Reserve Management and Audit Committee Characteristics: Evidence from U.S. Property–Liability Insurance Companies

• Author: Wen‐Yen Hsu,Gene Lai,Yenyu (Rebecca) Huang
• Date: 01 December 2019
• DOI: http://doi.org/10.1111/jori.12251
• Published date: 01 December 2019

RESERVE MANAGEMENT AND AUDIT COMMITTEE

CHARACTERISTICS:EVIDENCE FROM U.S.

PROPERTY–LIABILITY INSURANCE COMPANIES

Wen-Yen Hsu

Yenyu (Rebecca) Huang

Gene Lai

ABSTRACT

We examine the relation between reserve management and a set of audit

committee characteristics of property–liability insurers, using reserve errors

as a proxy for reserve management. We find that insurers with three audit

committee characteristics have more conservative loss reserve estimations:

larger audit committee size and more members with accounting expertise,

and more audit committee meetings. Our results also find that three

recommendations of the 1999 Blue Ribbon Committee can make corporate

audit committees more effective: a minimum audit committee size, a

minimum level of accounting expertise, and a minimum number of audit

committee meetings. These results were obtained when we controlled for

board of director characteristics, firm-specific characteristics, and Sarbanes–

Oxley. Some board composition variables (e.g., director ownership) also

have an impact on reserve management during our study period. The

evidence overall suggests that the audit committee and some board

characteristics have an impact on reserve management (earnings manage-

ment) even in a regulated environment such as the insurance industry.

INTRODUCTION

Having an accurate statement on financial performance is important for property–

liability insurers, because both policyholder claims and stockholder wealth are highly

dependenton the financialhealth of the insurer.Although insurershave variousways to

manipulatefinancial performance, the mostcommon is loss reserve management (e.g.,

Wen-Yen Hsu is a Professor at the Department of Risk Management and Insurance, Feng Chia

University, 100, Wenhwa Road, Seatwen, Taichung 40724, Taiwan. Hsu can be contacted via

e-mail: wyhsu@fcu.edu.tw. Yenyu (Rebecca) Huang is an AssociateProfessor at the Department

of Tourism and Leisure Management, St. John’s University, No. 499, Section 4, Danjing Road,

Danshuei, Taipei,Taiwan. Huang can be contacted via e-mail:vision@mail.sju.edu.tw. GeneLai

is the James J. Harris Chair in Risk Management and Insurance at Department of Finance,

University of North Carolina at Charlotte, 9201 UniversityCity Blvd., Charlotte, NC 28223. Lai

can be contacted via e-mail: glai@uncc.edu. He is also the corresponding author.

2018 The Journal of Risk and Insurance (2018).

DOI: 10.1111/jori.12251

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Weiss, 1985; Grace, 1990; Beaver, McNichols, and Nelson, 2003; Gaver and Paterson,

2004; Eckles and Halek, 2010; Eckles et al., 2011; Grace and Leverty, 2012) for several

reasons. Claim loss reserves (hereafter, loss reserves) are the largest liability on a

property–liabilityinsurer’s balancesheet, they havesubstantial managerialdiscretionin

their estimation, and manipulationin their estimation can have a substantial impact on

the quality of financial reporting.

Rigorous external monitoring mechanisms and strong internal corporate governance are

both essential for financial reporting quality and the protection of stakeholders. Absent

good monitoring and corporate governance, financial reporting systems may be

manipulated. Distorted financial statements mislead investors, regulators, and policy-

holders. External monitors, such as auditors (Petroni and Beasley, 1996) and regulators

(Gaver and Paterson, 2004), are generally ineffective at detecting or mitigating

inappropriate reserve management. In most corporations, boards delegate responsibility

for scrutinizing financial statements to their audit committees (see the Public Oversight

Board [POB], 1993). In June 2006, the National Association of Insurance Commissioners

(NAIC) incorporated several provisions of the Blue Ribbon Committee (BRC) on

improving the effectiveness of the Corporate Audit Committee (1999), the Sarbanes–Oxley

Act (SOX, 2002), and the Securities and Exchange Commission (SEC, 2003) in revision of its

Annual Financial Reporting Model Regulation (Model Audit Rule). Public insurers, as well

as most mutual and privately owned insurers, are required to abide by the revisions. One

element in the Model Audit Rule requires that boards of directors establish an audit

committee to oversee the insurer’s accounting and financial reporting processes (NAIC,

2006, Section 14F). The Model Audit Rule also recommends that audit committee members

meet with external auditors periodically without the managers’ presence. To date, the

effectiveness of internal monitors, such as audit committees, in constraining reserve

management has not been evaluated. We take this opportunity to examine the relation

between loss reserve management and various characteristics of audit committees. The

results of our study provide evidence on whether the proposed regulations on an audit

committee’s independence, size, accounting expertise, incentives, and diligence can

improve the committee’s effectiveness.

The effectiveness of audit committee characteristics in the insurance industry is interesting

for several reasons. First, the insurance industry is highly regulated, with special financial

reporting standards and rules. Empirical evidence on unregulated industries may or may

not apply to this industry. Demsetz and Lehn (1985) suggest that regulation “provides

some subsidized monitoring and disciplining of the management of regulated firms”

(p. 1161). Regulation in the insurance industry largely represents external corporate

control. This setting allows us to examine the efficacy of firms’ internal control systems

(e.g., audit committees) while controlling for the possible substitution effect of external

corporate control mechanisms. Our results can shed new light on the role of internal

corporate governance in a regulated industry.

Second, insurers must file annual statements following the Statutory Accounting

Principles (SAP) of the NAIC, which are very different from the Generally Accepted

Accounting Principles (GAAP). Conservatism is the main purpose of the SAP.

Finally, the account structure of companies in the i nsurance industry are

significantly differe nt from that in other industries. Loss reserve s, in particular,

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