Gaining From Loss: Property-Liability Insurer Stock Values in the Aftermath of the 1989 California Earthquake

Market Reactions to Legislation and Catastrophic Loss Catastrophic losses are a major concern in the property-liability insurance industry, because earthquakes and other natural disasters create special problems for insurers. Although the probability of catastrophic loss is very small, its impact on insurance firms covering the losses is substantial. For example, insurers are expected to pay billions of dollars for damages caused by the California earthquake of October 17, 1989.(1) A number of studies have examined the impact of large losses and the impact of legislation on insurers' stock values. Sprecher and Pertl (1983) and Davidson, Chandy, and Cross (1987) find that large losses have a negative impact on stock prices. Fields and Janjigian (1989) find that the 1986 Chernobyl reactor accident had a significant negative impact on the security prices of U.S. electric utilities. Hill and Schneeweis (1983), Bowen, Castanias, and Daley (1983), and Spudeck and Moyer (1989) find that many electric utility firms experienced decreased stock prices and increased risk following the 1979 Three Mile Island incident. The impact of legislation on insurance firm value has also been documented. Fields, Ghosh, Kidwell, and Klein's (1990) examination of the impact of California Proposition 103--which imposed constraints on insurers' ability to raise rates--found that insurance firms' stock values reacted negatively several days before and after passage of the Proposition. With the exception of a study by Walker (1988), there are no analyses of the impact of catastrophic losses on insurance firm value. This question is motivated by notable natural disasters involving large property losses, such as Hurricane Hugo in September 1989 and the October 1989 California (Loma Prieta) earthquake. We chose the earthquake for study because anticipation of the hurricane may have caused an information leakage effect. The timing of the earthquake could not have been anticipated. Its occurrence sent new, relevant information to the marketplace in short order. Hypotheses Two opposing hypotheses motivate this study. First, rapid depletion of surplus accounts following a catastrophe may cause investors to discount property-liability insurer stock values, depending on the actual or implied loss exposure of individual insurers. Reinsurance, which serves to spread catastrophic losses across many insurers, might lessen the depletion of surplus accounts for some firms following the earthquake. The second hypothesis is that insurers benefit from an isolated catastrophic event because of subsequent increased consumer or institutional demand, including increases in coverage required and additional premium earnings. This should affect stock prices positively, especially if much of the property damaged in a catastrophe had not been insured, as was the case in California at the time of the Loma Prieta earthquake. A significant portion of the earthquake loss was not covered, because high earthquake insurance rates and low perceived risk discouraged many property owners from carrying coverage. Only about 30 percent of California homes and businesses had earthquake insurance to cover the losses.(2) If the second hypothesis predominates, stock price increases should be especially pronounced for companies that write large amounts of insurance in California. The expectation is that additional earnings from increased demand will more than offset the losses. Hypothesis two is at odds with the results of previous studies cited above, which indicate that losses have a negative impact on firm value. The losses reported in earlier studies may have been caused by an erosion of consumer confidence in the safety or value of a firm's product or service that lessened demand. That is, a particularly large loss (fire, airplane crash, etc.) may have had a negative effect on consumer demand for the product or service, leading to depressed stock prices. …