Conditional Conservatism, Regulation, and Insolvency Risk

Abstract

We develop a new method of assessing conditional conservatism using more detailed data available from the insurance industry. We look at how conditional conservatism affects insolvency risk and the financial strength rating of property-liability (P&L) insurance companies. We also investigate how a change to accounting rules affects conditional conservatism. The P&L insurance industry is a perfect setting for studying accruals because we have specific and detailed firm-year level information about loss accrual development. The data enable us to develop a new method of measuring conditional conservatism, which is based on the concavity of the loss development curve. We study U.S. domiciled P&L insurance companies from 1995 to 2015. We find that the greater the degree of conditional conservatism, the lower is insolvency probability, and the better is the financial strength rating, with other things being constant. The result indicates that regulators and rating agencies reward insurers that voluntarily utilize conditional conservatism accounting strategy. Moreover, we find that the level of conditional conservatism is reduced after the enactment of the Model Audit Rule (MAR). MAR, like the Sarbanes-Oxley Act Section 404, increased board oversight of internal risk management. Our result provides evidence that complying with additional disclosure requirements reduces P&L insurers’ incentives to use conditional conservatism to mitigate regulatory monitoring costs.

Keywords: Conditional Conservatism, Concavity, Insolvency Risk, Model Audit Rule, Information Asymmetry

JEL Classification: G22, G28, G33, M41, M48