The Cost of Biased Insurer Ratings

Numerous firms offer competing ratings of insurer financial condition. Insurance consumers, producers, and others commonly puzzle over which rating is more accurate. A 1994 Government Accounting Office (GAO) report judged the performance of a group of these insurance rating agencies. That report focused on Type I error (i.e., too high a rating on an insurer that defaults) rather than an appropriate balance between Type I and Type II error (i.e., too low a rating on an insurer that is financially stronger than indicated by the rating). This study investigates the consequences of focusing on Type I errors. We assume that both the demand and supply of insurance are related to an insurer’s rating. Using these assumptions, a model demonstrates the theoretical existence of a set of optimal insurer ratings and the societal cost imposed by rating-induced deviations from this set.