Real Effects of Rating Standards for Catastrophic Risks

Rating standards affect risk-taking behavior of firms. We present a model that explains firms' selection of target ratings and their best response to a rating standard change, which prompts some firms to increase the risk. We then test the main predictions of the model using a natural experiment of hurricane Katrina in the US in 2005. It urged the major rating agencies to increase the stringency of the rating standards for insurers exposed to catastrophic losses, by increasing the minimum amount of capital insurers need to hold for these exposures. We find that insurers with relatively high benefits of maintaining the current rating and low cost of raising new capital improved their capital position in response to the change. By contrast, insurers with lower benefits and high costs reduced their capital and increased the risk in response to the more stringent rating standards