Insurer Reserve Error and Executive Compensation

ABSTRACT This article investigates incentives of insurance firm managers to manipulate loss reserves in order to maximize their compensation. We find that managers who receive bonuses that are likely capped or no bonuses tend to over-reserve for current-year incurred losses. However, managers who receive bonuses that are likely not capped tend to under-reserve for current-year incurred losses. We also find that managers who exercise stock options tend to under-reserve in the current period. INTRODUCTION This article investigates whether managers of insurance firms manipulate loss reserves in order to maximize their total compensation. Events such as the downfall of Enron, WorldCom, and Tyco have highlighted the importance of prudent managerial practices, especially procedures involving managerial discretion. Insurance firms have not been exempt from scandals resulting from accounting manipulations. AIG came under scrutiny for manipulating accounting results in order to meet earnings goals. Among other charges, former New York state Attorney General Eliot Spitzer "alleges that AIG adjusted its accounting books with unsupported accounting entries to increase the company's reserve levels before issuing its quarterly [earnings] reports. Mr. Smith [CEO, Howard I. Smith] is accused of personally supervising the entries, referred to as 'topside' or 'top level' adjustments, instructing employees to make changes" (National Underwriter, 2005). (1) There is a significant academic literature on the manipulation of accounting data by insurance firms in order to circumvent regulatory scrutiny or smooth tax liability. Grace (1990) and Petroni (1992) are seminal papers that explore the use of loss reserving practices by insurance firms to avoid regulatory action and to smooth earnings. In addition to discretionary reserving practices, Petroni and Shackelford (1999) found that insurance companies shift their premiums and losses across states in order to manipulate state taxes paid. There also exists a separate literature that suggests managers (of noninsurance firms) use discretionary accounting methods to increase their compensation (Healy, 1985; Gaver, Gaver, and Austin, 1995; Holthausen, Larcker, and Sloan, 1995). This does not mean that the manager will always try to boost reported income. For instance, if a firm falls well below a targeted earnings threshold needed to trigger a bonus payment to the manager, the manager does not always have enough discretion to raise earnings above the threshold (at least legally). In this case, the manager has an incentive to minimize current-period income to increase possible discretion in future periods. While there is a substantial literature investigating insurance earnings smoothing for regulatory compliance or tax minimization, and a substantial literature investigating managers' use of accounting discretion to affect their compensation, there has been little research linking these two literatures. (2) We investigate the incentives of insurance executives to increase their total compensation through the manipulation of accounting results. Insurance company executives have at least one discretionary accounting accrual that can influence their total compensation: loss reserving. Further, because of statutory reporting, any estimation errors made in the initial establishment of loss reserves can ultimately be identified as the actual losses are realized and reported over subsequent years. We extend the insurance literature by examining the relationship between compensation of insurer executives and their loss reserve estimation practices. We hypothesize that insurance company executives will use their discretion over loss reserves to maximize the value of particular compensation components (e.g., bonuses, payment in restricted company stock and options). The remainder of the article is organized as follows. The second section discusses related literature. …