Academic journal article Academy of Accounting and Financial Studies Journal

An Overview of U.S. Property-Liability Insurer Earnings Management Via Loss Reserves

Academic journal article Academy of Accounting and Financial Studies Journal

An Overview of U.S. Property-Liability Insurer Earnings Management Via Loss Reserves

Article excerpt

INTRODUCTION

Managerial accounting discretion is a critical issue in both accounting and insurance industry. While majority of studies on this subject is discussed in the accounting literature, a growing stream of literature uses the property and liability insurance industry as a perfect laboratory to investigate accounting discretion using insurer's specific reserves called loss reserves.

Loss reserves are insurer's estimated liabilities for unpaid claims. Under Statutory Accounting Principles (SAP) (1), insurers are required to disclose the gradual settlement of claims over time and record all changes of the loss reserves estimates. As claims occur and are reported, insurers revise their original loss reserve estimates for each year. These revisions are known as "development".

Comparing insurer's loss reserve development to the initial estimate creates a direct measure of managerial accounting discretion which is widely used as a measure of earnings management in the insurance industry (Weiss, 1985; Petroni, 1992; Beaver et al., 2003; Eckles & Halek, 2010; Grace & Leverty, 2010:2012).

Watts & Zimmerman (1978) state that earnings management occurs when managers have a discretionary behavior related to accounting numbers to maximize the value of the company. In fulfilling this object, managers may set loss reserve estimates relatively higher or lower for many reasons including earnings smoothing (Smith, 1980; Weiss, 1985; Grace, 1990; and Beaver et al., 2003), tax purpose (Grace, 1990; Gaver & Peterson, 2001; Grace & Leverty, 2012), financial weakness (Petroni, 1992; Petroni & Beasley, 1996; Gaver & Paterson, 2004), regulatory scrutiny avoidance (Nelson, 2000; Petroni, 1992; Gaver & Paterson, 2004; Grace & Leverty, 2012), contracting motivations (DeAngelo et al., 1994; Jaggi & Lee, 2002), capital market (Teoh et al., 1998), external monitoring (Petroni & Beasley, 1996; Gaver & Patterson, 2001), and executive compensation incentives (Eckles & Halek, 2010; Eckles et al., 2011).

The implications of insurer's earnings management affect shareholders, regulators, and rating agencies. These parties have an interest in knowing the integrity of financial reporting through loss reserve error direction, magnitude, and variability. Shareholders and regulators often focus on loss reserve as it may reflect the financial weakness of a firm (Petroni, 1992; Nelson, 2000). Also, rating agencies appear to consider reserve error variability when they assign the insurer ratings (Carson et al., 2016).

This paper provides an overview of property and liability insurer earnings management using insurer's loss reserves. The next section defines insurer's loss reserve in details and how other areas explain earnings management. Then insurer earnings management calculations such as loss reserves direction, magnitude, and variability are introduced. Also, real activity measurement and discretionary/non-discretionary accruals are compared. The following section thoroughly discusses motivations, incentives, and outcomes of insurer's loss reserves in the literature. This paper then suggests the potential research areas and the last section concludes.

Loss Reserve

Definition

Loss reserves, the insurer's estimated liability for unpaid claims, normally are the largest liability item on a property and liability insurer's balance sheet. National Association of Insurance Commissioners (NAIC) mandates all insurance companies to follow accounting procedures under Statutory Accounting Principles (SAP), insurers report their loss reserves amount on firm's annual statutory filings on Part 2 of Schedule P. An excerpt from Schedule P of AllState can be found in Tables 1 and 2. Table 1 is reported in raw numbers while Table 2 is reported in percentage scale. These data are used to construct the loss reserve error for firm i for year t. …

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