Accounting Conservatism in the Property-Liability Insurance Industry

40 Pages Posted: 13 Feb 2017 Last revised: 25 Sep 2019

See all articles by J David Cummins

J David Cummins

Temple University - Risk Management & Insurance & Actuarial Science

Mary A. Weiss

Temple University

Juan Zhang

Temple University, Fox School of Business and Management

Date Written: September 24, 2019

Abstract

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

Cummins, J. David and Weiss, Mary A. and Zhang, Juan, Accounting Conservatism in the Property-Liability Insurance Industry (September 24, 2019). Fox School of Business Research Paper No. 17-008. Available at SSRN: https://ssrn.com/abstract=2915656 or http://dx.doi.org/10.2139/ssrn.2915656

J. David Cummins

Temple University - Risk Management & Insurance & Actuarial Science ( email )

Fox School of Business and Management
1801 Liacouras Walk.
Philadelphia, PA 19122
United States
215-204-8468 (Phone)
215-204-4712 (Fax)

Mary A. Weiss

Temple University ( email )

Fox School of Business and Management
1801 Liacouras Walk
Philadelphia, PA 19122
United States
215-204-1916 (Phone)

HOME PAGE: http://www.sbm.temple.edu/~rmidept/weiss.html

Juan Zhang (Contact Author)

Temple University, Fox School of Business and Management ( email )

Philadelphia, PA
United States
267-250-7157 (Phone)

HOME PAGE: http://sites.google.com/temple.edu/juan-zhang/

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