The Effect of External Monitoring on Conservative Financial Reporting in the Property-Casualty Insurance Industry

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Author Information : Willie Reddic (Syracuse University)
Jill Bisco (The University of Akron)
Kayla Denise Booker (Rhodes College)

Year of Publication : Auditing: A Journal of Practice and Theory, forthcoming

Summary of Findings : This paper examines the effect of state insurance inspections (i.e., regulatory financial examinations) on the conservativeness of loss reserves. Incremental to the effect of external auditors, the study finds that loss reserves are most conservative following the state examinations.

Research Questions : Does external monitoring by state regulators motivate Property and Casualty (P&C) insurers to report more conservative loss reserves during and following the regulatory financial examination?

What we know : Research indicates that external monitoring via a financial statement audit encourages more conservative reporting not only by public companies that must be audited per the SEC, but also by private companies that can choose to be audited (Gaver and Paterson 2014). In addition, prior research indicates that external monitoring leads to more conservative estimates, especially with respect to loss reserves when monitoring is performed by a Big N audit firm (Petroni and Beasley 1996; Gaver and Paterson 2001, 2007, 2014).

Novel Findings : While existing studies focus on how external auditing affects reported loss reserves, no studies have explored the incremental effect of state-mandated regulatory financial examinations (RFEs) on P&C insurers’ loss reserve reporting. We address this gap in the literature by exploring whether P&C insurers report more conservative loss reserve estimates (i.e., reduce under-reserving reporting practices) in the year when an RFE is conducted and in the 2 years immediately following the RFE.

Implications for Practice : This research also provides important information for auditors and other external monitors. Understanding how RFEs impact reporting behavior enables auditors to establish benchmarks of behavior and to provide more robust annual assessments. This additional information can also help auditors in their reviews and in their efforts to better understand the financial health of the P&C insurance industry.

Implications for Policy: The findings will also allow state regulators to keep a “watchful eye” over the P&C insurers’ loss-reserving reporting practices following the regulatory financial examination.

Implications on Research: These findings should be of particular interest to both state insurance regulators and auditors. State funding for insurance departments is limited, and there was no previous evidence of the effectiveness of regulatory financial examinations in modifying loss reserve estimates.

Full Citations : Reddic, W.D., J. Bisco, and K. Booker, 2022. “The Effect of External Monitoring on Conservative Financial Reporting in the Property-Casualty Insurance Industry.” Auditing: A Journal of Practice and Theory, forthcoming

Abstract : When Property & Casualty (P&C) insurers understate their loss reserves, they increase the appearance of solvency. Understating loss reserves can lead to inadequate loss protection for policyholders. This paper investigates the effect of external monitoring by state regulators on financial reporting by P&C insurers. Specifically, we analyze whether a regulatory financial examination of P&C insurers, as mandated and conducted by state law, results in reporting more conservative loss reserve estimates. We find that P&C insurers report more conservative loss reserve estimates during and following a regulatory financial examination. Whereas past studies use audits as external monitoring events around which fluctuations in loss reserves are observed, we focus on regulatory financial examinations as external monitoring events that mitigate the use of loss reserves to manage perceptions of company health.

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