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Forestalling capital regulation or masking financial weakness? Evidence from loss reserve management in the property–liability insurance industry

Yi-hsun Lai, Wen-chang Lin and Liang-wei Kuo ()
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Yi-hsun Lai: National Yunlin University of Science and Technology
Wen-chang Lin: National Chung Cheng University
Liang-wei Kuo: National Chung Cheng University

Review of Quantitative Finance and Accounting, 2018, vol. 50, issue 2, No 5, 518 pages

Abstract: Abstract This study examines the extent to which capital thresholds induce insurers to strategically exert accounting discretion to forestall regulatory actions. Using a sample of US property–liability insurers during 1994–2009, we find that when managing their claim loss reserves, the average insurers are insensitive to the pressure of capital regulation as measured by the distance of their RBC ratio to the action threshold. Yet, when the insurers are virtually partitioned by their reserving tendency, the effect of regulatory pressure is significantly related to the downward reserve bias in the under-reserving insurer cohorts. This finding continues to hold even after we utilize the number of ratio violations in the insurance regulatory information systems to purge the financial weakness effect embedded in the distance to RBC bound ratio. Hence, our empirical evidence suggests that insurers that are about to trigger the regulatory threshold will have the incentives to understate their loss reserves to preclude the impending authorized preventive actions. Finally, our analyses also shed light on the heterogeneity of incentives to managing loss reserves among over- and under-reserving insurers.

Keywords: Property–liability insurer; Loss reserve management; Risk-based capital; Earnings management (search for similar items in EconPapers)
JEL-codes: G18 G22 M41 M48 (search for similar items in EconPapers)
Date: 2018
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DOI: 10.1007/s11156-017-0636-y

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