Property–Liability Insurer Reserve Error: Motive, Manipulation, or Mistake

ABSTRACT We use two reserve error definitions found in the literature to investigate the joint impact of previously studied incentives on the magnitude of reserve error. We find many prior conclusions are dependent upon the restricted setting in which the hypotheses are tested and on the definition of the reserve error. We find strong evidence that financially weak insurers underreserve to a greater extent than other insurers. However, our evidence casts doubt on the conclusion that insurers manipulate reserves to avoid solvency monitoring. We also find insurers increase reserves for tax purposes and to reduce the impact of regulatory rate suppression. INTRODUCTION The property-liability (P/L) insurance industry is frequently used to study managerial discretion (e.g., Petroni, 1992; Petroni and Beasley, 1996; Beaver and McNichols, 1998; Penalva, 1998; Gaver and Paterson, 1999, 2000; Petroni et al., 2000; Nelson, 2000; Beaver, McNichols, and Nelson, 2003; Gaver and Paterson, 2004, 2007). This is likely because the P/L industry provides two important advantages in the study of managerial discretion. First, it provides a homogeneous sample of firms that allows for easier decomposition of discretionary and nondiscretionary components (McNichols, 2000). Second, insurers are required to disclose revisions to a material accrual, the reserve for policy claim losses, thus providing a direct measure of managerial bias. The bulk of existing studies on the management of the P/L insurer loss reserve, however, examine the impact of only one or two rationales for why firms manage loss reserves without controlling for other important and relevant incentives. This leads to potential problems. First, the exclusion of alternative or additional motivations may influence econometric inferences, as prior findings could be the result of an omitted incentive. Second, many prior studies do not control for important nondiscretionary factors unique to the P/L insurance industry. Discretionary loss reserve revisions cannot be appropriately isolated without controlling for other firm incentives and economic factors (Guay et al., 1996). Additional issues remain unresolved in the extant literature. For example, the literature on the financial reporting of P/L loss reserves is split on how to measure the reserve error, the proposed measure of the potential managerial bias. Some compare the originally reported loss reserve to a future revised estimate (e.g., Kazenski, Feldhaus, and Schneider, 1992; Petroni, 1992; Beaver, McNichols, and Nelson, 2003), while others compare it to future claims paid (e.g., Weiss, 1985; Grace, 1990). No study examines whether the two error definitions yield consistent results. The main objective of this article is to use both reserve error definitions to examine jointly the hypothesized rationales for why insurers manage loss reserves. The set of hypotheses for why insurers manage reserves include: financial weakness (e.g., Petroni, 1992; Harrington and Danzon, 1994; Gaver and Paterson, 2004), tax (e.g., Grace, 1990), income smoothing (e.g., Weiss, 1985; Beaver, McNichols, and Nelson, 2003), and/or rate regulation incentives (e.g., Nelson, 2000; Grace and Leverty, 2010). Again in contrast to most prior research, we jointly test these hypotheses while accounting for a variety of economic and institutional factors often omitted in the past. We believe that insurance company management can have more than one motivation for reserve management; therefore, all the hypothesized variables associated with these various incentives should be estimated together. Our analysis yields results that are not always consistent with prior findings. The results also differ with the definition of the reserve error. Contrary to Weiss (1985), Grace (1990), and Beaver, McNichols, and Nelson (2003), we find little evidence that managers smooth income. We also find no support for a tax incentive to inflate loss reserves with the Weiss error. …