Management discretion of accruals prior to the demutualization of property-liability insurance companies.

Author:Weiss, Jane M.
 
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INTRODUCTION

The purpose of this study is to evaluate management flexibility in determining accounting estimates in a specialized setting; property-liability insurance companies conversions from mutual ownership to stock ownership. As discussed more fully below, the valuation of the mutual insurance company is a critical component of the conversion process and provides incentives for earnings (surplus) management. Therefore, surplus management is particularly salient in the demutualization setting.

An insurance company's claim loss reserve is by far the largest accrual that involves management discretion for these companies. Overestimating (underestimating) the reserves has the effect of decreasing (increasing) policyholders' surplus. Insurance companies experiencing growth and/or financial distress have an increased demand for additional surplus. Two methods of obtaining this additional surplus are through internally generated funds (e.g., underwriting profits) or externally generated funds (e.g., surplus notes, demutualization).

Demutualization is the conversion of a mutual insurance company to a stock company. The difference between the two forms of organization is the claim to unassigned surplus. The amount of unassigned surplus limits the amount of non-liquidating dividends available to policyholders in a mutual insurance entity and to stockholders in a stock company. Even if the company is a stock company, the stockholders' claims are subordinate to the claims of policyholders and other creditors.

This study examines whether managers of property-liability insurance companies use their discretion in estimating the claim loss reserve accrual prior to the demutualization of the company. The incentive to either overstate or understate the claim loss reserve is dependent on management's role subsequent to the demutualization process. If management has a significant role (i.e., principal shareholder) after demutualization, management's incentive will be to overstate the estimated reserves to transfer wealth from policyholders' to themselves. By overstating reserves, surplus is decreased resulting in a lower value for the company and lower price paid to policyholders, therefore transferring wealth. I hypothesize that if management has more than a limited role as an investor, in their self-interest, they will overestimate the insurer's loss reserve in years preceding demutualization as a method to decrease surplus. Alternatively, if management has a limited role as an investor and an insurer intends to generate funds through demutualization, managers acting in the best interests of policyholders will have the incentive to increase firm value prior to demutualization. A limited role by management, after demutualization, predicts that managers will increase surplus to increase firm value by underestimating the loss reserve in the year preceding demutualization

The regression results of 48 property-liability companies that demutualized during the period of 1982-1999 are consistent with the hypothesis of overstatement of reserves as a means to decrease surplus. No evidence was found to support the understatement of reserves. The results indicate that the management process has an impact on the reserve estimate in the year preceding demutualization with the evidence suggesting that management incentives impact the demutualization process. The impact on the demutualization process exists when there is no change in management. The direct impact on surplus management by the demutualization transaction itself appears to be limited. An insurance company's financial condition does not appear to impact the results.

The primary contribution of this paper is twofold. The first contribution is identifying other potential reasons for management discretion in determining the reserve estimate. Prior literature finds that management uses discretion in estimating claim loss reserves as a method of stabilizing underwriting results and that financially distressed firms use their discretion as a means to smooth earnings to avoid regulatory intervention. This study examines the management of policyholders' surplus. Specifically, it addresses management's discretion in estimating loss reserves as a result of managers' incentives within the conversion process. The second contribution is to give further insight to the incentives of an insurer to demutualize. Prior literature has found mixed results as to the reasons for an insurer to demutualize. Testing the hypotheses of surplus management prior to demutualization will add further insight into these incentives, including better access to capital, reduction in agency costs, and management selfinterest.

A secondary contribution is the extension to prior earnings management research. The advantage of the insurers providing losses reserve development in regulatory reports allows more direct and accurate tests of earnings management. Other earnings management research relies on models that estimate potential earnings management. The insurance setting also provides an opportunity to study earnings management research and the impact of the regulatory process on management discretion. Within the insurance industry, regulation prevents some discretion in the choice of accounting policies as well as the active involvement in the stock conversion process through the state insurance commissioners.

The organization of this paper is as follows: Section 2 develops the demutualization environment. Section 3 outlines the theoretical development for earnings management. The sample is described in Section 4 with the model described in Section 5. Section 6 presents the results of the empirical test while Section 7 summarizes the paper.

DEMUTUALIZATION ENVIRONMENT

Surplus

For the test conducted in this paper, it is important to understand the role that policyholders' surplus has in an insurance company and

the demutualization transaction. Three primary purposes of surplus include 1) providing the initial funds to establish the company and begin operations, 2) providing a continuing source of funds for growth, and 3) providing a safety cushion to absorb adverse underwriting and investment experience without loss to policyholders. Factors affecting surplus are derived from the second and third purposes and include underwriting results, investment performance, loss reserve developments and growth rate. Due to the adverse effects these factors could have on surplus, insurers are required by state insurance regulators to maintain minimum surplus levels to continue operations and protect policyholders from loss.

Insurance companies experience increased demand for capital as a result of growth and/or financial distress. If a company intends to grow, this growth must be accompanied by increased surplus. The traditional method to support growth is through internally generated profits. If the internally generated funds are insufficient, the insurer looks for other sources to obtain the surplus requirements. Financially distressed firms are firms that do not meet regulatory requirements or meet the requirements but their financial strength is vulnerable to unfavorable changes in underwriting or economic conditions. Not meeting or barely meeting the requirements results in regulatory surveillance. Therefore, financially distressed insurance firms have incentives to increase surplus by various methods. Raising capital through an equity offering is one method. However, mutual insurance companies, which are owned by the policyholders, do not have this option and are therefore required to demutualize to raise capital through an equity offering.

Demutualization

There are various incentives for companies to demutualize. The two most prominent incentives are better access to capital and reduced agency costs (Mayers & Smith, 2004). Companies, both financially healthy and financially distressed, want better access to capital to meet economic and competitive changes. Companies can meet these changes by either restricting operations to reduce costs or to expand operations to spread its overhead (Fitzgerald, 1990). Companies choosing the latter require additional capital and the necessary capital is obtainable through either internally generated funds or externally generated funds, such as demutualization. Up-front capital is required for expansion because statutory accounting principles do not allow the acquisition expenses to be matched with the generated revenue as in generally accepted accounting principles. Therefore, surplus is decreased as new business is written with the level of surplus measuring the company's underwriting capacity and expansion through internally generated funds (i.e., policyholders' surplus) is extremely difficult when underwriting losses occur in successive years (4).

Reduction of agency cost is another incentive for demutualization. The three functions performed within an insurance company include: 1) the management function, 2) the owner function, and 3) the customer function. These three functions of management, owner (shareholder), and customer (policyholder) are separate in stock companies while owner and customer are merged in mutual companies (policyholder) (Mayers & Smith, 1988). Fama and Jensen (1983) argue that separation of decision making and risk bearing is likely to accompany separation of decision making and decision control to minimize agency conflicts. Mayers & Smith (1988) and Cagle, Lippert & Moore (1996) summarize the advantages and disadvantages of stock and mutual companies in regards to agency conflicts.

An important stock company advantage is that many decision control mechanisms are already in place, therefore limiting the agency conflict between managers and shareholders. Some decision control mechanisms include: 1) shareholder monitoring, 2) the market for corporate control, 3) the managerial labor market, 4) monitoring by analysts, institutions and regulatory authorities,...

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