In the second in Lingnan University’s Chair Professor Research Sharing series of webinars, David Eckles, Professor of Risk Management and Insurance at the University of Georgia, presented the results of his paper investigating issues around US insurance ‘companies’ management of their reserves.

The paper, which is still under review and is titled Asymmetry in Earnings Management Surrounding Targeted Ratings, was co-authored by Prof Evan Eastman of Florida State University and Prof Martin Halek of the University of Calgary.

Specifically, the trio sought to discover if insurance firms manage their reserves, or their loss-setting process, to achieve a target rating, and whether external monitoring, say by an auditor, helps mitigate this management.

“Under-reserving makes your liabilities look smaller and makes your income look larger,” Prof Eckles pointed out. Such a strategy improves the apparent performance of a firm.

Prof Eckles’ new project was inspired by questions raised in two of his earlier studies about insurance company reserves and ratings. “Do insurance company managers manipulate reserves for whatever reason - whether it be to minimise taxes, avoid regulatory scrutiny, or for compensation reasons? While on the ratings side, we had just looked at a stock market response to ratings: if a company was upgraded or downgraded, was there a stock market response?”

So what is an insurance loss reserve? Overall, around 90 per cent of premiums paid for any policy will be required to cover losses. So, together with their actuaries, an insurance firms’ reserve managers estimate, within a range, the total losses they are likely to incur and the reserves that will, therefore, need to be established. The managers then have some discretion over the final figure decided on and reported to the US government.

If the market competition is really stiff, firms can feel pressured to keep cutting their policy premium rates. This can be very dangerous for both the policyholder and the state that may have to bail them out. “But the regulators are very cognisant of this,” Prof Eckles notes.

The A.M. Best agency provides ratings which assess the ability of insurance firms to meet policyholder obligations. These ratings are used by regulators, consumers, agents, brokers, insurers and corporations, and brokers and agents can be reluctant to place any business with firms that have ratings lower than A-.

For their current paper, Prof Eckles and his collaborators devised three hypotheses: firms that deviate from their target financial strength rating will manage their loss reserves; firms below their target financial strength rating will tend to under-reserve while firms above their target rating will not manage reserves; and, finally, high quality external monitors (such as the Big 4 audit firms and Big 4 actuaries) mitigate the ability of firms that deviate from their target

ratings to manage earnings.

Prof Eckles pointed out that the work for this paper differed from other research in the area in that his team used an actual accrual of an earnings management variable, rather than an estimate. In his team’s work, the real losses incurred for a 12-month period that had occurred five years previously, were compared to the original estimated losses for that historical year.

“If I underestimate my losses in any one year, this allows me to have a higher income in that year,” Prof Eckles noted. This affects not only the stability measured by the balance sheet, but also the earnings from the income.

The large volume of data used in the research came from a number of sources he explained. He and his colleagues looked at most of the property-casualty and property-liability companies in the US, with their data analysed at the affiliated and unaffiliated single insurer level, rather than in combined groups. Broken down, the sample was from 18,680 firm-year observations and 1,909 unique firms, covering the period from 1992 to 2008. As the data is looked at from a five-year retrospective perspective, this takes the relevant time range up to 2013.

Other input came from the 1991-2013 National Association of Insurance Commissioners statutory filings, which offer a standard dataset for insurance company research, and the A.M. Best financial strength ratings.

Prof Eckles reported that their research had found fairly robust empirical evidence that firms tend to under-reserve when they are below-target rating, in order to try and achieve a higher rating – and this held true for alternative definitions of target rating. There was no evidence, however, of reserve management for above-rating firms.

Perhaps of greater concern was that there is only limited proof that high quality monitoring mitigates earnings management strategies.