Accounting Conservatism in the Property-Liability Insurance Industry
40 Pages Posted: 13 Feb 2017 Last revised: 25 Sep 2019
Date Written: September 24, 2019
In this paper, we study two types of accounting conservatism in the P&L insurance industry – ex-ante conservatism and ex-post conservatism. Ex-ante conservatism means that liabilities are written up at the inception of liability regardless of any information, whereas ex-post conservatism refers to the overstatement of liabilities during the development of accruals in response to bad news. Ex-ante conservatism is news-independent and thus works as creating a cushion of reserves for future losses. In contrast, ex-post conservatism provides timely loss information and therefore is used to reduce the information asymmetry between managers and other outside parties. In our empirical test, we first create a measure of ex-ante conservatism based on the error in the loss reserves reported in the first development year. Then we model ex-post conservatism as an asymmetrically negative relationship between the incurred losses and current cash flows. We find that insurers’ loss reserves have asymmetric timeliness in reflecting good and bad news. Expected losses are reserved more quickly than expected gains. We additionally test and find that ex-ante conservatism preempts ex-post conservatism, but the effect decreases with the level of ex-ante conservatism. The level of ex-post conservatism is also constrained by income smoothing incentive but exaggerated by financial strength incentive. At last, we show that ex-post conservatism comes at an opportunity cost since insurers may reserve expected losses that do not occur in the future. Ex-post conservatism can lead to additional estimation error when a lower verification standard is required for reporting losses than gains.
Keywords: Ex-ante conservatism, Ex-post conservatism, Income smoothing, Loss reserving, Financial strength
JEL Classification: G22, G28, G33, M41, M48
Suggested Citation: Suggested Citation