Catastrophes and Insurance Stocks – A Benchmarking Approach for Measuring Efficiency

Abstract

AbstractThis study uses the numeraire portfolio to benchmark insurance stock returns as a natural measure for detecting abnormal insurance stock returns from catastrophic events. The assumptions underlying the efficient markets hypothesis using a numeraire denominated returns approach hold for catastrophic insurance events whereas other more traditional methods such as the market model and Fama-French three factor model often fail, typically due to the accumulation of estimation errors. We construct a portfolio of Australian insurance firms and observe the market reaction to major insured catastrophic events. Using the numeraire denominated returns approach we observe no particular trend in the cumulative abnormal returns of insurance securities following a catastrophic event. Using both the traditional market model and the Fama-French three factor model however, we observe significantly positive cumulative abnormal returns following an insured catastrophic event. The errors inherent in the market model and three factor model for event studies are shown to be eliminated using the numeraire denominated returns approach.