| An insurance policy is a promise by the insurer to perform in the future under certain conditions. As a result, the consumer cannot observe the insurer's performance until after having entered into the agreement, making the insurer's reputation a critical element of the consumer's selection process. Once an insurer's good reputation is established, in fact, a consumer is willing to pay more than the marginal cost of a policy to enter into an agreement with the insurer. A good reputation, therefore, is a valuable asset; yet, maintaining that positive reputation is also costly, leading to a choice by the insurer. The insurer can choose either to expend higher costs to maintain its positive reputation by fulfilling customer expectations or to expend lower costs that ultimately leads to performance below expectations and a loss of reputation. The latter is a form of moral hazard arising from the unobservable nature of performance at the start of the contract. The optimal strategy for an insurer depends on factors affecting the relative costs and revenues of each strategy. Here we create a simple model of reputation formation and maintenance, from which seven hypotheses regarding relevant factors in selecting an optimal strategy are derived. Those hypotheses are then tested empirically. Results indicate that passage of the Sarbanes-Oxley act had a significant effect on firm behavior. We also observe that leverage, firm age, and executive shareholdings are significantly related to reputational risk. In some samples, franchise value, the level of competition and discount rate were also related to instances of reputational loss. Further, we demonstrate that those factors tend to be associated with both insurers' choice of risk-taking and the number of publicly revealed events that potentially cause reputational loss. We consider these results significant for regulators and consumers. |
