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Catastrophic Events and Retroactive Liability Insurance: The Case of the MGM Grand Fire

1991; Wiley; Volume: 58; Issue: 2 Linguagem: Inglês

10.2307/253236

1539-6975

Stephen P. Baginski, Richard B. Corbett, William R. Ortega,

Financial Markets and Investment Strategies

Catastrophic Events and Retroactive Liability Insurance: The Case of the MGM Grand Fire This study examines the capital market response to the MGM Grand fire and to the announcement of MGM Grand's purchase of $170 million in retroactive liability insurance. The information transfer effect is also examined. Event study research methods support earlier findings that the news of the fire had an adverse effect on MGM's security price. Security prices of industry co-member firms, however, experienced a negative information transfer (positive returns) on the date of the fire, a result consistent with intra-industry shifts in market share. Shifts in systematic risks were not documented for MGM or a portfolio of industry co-members. Catastrophic Events and Retroactive Liability Insurance: The Case of the MGM Grand Fire Recent analytical papers have developed the conditions under which an insured's purchase of retroactive liability insurance is economically advantageous. Smith and Witt (1985) argue that tax arbitrage enables the insured to share in the insurer's immediate income tax reductions for loss reserves. Venezian and Fields (1987) identify additional shared economic benefits derived from differential expectations of ultimate loss and the insurer's comparative advantage in dealing with losses. These arguments imply a favorable capital market response to the announcement of a retroactive insurance purchase. However, it is possible that a retroactive insurance purchase has an additional role in determining firm value. If the capital market is unsure about the probability and amount of loss related to the insured risk, the retroactive insurance agreement may provide a reliable dollar estimate of a significant portion of the loss. Thus, the insurance policy serves to adjust the capital market's initial estimate of probable loss. This study examines the capital market response to the MGM Grand fire and to the announcement of MGM Grand's purchase of $170 million in retroactive liability insurance to help cover the costs of potential liability claims resulting from the fire. The notion that information about catastrophic loss results in security price changes for the announcing firm is developed and empirically demonstrated in Sprecher and Pertl (1983, 1988). Evidence that such losses have industry-wide impact (information transfer) is provided by Bowen, Castanias, and Daley (1983) and Hill and Schneeweis (1982). The information transfer effect is also examined in this study because of its potential to differentiate, at least partially, between 1) the market's interpretation of the economic advantages of retroactive insurance; and 2) the market's use of the insurance announcement to determine the extent of loss. The former is firm-specific while the latter may have industry impact due to competitive shifts within the industry or changes in industry risk. Thus, a finding of information transfer relating to both the fire and the retroactive insurance announcement would be indicative of the market using a retroactive insurance announcement to adjust expectations of probable loss. The results of this study are consistent with previous research in that the news of the fire had an adverse effect on MGM's security price. The security prices of industry co-member firms were affected in the opposite direction (negative information transfer) on the date of the fire, a result consistent with intra-industry shifts in market share. Also, MGM experienced a statistically significant negative unexpected security return associated with the retroactive insurance purchase. Once again, industry co-members experienced significant unexpected returns in the opposite direction. Shifts in systematic risk were not documented for MGM or the portfolio of industry co-members. The interpretation of these results is that the securities market used the retroactive insurance announcement to adjust expectations of probable loss. …