the traditional separation of stock, mutual, and public companies in the insurance industry
and the resulting differences in agency conflicts (see, e.g., Eling and Luhnen, 2010). Third,
Nier and Baumann (2006) emphasize that market discipline depends on the level of competi-
tion, i.e., market discipline is more effective in curbing the greater risk taking that arises in the
face of competition in those countries or industries where the competition is strong. Finally,
11
There are also authors who find no evidence of market discipline (Gorton and Santomero, 1990) but, com-
pared to the number of papers that do find such evidence, they are few in number. Of special relevance to
Solvency II because of the focus on European data is the work by Sironi (2003), who finds that European
banks’ debenture spreads reflect risk. More recently and also using European bank data, Distinguin, Rous,
and Tarazi (2006) observe that the accuracy of models in predicting bank financial distress through use of
stock market information depends on the extent to which bank liabilities are tradable. Models that account for
these nuances, therefore, will be more valuable.
12
In spite of their residual claimholder position and risk of total loss, this result is not trivial, since with limited
liability, equity holders might have an incentive to increase risk taking, as shown by Merton (1977). One
might thus argue that equity holders are less suitable monitors. Empirically, however, and also in more com-
plex theoretical models, this risk-increasing influence is not clear. See De Ceusters and Masschelein (2003).
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Pop (2006) finds international differences in market discipline and argues that much work
needs to be done, especially in Japan and certain European countries, to level the playing field
so that market discipline can operate. Thus, there might be variation in the effectiveness of
market discipline depending on the regulatory and cultural environment. The findings also
highlight the potential for regulation to undermine market discipline (see, e.g., Billett, Gar-
finkel, and O’Neal, 1998).
Finally, it should be noted that almost all studies in the banking sector address the monitoring
element of market discipline; that is, they test whether investors accurately understand chang-
es in the firm´s condition and incorporate these into prices. Such testing, however, reveals
nothing about the influencing component of market discipline, i.e., the response of firm man-
agers to investor feedback. Bliss and Flannery (2002) is one of the few studies that directly
measures this component by developing an influence regression using equity returns and ex-
pected managerial behavior. Their results show that market influence is weak. More research
into the influencing component would be extremely useful.
3.2. Evidence for market discipline in insurance
Market discipline in insurance has not been as extensively researched as it has in the banking
field and what work there is on the subject rarely employs non-U.S. data. Table 4 presents an
overview of this research, dividing it into three categories: investor-driven market discipline
(equity prices), customer-driven market discipline (price of insurance contracts, sum of pre-
miums, number of contracts, lapse), and selected other aspects (impact of guarantee funds,
studies on opaqueness).
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Table 3: Results of literature review for banking (CD: certificate of deposit, J: journal, MD: market discipline, SD: subordinated debt)
# Authors Title Country M ain results
1 Beighley, Boyd and Jacobs
(1975), J of Bank Research
Bank Equities and Investor Risk Perceptions:
Some Entailments to Capital Adequacy
US evidence for M D … in stock prices Share prices of bank stocks are estimated as a function of capital ratios, earnings and growth of earnings, asset size, and loss rates;
banks with higher capital ratios and lower loss rates tend to have higher share prices.
2 Pettway (1980), J of Financial
and Quantitative Analysis
Potential Insolvency, Market Efficiency, and the
Bank Regulation of Large Commercial Banks
US evidence for M D … in stock prices Considering several large banks that failed, returns to shareholders are simulated for several years prior to their failure. Returns on the
stocks of banks that failed decline relative to simulated returns two years before failure.
3 Brewer and Lee (1986),
Economic Perspectives
How the Market Judges Bank Risk US evidence for M D … in stock prices Betas are estimated as functions of accounting ratios; some of the measures chosen to reflect risk have positive, significant regression
coefficients.
4 Cornell and Shapiro (1986), J of
Banking and Finance
The Reaction of Bank Stock Prices to the
International Debt Crisis
US evidence for M D … in stock prices Percentage of Latin American loans to total assets has a significant, negative impact on returns in 1982; energy loans had a negative
impact in 1982-83. Loans purchased from Penn Square Bank had a negative impact on returns in the month in which that bank failed.
5 Shome, Smith and Heggestad
(1986), J of Financial Research
Capital Adequacy and the Valuation of Large
Commercial Banking Organization
US evidence for M D … in stock prices Stock prices are estimated as functions of earnings and capital ratios; the coefficient on the capital ratio is positive and significant for
some years, insignificant for other years.
6 Baer and Brewer (1986),
Economic Perspectives
Uninsured deposits as a source of MD: Some
new evidence
US evidence for M D … in stock prices Variability of stock prices help explain CD rates; Even when banks are solvent, the deposit market does charge riskier banks more; weak
evidence for M D in uninsured deposits; coefficients on risk measures used by bank supervisors not significant.
7 Smirlock and Kaufold (1987), J
of Business
Bank Foreign Lending, M andatory Disclosure
Rules, and the Reaction of Bank Stock Prices
US evidence for M D … in stock prices Evaluates the effect of the M exican debt crises on bank value; banks were not required to disclose their M exican debt at the time of the
1982 moratorium; nevertheless investors were able to discriminate among banks with different levels of exposure.
8 Randall (1989), New England
Economic Review
Can the M arket Evaluate Asset Quality
Exposure in Banks?
US evidence for MD is
weak
… in stock prices Stock prices of the bank holding companies that reported relatively large losses declined relative to market average stock prices only
after the problems became public knowledge, not during the periods which the banks began assuming relatively high risk.
9 Distinguin, Rous, and Tarazi
(2006), J of Financial Services
MD and the use of stock market data to predict
bank financial distress
Europe evidence for MD … in stock prices Early warning model for European banks, which tests if market based indicators add predictive value to models relying on accounting data;
link between market information and financial downgrading in the light of the safety net and asymmetric information hypotheses.
10 Park and Peristiani (2007), J of
Banking and Finance
Are bank shareholders enemies of regulators or
a potential source of MD?
US evidence for M D … in stock prices Shareholders’ risk-taking incentives were confined to a small fraction of highly risky institutions; even though shareholders have
incentives to transfer wealth by pursuing riskier strategies, this risk taking is mostly outweigh trough the possibility of losing charter value.
11 Curry, Fissel, and Hanweck
(2008), J of B. and Finance
Equity market information, bank holding
company risk, and MD
US evidence for M D … in stock prices Investigate whether equity market variables can add value to accounting models that predict changes in bank risk ratings; findings suggest
that one-quarter lagged market data adds forecast value to lagged financial statement data and prior supervisory information.
12 Pop and Pop (2009), Quarterly
Review of Economics and
Requiem for M D and the specter of TBTF in
Japanese banking
Japan evidence for MD is
weak
… in stock prices of too-big-
to-fail companies
The functioning of MD in Japanese banking may no longer be valid in the post-Resona period (bailout); the too-big-to-fail doctr
ine
created a hostile environment for effective M D; incentives to monitor and influence risk taking behavior are comprised.
13 Pettway (1976), J of Finance Market Tests of Capital Adequacy of Large
Commercial Banks
US evidence for MD is
weak
... in subo rdinated notes and
debentures
The rate premium is estimated as a function of the capital ratio of banks and other variables; the coefficient on the capital ratio is not
significant.
14 Beighley (1977), J of Bank
Research
Bank Equities and Investor Risk Perceptions:
Some Entailments to Capital Adequacy
US evidence fo r M D ... in subo rdinated no tes and
debentures
The rate premium is estimated as a function of several measures of risk including a loss ratio and a leverage ratio; the coefficients on the
loss and leverage ratios are positive and significant.
15 Fraser and M cCormack (1978),
J of Fin. and Quant. Analysis
Large Bank Failures and Investor Risk
Perceptions: Evidence from the Debt M arket
US evidence for MD is
weak
... in subo rdinated notes and
debentures
The rate premium is estimated as a function of the capital ratio and the variability of profits divided by total assets; none of the
independent variable has a significant coefficient.
16 Avery, Belton, and Goldberg
(1988), J of M oney, C. and B.
MD in regulating bank risk: New evidence from
the capital markets
US evidence for MD is
weak
... in subo rdinated notes and
debentures
SD risk premiums are weakly related to Moody's and Standard and Poor's ratings, but uncorrelated with the FDIC Index and any balance-
sheet variables. M oreover, the FDIC Index of bank riskiness is found to be negatively related to the public bond ratings.
17 Gorton and Santomero(1990), J
of Money, Credit and Banking
MD and bank subordinated debt: Note US evidence for MD is
weak
... in subo rdinated notes and
debentures
Virtually no relation between a bank's risk measures and its implied asset volatility; results offer little support for the presence of M D in the
subordinated debt market.
18 Flannery and Sorescu (1996), J
of Finance
Evidence of bank MD in subordinated
debenture yields: 1983-1991
US reduction of safety
nets increases MD
… in subordinated debt yields SD yields become more closely correlated with indicators of bank risk as regulatory treatment of failed banks' debentures became more
harsh; Investors have rationally reflected changes in the government's policy toward absorbing private losses in the event of failure.
19 Morgan and Stiroh (2001), J of
Financial Services Research
MD of banks: The asset test US evidence for M D … in bond spreads Bond spreads reflect the asset mix; credit card and commercial and industrial lending also carry a penalty in terms of higher spreads;
Banks contemplating a shift into riskier activities, e.g., in trading, can expect to pay higher spreads.
20 Jagtiani and Lemieux (2001), J of
Economics and Business
MD prior to bank failure US evidence for M D … in bonds during period prior
to failure
Bond spreads start rising (up to 100 %) as early as 6 quarters prior to failure as financial condition and credit rating deteriorates; increase
MD by increasing subordinated debt would be effective at the bank holding company level.
21 Sironi (2002), J of Banking and
Finance
Strengthening banks' M D and leveling the
playing field: Are the two compatible
cross
country
evidence fo r M D ... in subo rdinated debt Spread/rating-relatio nship is same fo r US & European banks; US banks tend to pay higher average spread because of poorer rating;
controlling on default risk US banks pay lower average spread than corresponding European banks; spreads rise when ratings worsen.
22 Sironi (2003), J of M oney, Credit
and Banking
Testing for MD in the European banking
industry: Evidence from subordinated debt
Europe evidence fo r M D ... in Euro pean subo rdinated
notes and debentures
Results support the hypothesis that SD investors are sensitive to bank risk, with the exception of SD issued by public sector banks, i.e.,
government owned or guaranteed institution; sensitivity of SD spreads to measures of stand-alone risk has been increasing from the first
23 Goyal (2005), J of Financial
Intermediation
MD of bank risk: Evidence from subordinated
debt contracts
US evidence for M D …
in subordinated debt with
restrictive covenants
MD through writing restrictive covenants (on investments, payment of dividends, financing) in bank debt contracts; deregulation leads to
higher risk-taking so private incentives to monitor bank's risk taking are stronger.
24 Ashcraft (2008), J of Financial
Intermediation
Does the M D banks? New evidence from
regulatory capital mix
US evidence for M D … in SD The FDIC Improvement Act has impact on the influence of debt investors over bank outcomes; increase in SD has positive effect in
helping a bank recover from distress; fixed income investors able to exert influence on behavior of distressed institution.
(Subordinated) debt prices
Equity prices
WORKING PAPERS ON RISK MANAGEMENT AND INSURANCE, NO. 101 – NOVEMBER 2011
12
Table 3: Results of literature review for banking (CD: certificate of deposit, J: journal, MD: market discipline, SD: subordinated debt) (continued)
# Authors Title Country M ain results
25 Crane (1976), J of Bank
Research
A Study of lnterest Rate Spreads in the 1974 CD
Market
US evidence for MD is
weak
… in uninsurance deposits The determinants of CD rates are evaluated using factor analysis; a factor that reflects profit rates and capital ratios is not a significant
variable in explaining CD rates.
26 Hannan and Hanweck (1988), J
of M oney, Credit and Banking
Bank Insolvency Risk and the Market for Large
Certificates of Deposit
US evidence for MD … in uninsurance deposits Estimate the relationship between the rates individual banks offer on large uninsured certificates of deposits and perceived bank risk. CD
rates tend to be hiqher at banks with more variable income and lower capital ratios, holding constant the influence of total assets.
27 Cargill (1989), J of Financial
Services Research
CAM EL Ratings and the CD M arket US evidence for MD … in CD rates Investigates the relationship between CD rates as a measure of bank risk and the CAMEL scores assigned to a bank as a result of an
onsite examination; results suggest that CAM EL ratings are primarily proxies for available market information about the quality of a bank.
28 Ellis and Flannery (1992), J of
Monetary Economics
Does the debt market assess large banks’
risk? Time series evidence from money center
US evidence for MD … in CD rates CD rates paid by large money center banks include significant default risk premia; consider time series data on specific banks’ daily
offering rates during the period M ay 1982 through Julv 1988.
29 Park (1995), Quarterly Review of
Economics and Finance
M D by depositors: evidence from reduced-form
equations
US evidence for MD … large time deposits Riskier banks offered higher interest on large time deposits but attracted less of these deposits; large time depositors forced risky banks
to pay higher premiums; analysis also considers the effects of bank size, but fails to find evidence that depositors prefer large banks.
30 Billett, Garfinkel, and O'Neal
(1998), J of Financial Economics
The cost of market versus regulatory discipline
in banking
US safety nets reduce
MD
... insured deposit are
impediments to MD
Insured deposit financing shields banks from the full costs of M D; M oody´s downgrades are associated with negative abnormal equity
returns that are increasing in the bank´s reliance on insured deposits; banks raise their use of insured deposits following increases in risk.
31 Park and Peristiani (1998), J of
Money, Credit and Banking
M D by Thrift Depositors US evidence for MD … debt and deposit (in thrift
institutions)
Riskier thrifts are found to pay higher interest rates and attract smaller amounts of uninsured deposits; qualitative results are similar for
fully insured deposits, but the statistical significance is substantially lower.
32 M ondschean and Opiela (1999),
J of Financial Services
Bank time deposit rates and MD in Poland: the
impact of state ownership and deposit
Poland evidence for MD is
weak
… in partial deposit insurance Establishment of explicit deposit insurance lowers incentive for monitoring; insurance coverage per bank forces to spread
(concentration) risk; M D is weak with fully guaranteed banks.
33 M artinez Peria and Schmukler
(2001), J of Finance
Do depositors punish banks for bad behavior?
M D, deposit insurance, and
cross-
country
safety nets do not
reduce M D
... deposit insurance and the
impact of banking crises
Depositors discipline banks by withdrawing deposits and by requiring higher interest rates; deposit insurance does not appear to diminish
the extent of MD; investors' responsiveness to bank risk.
34 Demirgüç-Kunt and Huizinga
(2004), J of Mon. Economics
M D and deposit insurance cross-
country
safety nets reduce
MD
... deposit insurance limits
MD
Deposit insurance reduces required deposit interest rates, while at the same time it lowers M D on bank risk taking; deposit insurance
schemes internationally vary in their coverage, funding, and management.
35 Imai (2006), J of Banking and
Finance
M D and deposit insurance reform in Japan Japan evidence for MD …
deposit insurance reform
on partly insured time
Reform raised sensitivity of deposit rates and growth to bank default risk; interest rate difference between partially insured time-deposits
and fully insured deposits increased for risky banks; reform had positive effects on MD by reducing supply of time deposits of risky banks;
36 Spiegel and Yamori (2007), J of
Banking and Finance
M arket price accounting and depositor
discipline: The case of Japanese regional banks
Japan evidence for MD … in deposit levels (evidence
for depositors discipline)
Banks that opt for price-to-market accounting have more intense depositors discipline; depositors in price-to-market-sample are more
sensitive to bank financial condition.
37 Uchida and Satake (2009), J of
International Financial Markets,
M D and bank efficiency Japan evidence for MD … in banks with more
outstanding deposits / more
Banks with more depositors have lower cost inefficiency (consistent with the hypothesis that depositors put a substantial pressure on
bank management); being listed at the stock market has a positive impact on cost inefficiency (not consistent with the MD hypothesis).
38 Hassan, Karels, and Peterson
(1994), J of Banking and Finance
Deposit insurance, M D and off-balance sheet
banking risk of large US commercial banking
US evidence for MD … in off-balance sheet
activities
Examine the riskiness of off-balance sheet activities by employing option-pricing models to calculate bank asset risk; empirical results
suggest the existence of MD of off-balance sheet activities; market participants price these as risk-reducing.
39 Koppenhaver and Stover (1994),
J of Banking and Finance
Standby letters of credit and bank capital:
Evidence of MD
US evidence for MD … in off-balance sheet
contingent liability
Hypothesis that MD causes a joint relationship between bank capital and standby letter of credit decisions for banks that are active
participants in the standby market or that rely heavily on purchased funds is tested and cannot be rejected.
40 Bliss and Flannery (2002),
European Finance Review
M D in the governance of US bank holding
companies: Monitoring vs. Influencing
US evidence for MD is
weak
… here focus on influence
(market influence is weak)
Influence regression using equity returns and expected managerial behavior, among others; although some patterns consistent with
market influences are identified, the methodology does not provide strong evidence taht investors influence managerial actions.
41 Nier and Baumann (2006), J of
Financial Intermediation
M D, disclosure and moral hazard in banking cross-
country
safety nets reduce
MD
... government safety nets
reduce M D
Safety nets result in lower capital buffers; stronger MD resulting from uninsured liabilities and disclosure results in larger capital buffers;
also finds that the effect of disclosure and uninsured funding is reduced when banks enjoy a high degree of government support.
42 Carow, Heron, Lie, and Neal
(2009), J of Corporate Finance
Option grant backdating investigations and
capital MD
US evidence for MD … in option grant patterns
related to agency-costs
Capital markets are proactive in disciplining companies for heightened agency problems even if there are no formal inquiries to that
matter; markets began to anticipate which firms would have backdating problems and bid their stock prices down.
Deposits (uninsured and insured)
Other (off-balance sheet activities, safety nets)
WORKING PAPERS ON RISK MANAGEMENT AND INSURANCE, NO. 101 – NOVEMBER 2011
13
Regarding the impact of rating changes on equity prices (investor market discipline), the early
study by Singh and Power (1992) and the recent studies by Halek and Eckles (2010, 2011)
find conflicting results. Singh and Power (1992) find no price reaction to rating changes,
whereas Halek and Eckles (2010, 2011) document asymmetric responses (downgrades cut
share prices, upgrades have little effect). Halek and Eckles (2010) attribute these differences
to the structure of the ratings data, the event study methods, and the timing of the data. Other
work on the impact of market signals on equity prices (Fenn and Cole, 1994; Brewer and
Jackson, 2002) is more in line with Halek and Eckles (2010, 2011), so that overall it seems
that there is evidence for market discipline in insurer stock prices.
The work on price of insurance offers implications rather than direct tests of market disci-
pline. For example, studies from the 1990s (Sommer, 1996; Phillips, Cummins, and Allen,
1998; Cummins and Danzon, 1997) find a negative relationship between price proxies and
firm risk in the property-casualty industry. This finding is consistent with market discipline,
but as lower prices could also cause greater risk, it is difficult to identify the cause and effect
relationship in this case. Also in a property-casualty context and using simple experiments,
Wakker, Thaler, and Tversky (1997) show the risk sensitivity of policyholders in that an in-
crease in default risk severely affects policyholder willingness to pay. Similar experimental
evidence is found in Albrecht and Maurer (2000), Zimmer, Schade, and Gründl (2009), and
Zimmer, Gründl, and Schade (2009). An important result of these studies is that in a transpar-
ent setting, market discipline will work, since knowing about differences in default risk se-
verely affects policyholder behavior.
As to consumer influences, Zanjani (2002) uses A.M. Best ratings as a risk measure to study
their relationship with life insurer lapse rates and finds some evidence of market discipline,
with a positive relationship between risk (i.e., ratings) and lapse. Epermanis and Harrington
(2006) consider insurer ratings in a property/casualty context and observe significant premium
declines following rating downgrades, particularly for firms that had low ratings even before
the downgrade. They also note the concentration of premium declines in commercial lines,
which tend not to be protected by guarantee associations. In line with these findings for prop-
erty-casualty insurance, Baranoff and Sager (2007) find that life insurance demand declines
after a rating downgrade. Eling and Schmit (2011) confirm this finding for the German mar-
ket. They find premium declines as well as increased lapse rates following rating downgrades.
All these studies document asymmetric responses to positive and negative news.
Moreover, three studies from the 1990s (Lee, Mayers, and Smith, 1997; Brewer, Mondschean,
and Strahan, 1997; Downs and Sommer, 1999) show that the establishment of guarantee funds
increases risk taking. The establishment of guarantee funds might hamper risk sensitivity,
especially that of policyholders.
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14
Table 4: Results of literature review for insurance (J: journal, GIC: guaranteed investment contracts, MD: market discipline)
# Authors Title Country M ain results
1 Singh and Power (1992) J of
Risk and Insurance
The Effects of Best’s Rating Changes on
Insurance Company Stock Prices
US no evidence for MD … in stock prices Statistically insignificant stock price reactions to both rating upgrades and downgrades; suggest that A.M. Best & Co. is a monitor of
publicly available information; it is not an agency that reveals new information to the financial markets.
2 Fenn and Cole (1994), J of
Financial Economics
Announcements of asset-quality problems and
contagion effects in the life insurance industry
US evidence for M D … in stock prices Contagion effects in the returns of life insurance stocks at time of announcements of problems in their investment portfolios; effects are
larger for insurers with significant junk bonds/commercial mortgage assets and mobile customers represented by GICs.
3 Brewer and Jackson (2002),
Fed. Reserve Bank of Chicago
Inter-Industry Contagion and the Competitive
Effects of Financial Distress Announcements:
US evidence for M D … in stock prices Insurers with risky assets experience larger stock price declines than those with less risky assets during downturns in the real estate and
bond markets.
4 Halek and Eckles (2010), J of
Risk and Insurance
Effects of Analysts' Ratings on Insurer Stock
Returns: Evidence of Asymmetric Responses
US evidence for M D … in stock prices Examine the information value contained in insurer rating changes; downgrades cut share prices by approximately 7 percent, upgrades
have little significant effect; share prices react more strongly to A.M. Best and Standard & Poor’s downgrades than to M oody’s.
5 Halek and Eckles (2011), Working
Paper
Determinants of Abnormal Reactions to Insurer
Rating Downgrades
US evidence for M D … in stock prices Observe that abnormal insurer returns resulting from rating downgrades are associated with, among other insurer characteristics, the
extent of the downgrades and the level of institutional ownership.
6 Sommer (1996), J of Risk and
Insurance
The Impact of Firm Risk on Property-Liability
Insurance Prices
US evidence for M D … in the price of insurance Examines the impact of insolvency risk (implied by the option pricing model of insurance) on the prices the insurer obtains for its products
(proxied by net premiums/discounted losses) in the property-liability market; finds negative relationship between firm risk and prices.
7 Cummins and Danzon (1997), J
of Financial Intermediation
Price, Financial Quality, and Capital Flows in
Insurance M arkets
US evidence for M D … in the price of insurance Price of insurance (ratio of premiums to discounted losses) is inversely related to insurer default risk; evidence that prices declined in
response to loss shocks of the mid-1980s.
8 Phillips, Cummins, and Allen
(1998), J of Risk and Insurance
Financial Pricing of Insurance in the M ultiple-
Line Insurance Company
US evidence for M D … in the price of insurance Prices vary across firms depending upon overall-firm default risk and the concentration of business among subsidiaries; within a given
firm, prices do not vary by line after adjusting for line-specific liability growth rates, negative relation between price and risk.
9 Carson, Doran, and Dumm
(2011), Risk M an. and Ins. Review
MD in the Individual Annuity Market US evidence for M D … in the price of annuties Measure annuity contract yields during the accumulation phase and find that firm financial strength is positively related to yield; this
anomaly can be viewed as a form of market discipline itself, for at least four related reasons; one is the incentive to provide a track record
10 Zanjani (2002), Federal Reserve
Bank of New York
MD and Government Guarantees in Life
Insurance
US evidence for M D … in lapse Uses A.M. Best ratings as his measure of financial risk to study its relationship with life insurer lapse rates; finds some evidence of MD,
with a positive relationship between risk (i.e., ratings) and lapse.
11 Epermanis and Harrington
(2006), J of M oney, Cr. and B.
MD in Property/Casualty Insurance: Evidence
from Premium Growth
US evidence for M D … in premium growth Consider insurer ratings in a property/casualty context and observe significant premium declines following rating downgrades, particularly
for firms that had low ratings even before the downgrade.
12 Baranoff and Sager (2007),
Working Paper
MD in Life Insurance: Insureds' Reaction to
Rating Downgrades in the Context of Enterprise
US evidence for M D … in premium growth (number
of policies), life insurance
Observe reduced demand for life insurance products (measured by the number of policies written) when ratings decline; Granger causality
demonstrates that the direction of the relationship flows from ratings downgrade to decline in demand, rather than the reverse.
13 Eling and Schmit (2011), Geneva
Risk and Insurance Review
Is There M D in the European Insurance
Industry? An Analysis of the German Insurance
Germany evidence for MD … in premium growth, lapse Analyze MD in the German insurance market using Epermanis and Harrington’s (2006) research design and find premium declines as well
as increased lapse rates following rating downgrades.
14 Eling and Kiesenbauer (2011), J
of Financial Services Research
Does Surplus Participation Reflect Market
Discipline?
Germany evidence for MD … in premium growth, lapse Find a significant positive dependence between surplus participation and new business growth as well as a significant negative
dependence between surplus participation and growth of lapse volume for the German market. Customers thus react to changes.
15 Lee, M ayers, and Smith (1997), J
of Financial Economics
Guaranty funds and risk-taking Evidence from
the insurance industry
US safety nets reduce
MD
… impact of guarantee funds Evidence suggests that the risk of insurers assets portfolio increases after the enactment of state guaranty funds; this effect is significant
only for stock insurers.
16 Brewer, Mondschean, and
Strahan (1997), J of Risk and
Insurance
The Role of M onitoring in Reducing the Moral
Hazard Problem Associated with Government
Guarantees: Evidence from the Life Insurance
US safety nets reduce
MD
… impact of guarantee funds Risk taking by life insurers is higher in states with guaranty funds that are underwritten by taxpayers. In states where taxpayers pay for the
costs of resolving insolvencies, life insurers hold portfolios with higher overall stock market risk and higher levels of risky assets. By
contrast, in states where the guaranty funds are underwritten by the industry, overall risk is no higher than in states without these funds.
17 Downs and Sommer (1999), J of
Risk and Insurance
Monitoring, Ownership, and Risk-Taking: The
Impact of Guaranty Funds
US safety nets reduce
MD
… impact of guarantee funds Empirical results provide support for the risk-subsidy hypothesis and demonstrate the essential link between insider ownership and risk-
taking.
18 Liu, Epermanis, and Cox (2005),
Working Paper
Agency Conflicts and M D: Evidence from
Guaranteed Investment Contracts
US evidence for M D … in guaranteed investment
contracts
Study the influence of GICs as a disciplinary mechanism for bondholders and find some M D influences. The agency conflict risk-shifting
behavior has, however, a much stronger influence.
19 Pottier and Sommer (2006),
Risk Man. and Ins. Review
Opaqueness in the Insurance Industry: Why Are
Some Insurers Harder to Evaluate than Others?
US some insurers are
difficult to evaluate
… e.g., smaller insurers, stock
insurers
Identifies insurer characteristics that are associated with greater difficulty in financial strength evaluation (smaller insurers, stock insurers,
greater stock investments, more diversified), as proxied for by the level of rating disagreement by M oody’s and Standard and Poor’s.
20 Lin, Oppenheimer, and Chen
(2008), Risk M. and Ins. Review
Intangible Assets, Going-for-broke and Asset
Risk Taking of Property and Liability Insurance
US evidence for M D … regarding asset risk and
ratings
Intangible assets play an important role in P&L insurers’ asset risk taking incentives; negative relationship between insurers’ asset risk
and intangible assets.
Equity prices
Price of insurance
Sum of premiums/number of contracts/lapse
Other (safety nets, opaqueness)
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Recently, some studies have documented the opaqueness of insurers, which might limit the
monitoring element of market discipline. For example, smaller insurers, stock insurers, insur-
ers with greater stock investments, and more diversified insurers are, in general, more difficult
to evaluate (see Pottier and Sommer, 2006). The willingness to monitor insurers might partic-
ularly depend on the line of business considered. Zhang, Cox, and Van Ness (2009) find evi-
dence that differences among insurers in the opacity of lines of business (life vs. non-life, long
vs. short tail) affect adverse selection for investors in the market for insurer equities, which
should directly affect market discipline.
3.3. Derivation of trends, consensus, and notable conflicts in the subject areas
Looking at the relevant work published over the last few decades reveals that the definition of
market discipline has evolved from simply considering the risk sensitivity of debt prices and
spreads to accounting for the effects of this risk sensitivity on managerial decisions (see
Covitz, Hancock, and Kwast, 2004). Market discipline is thus not an easy-to-measure one-
dimensional construct, but is, instead, multifaced. These different facets are reflected in how
market discipline is defined in the insurance context (see Section 2.1). Both in banking and
insurance almost all studies focus on the monitoring component of market discipline, which is
easier to measure than its influencing component (see Bliss and Flannery, 2002).
Overall, it appears that market discipline is reasonably strong in most insurance markets, but
that there is some variation when it comes to legal form (Liu, Epermanis, and Cox, 2005),
lines of business (Epermanis and Harrington, 2006), and countries (Eling and Schmit, 2011).
All these results are confirmed on a broader empirical basis in the banking sector (see, e.g.,
Morgan and Stiroh, 2001; Sironi, 2003; Pop, 2006).
Moreover, and again for both banking and insurance, there appears to be a consensus that in-
formational limitations and the regulatory environment play a major role in the level of mar-
ket discipline, especially with regard to incentive conflicts between principals (stockholders,
debtholders) and agents (managers). Agency problems are far stronger in those cases where
market discipline is undermined by informational limitations. For example, agency effects are
more common among mutual insurers, which generally have lower informational require-
ments than stock insurers. This result might be interpreted to mean that market discipline is an
appropriate approach in some contexts, but that regulatory efforts will work better in others.
In particular, regulatory efforts are likely more appropriate where informational limitations
exist, while market discipline might be more effective when much information is available
(see Eling and Schmit, 2011).
Another aspect is the asymmetry in findings regarding positive and negative news. The down-
side risk of sending a bad market signal is typically greater than the upside potential of a good
market signal. Examples in the insurance sector are papers by Epermanis and Harrington
WORKING PAPERS ON RISK MANAGEMENT AND INSURANCE, NO. 101 – NOVEMBER 2011
16
(2006), Baranoff and Sager (2007), and Halek and Eckles (2010). These results are consistent
with those found in the finance literature on the effects of negative and positive news (see,
e.g., Chan, 2003; Hong, Lim, and Stein, 2000).
There is thus a great deal of similarity between banking and insurance when it comes to find-
ings from market discipline research. However, there are also notable differences between the
two fields, especially regarding the relevance of debt instruments, which can be traced back to
differences in the business models of these two financial institutions. For example, Zhang,
Cox, and Van Ness (2009) discuss differences in opaqueness between banking and insurance
that might affect market discipline. They argue that some sources of information opaqueness
for banks and insurers are common, but that others are unique to insurers. In banking the lia-
bilities are typically well-defined with respect to duration and amounts. In insurance there is
greater asymmetric information because of the less certain duration of claim payments and the
difficulty to predict loss amounts. Babbel and Merrill (2005) note in this context that the
opaqueness and complexity of insurance contracts allow managers to create illusory values.
Colquitt, Hoyt, and McCullough (2006) show that property-liability insurers are able to use
greater discretion in setting loss reserves. Polonchek and Miller (1996) find greater infor-
mation asymmetries with respect to the assets and liabilities of insurers compared to banks.
Also Morgan (2002) provides evidence that insurers can be more opaque than banks, in his
case considering disagreements among rating agencies.
Harrington (2005) directly compares market discipline in banking and insurance. He argues
that market discipline is greater in insurance than in banking and concludes that capital re-
quirements should be less stringent for insurers. Based on an analysis of risk sensitivity, buyer
sophistication, search costs, and franchise value, he argues that overall market discipline is
highest in reinsurance, moderate in life and non-life, and low in banking (see Table 1 in Har-
rington, 2005).
3.4. Derivation of facilitators and impediments to market discipline in insurance
The discussion has shown that market discipline is strongly affected by outside factors that
can either facilitate or impede it. Recent government rescue efforts and direct intervention in
the insurance and, especially, banking markets has created a great deal of distortion that has
affected market discipline to a significant degree. These interventions give rise to some com-
plicated, but highly interesting, questions involving moral hazard, the role of guarantee funds,
the structure of rescue operations, the obligations of the firm being rescued, and the impact
intervention has on competition. The most important impediments to market discipline in in-
surance are the following.
1. Work on banking finds that guarantee associations are an impediment to market discipline
(see, e.g., Demirgüç-Kunt and Huizinga, 2004). Without guarantee schemes, bank manag-
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ers have strong incentives to avoid risky loans and risky investments; however, mandated
deposit insurance eliminates much of the risk involved in these activities. There are also
several insurance studies that observe increased risk taking following the establishment of
guarantee associations (see Lee, Mayers, and Smith, 1997; Downs and Sommer, 1999).
One study also finds that risk levels increase when the amount of insurance sold increases
in jurisdictions where guarantee associations exist (Brewer, Mondschean, and Strahan,
1997). These findings are in line with the expectation that the establishment of guarantee
funds reduces monitoring incentives and thus negatively affects market discipline. There
could thus be differences in market discipline between different lines of business or differ-
ent regions, depending on the insurance guarantee fund design in place.
2. In addition to these direct market distortions, there might also be indirect or implicit mar-
ket distortions. An example is bailout schemes, such as the “too-big-to-fail” concept,
where governments feel obliged to rescue a troubled bank or insurer because they fear fi-
nancial contagion.
3. The financial crisis revealed specific impediments to market discipline, e.g., the complexi-
ty of financial products. Financial institutions are often highly complex both in their own-
ership structure and in the nature of their business. For example, many insurers have doz-
ens of reinsurance arrangements primarily intended to diversify risk, but these also reduce
transparency and can sometimes mask financial problems (see Harrington, 2004).
4. Harrington (2004) mentions the judgment-proof problem as an impediment to market dis-
cipline. Under a compulsory insurance regime (e.g., auto liability, workers’ compensation,
or professional liability), individuals with few assets to insure might simply buy the cheap-
est insurance they can find, with no regard to insolvency risk. The combination of compul-
sory insurance and judgment-proof buyers reduces the risk sensitivity of demand.
There are thus a number of reasons to expect differences in market discipline depending on
the line of business. (1) The judgment-proof problem that arises in the case of compulsory
insurance impedes market discipline. (2) Government or privately organized fund guarantees
of all insurance claims and benefits destroy all incentives for market discipline. Reducing
coverage, however, could be quite conducive to market discipline. (3) Differences in lines of
business due to products and business complexity affect the degree of market discipline.
Standardized products make it easier to identify differences between insurers, but this is more
difficult when it comes to complex products and businesses. (4) An increase in financial lev-
erage increases company risk. Life insurers typically have a much higher leverage than non-
life insurers and this might affect the risk sensitivity of investors. (5) Market discipline could
be stronger in commercial lines compared to personal lines. Policyholders in personal lines
have less resources and competence (e.g., in terms of education to read financial reports) to
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engage in efficient monitoring than do policyholders in commercial lines, which are usually
larger and have more resources. On the other hand, personal line insurance decisions directly
affect an individual’s own wealth, whereas commercial insurance decisions do not usually
have much of a personal impact on the decision maker. This situation can create moral hazard
problems, which lowers the efficiency of monitoring in commercial lines. Nonetheless, evi-
dence indicates that market discipline in commercial lines is stronger than in personal lines
(Epermanis and Harrington, 2006).
In this context, we would also expect more market discipline in reinsurance than in insurance
because reinsurance covers only commercial business, while insurance covers both commer-
cial and personal lines. An implication for policymakers is that when comparing personal and
commercial insurance, it appears that market discipline is weak in some areas and strong in
others.
This last point is also true when it comes to legal form. Insurers listed on the stock market are
subject to more extensive reporting requirements than are mutual insurers. Liu, Epermanis,
and Cox (2005) document that agency effects are more common among mutual insurers,
which generally have lower informational requirements than do stock insurers. These results
can be interpreted to mean that relying on market discipline is appropriate in some areas, but
that formal regulation will work better in others. In particular, formal regulation is likely to be
the more effective course in the presence of informational deficits (i.e., with mutuals). Market
discipline will be more effective when information is generally available (i.e., with stocks).
When it comes to facilitating market discipline, the availability and quality of information is
crucial. In this context, an important result from the experimental literature (Wakker, Thaler,
and Tversky, 1997; Zimmer, Gründl, and Schade, 2009) is that if all necessary information is
available, customers will discipline insurance companies by changing their demand. However,
more information is not necessarily better information. In a theoretical world, Holmström
(1979) shows that in moral hazard problems more information about the agent is never detri-
mental to the principal and, under mild assumptions, is always actually beneficial. In the “re-
al” world, however, things can be quite different, especially when the cost of information is
taken into consideration. Furthermore, more information can be useful only if it is consistently
accessible and provided in a standardized form so that market participants can understand it
and make appropriate comparisons between insurers. Standardization, consistency, and acces-
sibility are thus important requirements for effective market discipline.
In conclusion, an effective market discipline framework needs to encompass the following.
Stakeholders need to consider themselves at risk and they need to be able to observe risk effi-
ciently, i.e., at reasonable costs. Reasons why risk sensitivity might be limited include guaran-
tee schemes, anticipation of “too-big-to-fail” effects, compulsory insurance and judgment-
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19
proof buyers, and product and business complexity. Even if stakeholders consider themselves
at risk, monitoring will be hampered when the necessary information is too difficult and/or
too costly to obtain. Furthermore, adverse selection could occur if some stakeholders have
more information than others. Only if stakeholders consider themselves at risk and are able to
observe risk efficiently will market discipline work. Market discipline will then manifest in
either a reduction in willingness to pay (price effect) or in a reduction in demand for insurance
from a particular provider (quantity effect). This might result in an influencing effect that can
manifest directly, by managers shifting their risk exposure, or indirectly, by regulators acting
on the signal.
4 Conclusions and future research
Market discipline focuses on the risk sensitivity of customer demand for insurance products
and on investor willingness to pay for equity and debt. Evidence from the banking sector
shows that market discipline can work very efficiently. However, the banking sector is differ-
ent from the insurance sector in some aspects, so not all findings from banking may be gener-
alizable to the insurance industry.
There are not enough insurance sector market discipline studies to conduct an in-depth impact
assessment, but those that do exist indicate that market discipline appears to vary in terms of
strength between the German insurance market (Eling and Schmit, 2011) and the U.S. market
(Epermanis and Harrington, 2006). Furthermore, there are important drivers of (standardiza-
tion and accessibility) and impediments to (market distortions such as guarantee funds) mar-
ket discipline that regulators should keep in mind when attempting to enhance it. If market
participants are not aware of risk and/or are unable to evaluate risk at a reasonable cost, there
will be no market discipline.
There are many avenues future research can take. There is a great need for empirical tests of
the risk sensitivity of policyholder demand, especially for countries other than the United
States. Regarding potential investor-driven market discipline, it might be interesting to ana-
lyze spreads of credit default swaps, data that are available, at least for large insurers and rein-
surers. For large insurers and reinsurers listed on stock markets, analyzing stock prices might
be useful. It also would be interesting to see how risk sensitivity varies across countries, by
comparing data from different regions and countries, and across different legal forms, by
comparing mutual and stock insurer data. Such empirical tests could then be compared with
results from other insurance and banking studies.
Another interesting task would be to measure the influence of market discipline in insurance
with the methodology employed by Bliss and Flannery (2002). We also need more theoretical
studies on market discipline in insurance, e.g., models that analyze the implications of market
discipline on competition or models on the role of franchise value in insurance and how this is
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20
affected by risk. These theoretical models could then be tested with empirical data to increase
our knowledge of market discipline in the insurance industry.
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21
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