Academic journal article Journal of Legal, Ethical and Regulatory Issues

Management Discretion of Accruals Prior to the Demutualization of Property-Liability Insurance Companies

Academic journal article Journal of Legal, Ethical and Regulatory Issues

Management Discretion of Accruals Prior to the Demutualization of Property-Liability Insurance Companies

Article excerpt

INTRODUCTION

The purpose of this study is to evaluate management flexibility in determining accounting estimates in a specialized setting; property-liability insurance companies conversions from mutual ownership to stock ownership. As discussed more fully below, the valuation of the mutual insurance company is a critical component of the conversion process and provides incentives for earnings (surplus) management. Therefore, surplus management is particularly salient in the demutualization setting.

An insurance company's claim loss reserve is by far the largest accrual that involves management discretion for these companies. Overestimating (underestimating) the reserves has the effect of decreasing (increasing) policyholders' surplus. Insurance companies experiencing growth and/or financial distress have an increased demand for additional surplus. Two methods of obtaining this additional surplus are through internally generated funds (e.g., underwriting profits) or externally generated funds (e.g., surplus notes, demutualization).

Demutualization is the conversion of a mutual insurance company to a stock company. The difference between the two forms of organization is the claim to unassigned surplus. The amount of unassigned surplus limits the amount of non-liquidating dividends available to policyholders in a mutual insurance entity and to stockholders in a stock company. Even if the company is a stock company, the stockholders' claims are subordinate to the claims of policyholders and other creditors.

This study examines whether managers of property-liability insurance companies use their discretion in estimating the claim loss reserve accrual prior to the demutualization of the company. The incentive to either overstate or understate the claim loss reserve is dependent on management's role subsequent to the demutualization process. If management has a significant role (i.e., principal shareholder) after demutualization, management's incentive will be to overstate the estimated reserves to transfer wealth from policyholders' to themselves. By overstating reserves, surplus is decreased resulting in a lower value for the company and lower price paid to policyholders, therefore transferring wealth. I hypothesize that if management has more than a limited role as an investor, in their self-interest, they will overestimate the insurer's loss reserve in years preceding demutualization as a method to decrease surplus. Alternatively, if management has a limited role as an investor and an insurer intends to generate funds through demutualization, managers acting in the best interests of policyholders will have the incentive to increase firm value prior to demutualization. A limited role by management, after demutualization, predicts that managers will increase surplus to increase firm value by underestimating the loss reserve in the year preceding demutualization

The regression results of 48 property-liability companies that demutualized during the period of 1982-1999 are consistent with the hypothesis of overstatement of reserves as a means to decrease surplus. No evidence was found to support the understatement of reserves. The results indicate that the management process has an impact on the reserve estimate in the year preceding demutualization with the evidence suggesting that management incentives impact the demutualization process. The impact on the demutualization process exists when there is no change in management. The direct impact on surplus management by the demutualization transaction itself appears to be limited. An insurance company's financial condition does not appear to impact the results.

The primary contribution of this paper is twofold. The first contribution is identifying other potential reasons for management discretion in determining the reserve estimate. Prior literature finds that management uses discretion in estimating claim loss reserves as a method of stabilizing underwriting results and that financially distressed firms use their discretion as a means to smooth earnings to avoid regulatory intervention. …

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