Auditor quality, audit fees, organizational structure, and risk taking in the US life insurance industry

• Published date: 01 June 2020
• Date: 01 June 2020
• Author: Erin Lu,Gene C. Lai,Michael McNamara,Li‐Ying Huang
• DOI: http://doi.org/10.1111/rmir.12145

Risk Manag Insur Rev. 2020;23:151–182. wileyonlinelibrary.com/journal/rmir

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151

Received: 15 April 2020

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Accepted: 15 April 2020

DOI: 10.1111/rmir.12145

FEATURE ARTICLE

Auditor quality, audit fees, organizational

structure, and risk taking in the US life

insurance industry

Li‐Ying Huang

1

|Gene C. Lai

2

|Erin Lu

3

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Michael McNamara

4

1

Department of Accounting and

Information, Overseas Chinese University,

Taichung, Taiwan, ROC

2

Department of Finance, University of

North Carolina, Charlotte, North Carolina

3

Department of Risk Management,

Optimus Capital, Shanghai, China

4

Department of Finance and Management

Science, Washington State University,

Pullman, Washington

Correspondence

Gene C. Lai, Department of Finance,

University of North Carolina, Charlotte,

NC.

Email: glai@uncc.edu

Abstract

Using a system of simultaneous equations, this study

examines the relation among external audit mon-

itoring, in the US life insurance industry. We find

insurers with higher leverage risk and surplus risk

are more likely to use Big‐4 auditors and to pay

higher fees. In return, insurers hiring Big‐4 auditors

and paying higher audit fees have lower leverage risk

and surplus risk. Second, the results suggest that

mutual life insurers have a higher leverage risk and

surplus risk than stock life insurers. This evidence is

in contrast to that for property–liability insurance

companies. Third, we find insurers are less likely to

hire Big‐4 auditors and to pay higher audit fees after

implementation of the Sarbanes–Oxley Act (SOX).

Finally, life insurers with Big‐4 auditors or paying

higher audit fees are more likely to take lower risks

after the implementation of SOX.

KEYWORDS

audit quality, Big‐4 auditors, organizational structure, risk taking,

Sarbanes–Oxley Act

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© 2020 The American Risk and Insurance Association

1|INTRODUCTION

The purpose of this paper is to examine US life insurer risk‐taking behaviors in relation to

auditor quality, audit fees, organizational structure, and a number of board composition vari-

ables. Risk taking and its impact on stakeholders (e.g., stockholders, policyowners, and reg-

ulators) are a major concern for life insurers. Galai and Masulis (1976) suggest that stockholders

with limited liability have some incentive to take excessive risk in order to maximize corporate

value at the expense of bondholders. The argument is applicable to stock life insurers when

bondholders are replaced by policyowners. If insurers take excessive risk and become insolvent,

then policyholders would suffer even though they can eventually get help from guaranty funds.

Insurance regulators have the responsibility to ensure that the insurance market functions well

and to minimize the social costs of insolvent insurers.

Auditor companies are viewed as a source of external governance and play an important

role in a firm's behavior.

1

Becker, DeFond, Jiambalvo, and Subramanyam (1998), Francis,

Maydew, and Sparks (1999), and Gaver and Paterson (2001) find that a high‐quality audit

reduces the incidence of earnings management. Schmidt and Wilkins (2013) document that

companies that engage “Big‐4”auditors have a shorter duration of a financial statement re-

statement's “dark period,”which represents the length of time between a company's discovery

that it will need to restate financial data and the subsequent disclosure of the restatement's

effect on earnings. In other words, the impact of using Big‐4 auditors versus Non‐Big 4 auditors

may be different.

The 2008–2009 financial crisis raised concern about curbing excessive risk‐taking activities

of financial institutions (e.g., Acharya, Philippon, Richardson, & Roubini, 2009; Ellul &

Yerramilli, 2013; Hasana, Siddiquec, & Sun, 2015). The collapse of an insurer might result in

negative externalities for various parties (e.g., policyholders, stockholders, agents and brokers,

etc.).

2

Therefore, understanding the interplay between insurer risk‐taking and external moni-

tors (e.g., auditors) is of great importance.

Two dominant organizational forms in the US life insurance industry are stock insurers and

mutual insurers. Risk taking behavior are different for different organizational forms. The

separation of ownership and control is stronger in mutual insurers than stock insurers.

Therefore, the owners of mutual insurers have less incentive to monitor managers than do the

owners of stock insurers. Empirical evidence shows that stock insurers have more risk than

mutual insurers in the property–liability insurance industry (Ho, Lai, & Lee, 2013;

Lamm‐Tennant & Starks, 1993).

Accounting scandals in the USA have focused attention on corporate governance issues. The

regulatory response to these scandals was passage of the Sarbanes–Oxley Act of 2002 (hereafter,

SOX). This Act imposes a number of corporate governance, auditor independence, enhanced

financial disclosure, and other rules on all publicly traded companies in the USA.

3

For example,

SOX imposes restrictions on the types of services that audit firms can provide to their clients.

There is no empirical research that has examined the impact of SOX on external and internal

governance in the life insurance industry. Hence, we examine the impact of SOX on external

and internal governance of life insurers and explore how SOX affects life insurers’risk taking.

1

Regulators and independent directors are also formal monitors and we control for their impact in our analysis.

2

Some explanations of the bailout of AIG in September 2008 were: AIG was deemed big to fail (its assets top 1 trillion

US dollars), AIG was too global to fail, and AIG was too interconnected to fail (see Fox, 2008).

3

To save space, we only discuss the rules that relate to corporate governance.

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HUANG ET AL.

Our sample consists of 3,839 firm‐year observations over a 13‐year period from 2000 to 2012. To

better analyze the life insurers' risk‐taking behaviors from different perspectives, we calculate three

risk measures: leverage risk, underwriting risk, and surplus risk. Using a system of simultaneous

equations allows us to empirically account for the fact that the degree of external audit monitoring

and level of risk taking are potentially determined jointly. Big‐4 auditor (measuring audit quality) and

audit fees (representing audit efforts) and are two proxy variables for external audit monitoring. These

measures are significantly affected by risk factors (Broye & Weill, 2008;Cantoni,D'Silva,&

Isaacs, 2010; Datar, Feltham, & Hughes, 1991; Firth & Smith, 1995;Gonthier‐Besacier & Schatt, 2007;

Hay, Knechel, & Wong, 2006;Hughes,1986; Lee, Stokes, Taylor, & Walter, 2003;Thornton&

Moore, 1993; Titman & Trueman, 1986).Atthesametime,risk‐taking is influenced by external audit

monitoring (Ho et al., 2013; Jin, Kanagaretnam, & Lobo, 2011).

Using a system of simultaneous equations, this study examines the relation among external

audit monitoring, organizational structure, and firm risk taking in the US life insurance in-

dustry. The most important results are summarized as follows. First, there is a relation between

audit quality, audit fees, and firm risk taking. For example, insurers with higher leverage risk

and surplus risk are more likely to use Big‐4 auditors and to pay higher fees. In return, insurers

hiring Big‐4 auditors and paying higher audit fees have lower leverage risk and surplus risk.

Second, the results suggest that mutual life insurers have a higher leverage risk and surplus risk

than stock life insurers. This evidence is in contrast to that for property–liability insurance

companies. Third, we find insurers are less likely to hire Big‐4 auditors and to pay higher audit

fees after implementation of the SOX. Finally, life insurers with Big‐4 auditors or paying higher

audit fees are more likely to take lower risks after the implementation of SOX

The contributions to the literature are stated below. To the best or our knowledge, this is the first

study which focuses on audit quality and audit fees and their impact on risk taking in the US life

insurance industry.

4

Cole, He, McCullough, Semykina, and Sommer (2011) and Ho et al. (2013)

examine the impacts of various stakeholders/monitors on insurers' risk taking. Both papers focus on

the property–casualty insurance industry. In addition, Cole et al. (2011)donotconsidertheimpactof

external auditors and Ho et al. (2013) do not use a system of simultaneous models to account for

insurers' potentially endogenous choices on corporate governance and risk taking as our analysis

provides. Second, we investigate the joint impact of external audit monitoring and organizational form

on insurers' risk‐taking behavior, which is new to the literature of organizational structure for the life

insurance industry.

5

Third, previous research on external audit monitoring has largely focused only

on companies with (publicly traded) equity. Our study sheds light on how the role of external auditors

play in a mutual form of organization, which exhibits the greatest agency problem between owners

(policyholders) and management.

6

Our study adds to the literature on the role that external auditors

play in the mutual form of organization.

4

More specifically, Gaver and Paterson (2001) investigate whether certain external auditor–actuary pairs are associated

with less understatement of loss reserves (a type of earnings management) by 465 property–casualty insurers and Ho

et al. (2013) found Big‐4 auditors had a negative effect on insurers' investment risk, but the results are not significant. To

our best knowledge, there is no prior literature on the relation between external auditors and life insurers' risk taking.

5

The influence of organizational structure on firms' decisions continues to draw attention from the academic com-

munity. Some recent works in the general industry are: Mergers and acquisitions (Maksimovic, Phillips, & Yang, 2013),

CEO compensation (Cronqvist & Fahlenbrach, 2013; Edgerton, 2012), cash policy (Gao, Harford, & Li, 2013), and

innovation (Bernstein, 2015). Topics in the insurance industry include: diversification (Berry‐Stölzle, Liebenberg,

Ruhland, & Sommer, 2012), reinsurance (Yanase & Limpaphayom, 2017), outside directors (He & Sommer, 2010),

CEO turnover (Cheng, Cummins, & Lin, 2017; He & Sommer, 2011), and risk taking (Ho et al., 2013).

6

Ho et al. (2013, p. 172–173) provide thorough literature review on the relation between organizational structure and

insurer risk taking.

HUANG ET AL.

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