Rating standards for catastrophic risks and the insurers' capital structure ∗

We model the choice of capital structure, pricing and targeted rating of an insurance firm and present corroborating evidence by studying the effect of the rating standard change for catastrophic losses on the insurers’ capital structure. Our model demonstrates that the optimal targeted rating and capital structure are obtained in a trade-off between benefits of targeting higher rating due to the ability to sell insurance at higher price and the cost of capital needed to sustain the rating. In addition, we derive the distribution of companies within the rating bin and provide results on how it depends on the insurers’ volatility of liabilities, capital costs, and future growth opportunities. We provide empirical results consistent with the implications of the model in a data set covering US property-casualty insurance industry in 2000-2009. We show that the adjustment of the rating standard introduced in the aftermath of hurricane Katrina in 2005 has a heterogeneous effect on insurers’ capital structure and leads to increasing dispersion of firms with respect to insolvency risk.