The Role of Loss Reserve Errors in the Smoothing of Policyholder Surplus

Abstract

The penchant for insurers to engage in loss reserve earnings management has been well-established in the extant literature. Less well understood is the existence of a pattern in the systemic loss reserves errors found in the U.S. property-casualty insurance industry. This research examines that behavior and investigates the relationship between loss reserve errors and the cost of alternative sources of capital in the marketplace. We hypothesize that during times of relatively higher cost of alternative sources of capital insurance management will use its loss reserve estimates as a means of smoothing reported surplus for accounting purposes. We collect data from the U.S. property-casualty insurance industry over the period 1996 to 2011 and use GMM modeling techniques to control for dynamic responses. In addition to an aggregated industry analysis, we also perform separate analyses based on the insurer’s form of ownership. We find evidence that insurers use loss reserves to modulate reported surplus to compensate for changes in the relative cost of other sources of capital. Our results also show that these relationships vary depending on the ownership structure of an insurer.