Abstract
The implementation of the Sarbanes–Oxley (SOX) Act in 2002 imposed a wide range of new oversight standards seeking to assure greater accuracy and transparency in the financial reporting of publicly traded firms in the U.S. This research assesses the relationship that the implementation of SOX shares with loss reserve estimation accuracy in the U.S. property-casualty insurance market. Using a comparative difference-in-difference approach, this research finds that, while publicly traded insurers have indeed experienced a significant reduction in loss reserve errors subsequent to SOX, the reduction is not attributable to SOX. These results hold true under a handful of robustness analyses.
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Notes
The content of the Act is available online at www.sec.gov/about/laws/soa2002.pdf.
For a regular summary of the U.S. insurance industry’s annual operations and results, please see the Annual Report on the Insurance Industry (issued annually by the Federal Insurance Office, U.S. Department of the Treasury).
Unless otherwise explicitly noted in the paper, all references to earnings management refer to accrual-based earnings management, as opposed to real earnings management. The former is the use of accepted accounting techniques to manipulate standard accounting procedures in order to achieve specific outcomes in a firm’s financial reports. Real earnings management employs operational decisions, such as reductions and/or postponements of investments, as a means of affecting financial report results.
Some prior literature used the difference between incurred losses at time t and cumulative paid losses at time t + 5 as a measure for reserve errors (see, for example, Weiss 1985; Grace 1990; Browne et al. 2009). Actuaries, however, do not recommend this method, because paid losses do not include cases and estimates of incurred but not reported losses. Thus, we chose the incurred losses instead of paid losses in our calculation of reserve errors, which is more in line with how the insurance industry measures such estimates.
The lines of business include fire, accident and health, medical malpractice, product liability, workers’ compensation, airline, automobile, reinsurance, other liability, farmers multiple peril, homeowners multiple peril, mortgage guaranty, financial guaranty, surety, fidelity, theft, boiler, credit, earthquake, commercial multiple peril, ocean marine, inland marine, international, and others.
The NAIC (http://naic.org/) includes insurance regulators from the 50 states, the District of Columbia and the five U.S. territories. When uniformity is appropriate, the organisation provides a forum for the development of uniform insurance regulatory policy.
Given that reserve error estimation relies on the loss development values of the ensuing 5 years, we use data extending out to 2011, i.e., 2006 plus 5 years, to calculate 2006 reserve errors. Additionally, given that our lagged return on asset (ROA) variable is generated using the 3 prior periods, we incorporated data as early as 1995 in creating our 1998 lagged ROA variable.
Prior to 2002, all insurers filed reports in accordance with the NAIC Annual Statement requirements. With the passage of SOX, public insurers now report under both SOX and the NAIC.
Reclassification of 2002 as part of the pre-SOX period yields similar results to those reported here.
As a robustness check, we dropped the contingent commission variable and re-estimated our models. Our results remain the same with or without this variable.
Federal corporate tax rates can be found at www.taxfoundation.org/taxdata/show/2140.html.
Browne et al. (2012) suggest that AM Best’s solvency rating, the risk-based capital (RBC) ratio and the number of violations according to Insurance Regulatory Information System (IRIS) ratios are all valid proxies of an insurer’s financial condition and provide similar implications in empirical models.
The alternative models are estimated by including other industry-level control variables, including overall surplus capacity, and investment yield. The coefficients for those variables are generally not statistically significant and are therefore not included in the final models.
The Annual Financial Reporting Model Regulation (commonly referred to as the Model Audit Rule) promotes the adoption of SOX-like standards for all state-licenced insurers. The model act is available for review at http://www.naic.org/store/free/MDL-205.pdf.
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Appendix: Definition of variables
Appendix: Definition of variables
Variable | Definition |
|---|---|
\( \left| {\text{Total errors}} \right| \) | Absolute value of (incurred lossi,t – incurred lossi,t+5)/total assets. |
\( \left| {\text{Discretionary errors}} \right| \) | Absolute value of (discretionary errors/total assets) in 000s, where discretionary errors are predicted values of reserve errors based on whether a firm has net operating loss carryforwards, regulatory capital adequacy and net income |
Public | Dummy variable that equals 1 if the firm belongs to an ultimate owner that is a publicly traded company |
Mutual | Dummy variable that equals 1 if the firm is a mutual insurer |
Group | Dummy variable that equals 1 if the firm belongs to a group, and 0 otherwise |
Total Assets | Total admitted assets in millions |
Contingent Commission | Dummy variable that equals 1 if the firm uses contingent commission, and 0 otherwise |
Reinsurance | Reinsurance premiums ceded/(direct premiums written + reinsurance premiums assumed) |
Lagged ROA | Average ROA over the previous 3 years |
Tax | Marginal tax rate corresponding to the net income plus reserve errors |
Good Rating | Dummy variable that equals 1 if rating from AM Best is A- or above, and 0 otherwise |
Long Tail | Percentage of net premiums written in long-tailed lines |
Product Herf | Line of business Herfindahl index |
Geo Herf | Geographical Herfindahl index |
Industry Loss Ratio | Insurance industry average loss ratio |
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Ma, YL., Pope, N. The impact of Sarbanes–Oxley on property-casualty insurer loss reserve estimates. Geneva Pap Risk Insur Issues Pract 45, 313–334 (2020). https://doi.org/10.1057/s41288-019-00139-5
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DOI: https://doi.org/10.1057/s41288-019-00139-5