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

Property and Casualty (P&C) insurers report more conservative loss reserves—estimates of what the company will pay in future claims—following state-mandated regulatory financial examinations (RFEs).

Willie Reddic, associate professor of accounting, and two co-authors—Jill Bisco, associate professor of finance at the University of Akron and Kayla Booker, associate professor of business at Rhodes College—relate this finding in “The Effect of External Monitoring on Conservative Financial Reporting in the Property-Casualty Insurance Industry,” forthcoming in Auditing: A Journal of Practice and Theory.

Their results track with prior work in accounting that describes how external monitoring encourages more conservative reporting by both public and private companies. “The twist in this study is that we’re looking at a sector—insurance—which, like banking, is usually disregarded in the accounting literature because they go through a large amount of regulation,” Reddic says. “As a former state insurance regulator, I realized that regulators actually conduct their own form of audit, similar to how a CPA firm would.”

The stakes for the company being audited in an RFE (which typically lasts three to five years), however, are significantly higher. “The main difference between, say, a CPA firm and a regulator audit is that a regulator can suspend or revoke a company’s license and shut it down,” Reddic said. When the researchers looked at highly detailed data (provided by the National Association of Insurance Commissions) of firms from the year during which they underwent a regulator audit and the two following years, they found that “the companies’ conservatism increases exponentially,” he says.

Reddic hopes that understanding how RFEs impact companies’ reporting will serve as a valuable tool for auditors and other external monitors in keeping a watchful eye on the P&C insurers’ loss-reserving practices. “They can use it as a monitoring gauge of what the company was doing before the exam, and then—whether or not the company provides data—they can get information from state regulators to determine whether the companies are doing anything risky,” Reddic explains.

The study also confirms that state funding for insurance departments is money well spent and can help ensure adequate loss protection for policyholders. “Under-reserving reporting is risky; it puts stakeholders and policyholders in jeopardy,” Reddic says. “Our results imply that these examinations provide a valuable service to consumers as well as other businesses by reducing this risky behavior.”

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