RATINGS: IT'S ACCRUAL WORLD

• Author: David L. Eckles,James M. Carson,Evan M. Eastman
• DOI: http://doi.org/10.1111/jori.12179
• Published date: 01 September 2018
• Date: 01 September 2018

©2016 The Journal of Risk and Insurance. Vol.85, No. 3, 787–809 (2018).

DOI: 10.1111/jori.12179

Ratings: It’s Accrual World

James M. Carson

Evan M. Eastman

David L. Eckles

Abstract

Loss reserves are a discretionary tool for managing insurer earnings, with

more accurate and/or less volatile reserve errors resulting in higher accruals

quality.We investigate whether accruals quality is related to insurerfinancial

strength ratings. Specifically,we use insurer loss reserve errors as a measure

of the quality of accruals and examine whether overall accruals quality, as

well as a decomposition into innate and discretionary accruals quality, is

related to insurer financial strength ratings. We find that firms with lower-

quality (noisier) accruals receive lower financial strength ratings from A.M.

Best. This result holds for both innate and discretionary accruals. Overall,

we provide the first evidence that the quality of accounting information is a

significant factor in ratings of insurance firms.

Introduction

Insurer financial strength ratings have been studied by academics due to the useful-

ness of ratings to regulators, consumers, corporations, agents/brokers, and insurers.

Ratings largely determine the price insurers can charge for their product, provide an

indication of a firm’s risk of insolvency, and convey new information to capital mar-

kets (Halek and Eckles, 2010). While prior studies have investigated the determinants

of financial strength ratings (e.g., Doherty and Phillips, 2002), these studies have not

considered accounting quality as a determinant of ratings.

James M. Carson is the Daniel P. Amos Distinguished Professor of Insurance, Department of

Insurance, Legal Studies, and Real Estate, TerryCollege of Business, University of Georgia, 206

Brooks Hall, Athens, GA 30602. Carson can be contacted via e-mail: jcarson@uga.edu. Evan

M. Eastman is a Doctoral Candidate, Department of Insurance, Legal Studies, and Real Estate,

Terry College of Business, University of Georgia,206 Brooks Hall, Athens, GA 30602. Eastman

can be contacted via e-mail: eeastman@uga.edu. David L. Eckles is an Associate Professor of

Risk Management and Insurance, Department of Insurance, Legal Studies, and Real Estate,

Terry College of Business, University of Georgia, 206 Brooks Hall, Athens, GA 30602. Eckles

can be contacted via e-mail: deckles@uga.edu. The authors would like to thank the editor,Keith

Crocker,two anonymous referees, and Lorilee Medders for helpful comments. The authors are

grateful to participants at the 2015 FSU/UGA Research Symposium, the 2015 World Risk and

Insurance Economics Congress, and the 2015 Southern Risk and Insurance Association Annual

Meeting for their feedback. The authors would also like to thank A.M. Best and Robert E. Hoyt

for assistance in obtaining ratings data.

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788 The Journal of Risk and Insurance

In this article, we examine whether accruals quality is related to a firm’s financial

strength rating. Eckles, Halek, and Zhang (2014) provide evidence that insurers with

higher reserve error volatility have greater information risk. We suggest that insurers

with higher reserve error volatility have lower quality, or noisy,accruals. Thus, based

on the foregoing, we examine two research questions. First, we investigate whether

overall earnings quality, as measured by the noisiness (standard deviation) of an

insurer’s loss reserve errors, is related to the firm’s financial strength rating. Thus,

the more volatile an insurer’s loss reserve errors, the poorer is the insurer’s accruals

quality. Second, we decompose accruals quality into two components, discretionary

and innate, to determine whether the ratings effect differs between the two types.

This topic is of interest to researchers and several other parties. While prior research

has sought to identify the relative importance of various factors in A.M. Best’s (here-

after, “Best”) ratings process, no prior study has examined the possible role of the

quality of accounting information in assigning ratings. In addition, prior studies find

evidence that insurers can use discretionary accruals in an attempt to mask solvency

issues (e.g., Petroni, 1992; Gaver and Paterson, 2004; Grace and Leverty, 2012). There-

fore, if regulatory solvency monitoring is based on regulatory ratios that are sensitive

to accounting manipulation, Best could have an advantage in detecting insolvency if

Best incorporates accruals quality into its ratings.1

Using an ordered probit model, we model financial strength ratings as a function

of accruals quality and variables to control for various factors, including proxies for

firm risk of insolvency, for a large sample of property–liability insurers from 1993 to

2006. As mentioned above, we measure accruals quality in terms of the volatility (the

standard deviation) of loss reserve errors. We also decompose accruals quality into

innate and discretionary accruals (Francis et al., 2005; Eckles, Halek, and Zhang, 2014)

in an effort to examine differential ratings effects.

We offer two main results. First, we find evidence that financial strength ratings are

positively associated with accruals quality. That is, as measured by loss reserve error

volatility,insurers with higher quality (less noisy) accruals receive higher Best ratings.

This result suggests that Best is able to detect poor accruals quality and assigns a lower

financial strength rating to these firms having higher information risk. Second, we find

that reduction in financial strength ratings tends to be stronger for poor innate accru-

als quality relative to discretionary accruals quality. This finding suggests that Best

perceives greater insolvency risk arising from poor innate accruals (uncontrollableby

the firm) relative to discretionary accruals (controlled by managers).

We make several contributions to the literature. First, we contribute to the literature

investigating insurer financial strength ratings. We are the first to link accounting

quality when examining the determinants of financial strength ratings and find that

accruals quality incrementally explains insurer ratings. Second, we contribute to the

literature on insurer loss reserve errors. While the majority of extant literature ex-

1Pottier and Sommer (2002), for example, find evidence that private sector measures of insol-

vency,including Best’s financial strength ratings, are better predictors of insolvency compared

to measures used by the public sector. The sensitivity of public sector measuresto accounting

manipulation could be one potential explanation for this finding.