The effects of uncertainty on the relation between earnings and stock price: Evidence from the insurance industry in the wake of catastrophic events

This study hypothesizes that earnings numbers become more important to investors when uncertainty about a firm's prospects is high. I examine the effects of earnings uncertainty on the market response to earnings announcements of property and casualty (P&C) insurers following large-scale catastrophes. Assuming that earnings reflect the ability of the firm to generate cash flows and that firm value is the present value of the future cash flows, uncertainty about earnings reflects uncertainty about firm value. A sizable catastrophe represents a shock to expectations about both current and future earnings, so I expect this shock to be reflected in stock price.; The sample includes 1,628 earnings announcements for 117 publicly-traded P&C insurers during the years 1989-1992. The results strongly support the hypothesis that exposure to catastrophe losses significantly increases both the magnitude of abnormal returns at the time of quarterly earnings announcements and earnings response coefficients, even after controlling for predisclosure information and noise in earnings. This evidence suggests that earnings numbers become more important to investors in P&C insurance securities during periods of heightened uncertainty associated with large-scale catastrophes. Additional evidence suggests that catastrophe-induced uncertainty dissipates, on average, by the end of the quarter in which the catastrophe occurs.; The study's sample selection process revealed that CRSP SIC codes alone do not identify all publicly-traded P&C insurers. By tracing insurance firms from an industry-specific data base to CRSP, I was able to identify a sample of publicly-traded P&C insurers more than twice the size of those used in prior research. Future research in the P&C insurance industry using publicly-traded firms can attain larger sample sizes by selecting firms based on a broader set of criteria than SIC codes alone.