Assessing the probability of default of publicly traded companies: The case of insurance

Over the last two decades, there has been a growing interest in managing credit risks of financial organizations. This study measures the risk of default of insurance undertakers based on the variations in their stock prices. It also verifies if the market information embedded in publicly traded stock prices could be used as an early-warning system for changes in the financial situation of complex financial organizations, such as international insurance and reinsurance companies.; Using conditional CAPM to model stock price expectations (Hall & Miles, 1990), conditional expected shortfalls in stock prices is assessed by combining quasi-maximum-likelihood fitting of a GARCH model to estimate expected volatility and extreme value theory (EVT) for estimating the tail of innovation distribution of the GARCH model (McNeil & Frey, 2000). We compare the probabilities of default obtained with our method and the credit assessments of major credit rating agencies, in particular Standard & Poor's and AM Best. Our results suggest that the market can anticipate important financial changes that may affect public insurance companies.; We also conduct an event study to verify the ability of the market to anticipate changes in the financial condition of individual firms. More specifically, we test for abnormal returns in relation with rating change announcements. Absence of unusual returns near the announcement dates supports the contention that the financial market anticipates rating changes.