The Association between External Monitoring and Earnings Management in the Property‐Casualty Insurance Industry

Jennifer J. Gaver and Jeffrey S. Paterson

Journal of Accounting Research, 2001, vol. 39, issue 2, 269-282

Abstract: This paper examines the association between external monitoring and earnings management by property‐casualty insurers. We extend previous work by Petroni and Beasley (1996) by expanding the set of external monitors to include both auditors and actuaries. We investigate whether certain auditor‐actuary pairs are associated with less understatement of the loss reserve account by financially struggling insurers. Our data consist of loss adjustments reported by 465 property‐casualty insurers for reserves established in 1993. The results indicate that under‐reserving by weak insurers is essentially eliminated when the firm uses auditors and actuaries that are both from Big Six accounting firms. In contrast, non‐Big Six actuaries have less impact on under‐reserving by weak insurers. Our results suggest that the quality usually associated with Big Six auditors falls when the audit firm relies on third party actuaries to evaluate the loss reserve estimates of struggling insurance clients. We conjecture that Big Six actuaries insist on more conservative loss reserve levels because, compared to actuarial consulting firms, they are more attuned to the liability exposure of the auditor.

Date: 2001
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Journal of Accounting Research is currently edited by Philip G. Berger, Luzi Hail, Christian Leuz, Haresh Sapra, Douglas J. Skinner, Rodrigo Verdi and Regina Wittenberg Moerman

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