Journal of Accounting and Economics 35 (2003) 347376

Management of the loss reserve accrual and the distribution of earnings in the property-casualty insurance industry$
William H. Beaver, Maureen F. McNichols, Karen K. Nelson*
Department of Accounting, Graduate School of Business, Stanford University, Stanford, CA 94305, USA Received 2 March 2002; received in revised form 14 January 2003; accepted 27 January 2003

Abstract We document that property-casualty insurers with small positive earnings understate loss reserves relative to insurers with small negative earnings. Furthermore, loss reserves are managed across the entire distribution of earnings, with the most income-increasing reserve accruals reported by small prot rms, and the most income-decreasing reserve accruals reported by rms with the highest earnings. We analyze this pattern separately for public, private, and mutual companies, and nd that public companies and mutuals manage loss reserves to avoid losses, but that private companies do not. We also nd evidence of reserve management to avoid losses by nancially healthy and distressed rms. r 2003 Elsevier B.V. All rights reserved.
JEL classication: M41; G22; G28 Keywords: Earnings management; Earnings distribution; Discretionary accruals; Property-casualty insurance

We appreciate the helpful comments and suggestions of Jerry Zimmerman (the editor), an anonymous reviewer, and workshop participants at the American Accounting Association Annual Meeting, the 11th Annual Conference on Financial Economics and Accounting, Athens University of Economics and Business, Columbia University Burton Workshop, Harvard University Kennedy School of Government, Indiana University, MIT, University of Oregon, Stanford University, and Syracuse University. Research assistance was provided by Qintao Fan and Yvonne Lu. We gratefully acknowledge the support of the Stanford Graduate School of Business Financial Research Initiative. *Corresponding author. Present address: Department of Accounting, Jones Graduate School of Management, Rice University, Houston, TX 77005, USA; Tel.: +1-713-348-5388; fax: +1-713-348-6331. E-mail address: nelsonk@rice.edu (K. Nelson). 0165-4101/03/$ - see front matter r 2003 Elsevier B.V. All rights reserved. doi:10.1016/S0165-4101(03)00037-5

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1. Introduction This study examines the relation between discretionary loss reserve accruals and the distribution of reported earnings for a sample of property-casualty (P&C) insurers. Two distinctive features of the P&C insurance setting motivate studying earnings management in this sector. First, required disclosures for a material accrual, the claim loss reserve, allow us to develop a relatively reliable measure of managements exercise of discretion over earnings. Second, a variety of ownership structures exist within the industry, including public, private, and mutual companies. This variation allows us to examine more directly than in most prior research how incentives inherent in different ownership structures affect earnings management behavior. Our rst research objective is to examine the relation between management of the loss reserve accrual and the distribution of reported earnings. For a sample of non-insurance rms, Burgstahler and Dichev (1997), hereafter BD, and Degeorge et al. (1999) nd a discontinuity in the distribution of earnings in the region immediately around zero, which they interpret as evidence that rms manage earnings to avoid reporting losses. However, lacking a model of accruals or an estimate of discretionary accruals, there is ambiguity in interpreting these results. We document that P&C insurers report small positive earnings with greater frequency than expected given the relative smoothness of the remainder of the earnings distribution, and that these rms signicantly understate the loss reserve accrual relative to rms with small negative earnings. Thus, our evidence is consistent with P&C rms managing accruals to avoid losses. We also provide evidence on managements exercise of discretion over the entire earnings distribution rather than only in the area immediately around zero. The magnitude and frequency of earnings management is of signicant interest to standard setters and regulators, but existing research provides little relevant evidence (Healy and Wahlen, 1999; Dechow and Skinner, 2000). Our analysis indicates that earnings management occurs across the entire distribution of reported earnings, with earnings management by small prot rms accounting for only a fraction of total earnings management activity. Specically, we nd that the least protable rms understate reserves relative to the most protable rms. This evidence is consistent with P&C rms managing loss reserves to smooth earnings rather than to take an earnings bath. Our second research objective is to examine the effect of ownership form and nancial condition on management of the loss reserve accrual and the distribution of earnings. Because the extent of ownermanager and ownerpolicyholder conicts varies across public, private, and mutual insurers (Mayers and Smith, 1988, 1994), incentives to manage earnings are also likely to vary.1 For public and mutual insurers, we nd that small prot rms signicantly understate loss reserves relative
Concurrent research by Beatty et al. (2002) examines whether there is a discontinuity in the distribution of earnings changes for public and private banks.
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to small loss rms. In contrast, there is no evidence that private insurers manage reserves to avoid reporting losses. For all three ownership forms, there is evidence of income smoothing, as loss reserves are signicantly overstated by the most protable rms. Taken together, our results show that managing reserves to avoid losses and smooth earnings is not unique to public companies. Finally, we examine whether insurers nancial condition affects reserve management across the distribution of reported earnings. Following prior research (e.g., Petroni, 1992), we partition our sample according to whether the rm is nancially healthy or nancially distressed. Holding nancial condition constant, we nd that management of reserves to avoid losses is more pronounced in the sample of healthy insurers. However, both the sample of nancially distressed insurers and the sample of nancially healthy insurers understate loss reserves in the left tail of the earnings distribution relative to the right tail of the distribution. However, because distressed insurers occur more frequently in the left tail of the distribution, they tend to report loss reserves that are understated, on average, relative to healthy insurers. Our study makes several contributions to the literature on earnings management in general, and on insurers management of the loss reserve accrual in particular. First, we provide direct evidence that P&C rms who avoid reporting small losses do so by managing loss reserves. This nding also documents a form of discretionary behaviormanagement of the reserve accrual to avoid losses not previously known to exist for P&C rms. Second, our results indicate that earnings management is not concentrated in these rms, but instead is pervasive across all levels of earnings. Our evidence thus extends Beaver and McNichols (1998) who nd wide-spread evidence of positive serial correlation in discretionary loss reserve accruals. Finally, our results complement the literature focusing on earnings management by public rms by documenting that similar patterns of earnings management are observed for rms that are not public. The layout of the paper is as follows. Section 2 provides an overview of the accounting for claim loss reserves which underlies our estimate of managements discretionary accrual behavior. Section 3 develops our hypotheses. Section 4 describes the sample and data. Section 5 presents our empirical ndings. Section 6 concludes.

2. Estimating discretionary loss reserve accruals Claim loss reserves are generally the largest liability on a P&C insurers balance sheet, and the income effect of the related provision is substantial. In our sample, the loss reserve liability is 56 percent of total liabilities, and the provision for losses is 71 percent of premium revenue. The matching principle requires insurers to charge claim losses to operations in the period they are incurred and the related premium revenue is recognized. Although some claims are settled in the year incurred, the majority will remain outstanding for several years. The uncertainty surrounding the estimation of the cost to settle incurred but unpaid claims provides an opportunity

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for substantial earnings management because understating (overstating) the reserve accrual increases (decreases) reported earnings.2 As information becomes available regarding prior period claims, insurers revise their original estimate of loss reserves with a charge to current period operations. After all claims for a period have been settled, policy losses for that period are known with certainty. Insurers are required to disclose the year-by-year revisions, called loss reserve development, for each of the past 10 years. Using the revised estimate as a proxy for the unbiased expectation of policy losses, we calculate the discretionary loss reserve accrual as follows:3 DEVtj;t RESERVEtj;t RESERVEt;t =ASSETSt 1 where RESERVEt,t is the loss reserve for year t reported in year t, and RESERVEtj;t is the revised estimate of the year t loss reserve reported in year t j: As in Petroni (1992), we scale loss reserve development by total (admitted) assets in year t ASSETSt :4 We calculate DEVtj;t for a 5 year development period (i.e., j=5), if available; otherwise, we calculate DEVt+j,t using the most recent revised estimate (i.e., j=1 to 4).5 In the absence of discretion, the expected value of DEV conditional on earnings in year t is zero. This is because loss reserve development is analogous to a forecast error. If a forecast is unbiased, then the subsequent forecast error has an expected value of zero. Thus, DEV is a function of ex post surprises (which, by denition, have an expected value of zero) and the effects of discretion. Essentially, discretion causes a non-zero expected value. Moreover, loss reserve development does not possess any tendency for reversal, as do accruals such as accounts receivable. Rather, loss reserve development measures the reversal that will occur in the reserve accrual due to misstatements in the originally reported reserve. Specically, DEV is positive (negative) if originally reported reserves are understated (overstated).
Although we measure discretion using the loss reserve accrual (i.e., the liability) rather than the provision for claim losses (i.e., the expense), errors in the reserve accrual directly affect the computation of earnings. However, if an insurer understates (or overstates) the reserve accrual by a constant amount each year, then earnings after the rst year will be the same as they would have been if no error had occurred, although they will still be misstated relative to what they would have been if the insurer were to report the correct reserve accrual in subsequent years. Nevertheless, in our sample the error in reserves varies across years for all but a few insurers. 3 We suppress rm subscripts to simplify the notation. See the appendix for an illustration of the required claim loss disclosures and a numerical example of the calculation of loss reserve development. 4 Certain economic resources recognized as assets under Generally Accepted Accounting Principles (GAAP) are required by Statutory Accounting Practices (SAP) to be excluded from the balance sheet, and are thus referred to as non-admitted assets. Non-admitted assets are generally non-liquid items such as property, plant, and equipment, furnishings and supplies, and leasehold improvements. Henceforth, references to total assets should be interpreted as total admitted assets. Our results are robust to scaling by the developed loss reserve, RESERVEtj;t . 5 We also calculated DEVt+j,t using the longest development period available (maximum of 10 years). The untabulated ndings using this measure of discretionary loss reserves are consistent with the results reported below.
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3. Hypotheses Based on a higher than expected frequency of slightly positive earnings, BD and Degeorge et al. (1999) conclude that rms manage earnings to avoid losses. However, neither paper directly relates the clustering of observations immediately above zero to a measure of discretionary behavior. We hypothesize that P&C insurers manage the loss reserve accrual to avoid reporting losses. Although there are other discretionary choice variables available to insurers attempting to avoid a small loss (e.g., security gains, management of other accruals), the magnitude of the loss reserve accrual and the considerable subjectivity inherent in its estimation suggest that it is the primary means of exercising discretion in this industry. Furthermore, neither auditors (Petroni and Beasley, 1996) nor regulators (Gaver and Patterson, 2002) appear to be effective in detecting and/or mitigating this form of managerial discretion. Thus, we test the following hypothesis, stated in null form: H1: P&C insurers do not manage the loss reserve accrual to avoid losses. Stated in terms of our measure of discretionary loss reserve accruals, the null hypothesis is that there is no difference in the loss reserve development of small prot and small loss rms. The alternative hypothesis is that loss reserve development is signicantly higher for small prot rms relative to small loss rms. The rst hypothesis focuses on a narrow range of the earnings distribution immediately around zero. However, there is relatively little prior evidence about the magnitude and pervasiveness of earnings management across the entire earnings distribution. Healy (1985) and McNichols and Wilson (1988) provide evidence consistent with rms recognizing income-decreasing discretionary accruals when performance is either weak or strong, and income-increasing accruals at intermediate levels of performance. However, the magnitude of managers discretion over earnings is not easily identied from these studies. The proxy for discretionary accruals used in the rst of these studies, the change in accruals, likely includes a signicant non-discretionary component, while the proxy in the second study, the residual provision for bad debts, likely reects only a small portion of managements discretion over earnings. We test for evidence of pervasive earnings management using a discretionary accrual measure that we expect is less likely to contain a nondiscretionary element and more likely to be comprehensive than discretionary accrual measures used outside the P&C insurance industry. Our second hypothesis, stated in null form, is: H2: P&C insurers do not manage the loss reserve accrual outside the region immediately above zero. Stated in terms of our measure of discretionary loss reserve accruals, the null hypothesis is that loss reserve development is zero in all earnings intervals. The alternative hypothesis is that loss reserve development is non-zero in at least one earnings interval outside the interval immediately above zero. The comprehensive alternative hypothesis captures two principal earnings management incentives,

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income smoothing and taking a bath. Income smoothing implies that loss reserve development is signicantly higher for the least protable rms relative to the most protable rms, while bath-taking implies that loss reserve development is signicantly lower for the least protable rms. Incentives to manage earnings likely vary with the ownership structure of the rm. A distinctive feature of our sample is that it includes public, private, and mutual companies. Mayers and Smith (1988, 1994) argue that incentive and agency issues differ across these ownership structures because of differences in how each structure combines the management, ownership, and policyholder (in effect, debt holder) functions. According to Mayers and Smith, the potentially complete separation of these functions in public companies raises issues of incentive alignment between owners and managers as well as between owners and policyholders. In private companies, the ownermanager conict is mitigated by the ability of a concentrated set of owners to monitor management actions at a relatively low cost; however, the ownerpolicyholder conict is still present. Finally, in a mutual company, the owner and policyholders functions are merged, thus mitigating this type of conict. However, Mayers and Smith argue that ownermanager conicts could be aggravated in mutual companies because of the lack of takeover threat.6 Because each ownership form faces diverse incentive issues, and because earnings management can arise in response to either ownermanager or ownerpolicyholder conicts, the incentives for earnings management may vary across ownership forms. P&C insurers have two additional incentives to manage earnings, taxation and regulation. Because the claim loss provision is tax deductible, insurers, particularly protable ones, have an incentive to overstate the loss reserve accrual. However, the Tax Reform Act of 1986 largely eliminated differences in the taxation of mutuals and stock companies (Mayers and Smith, 1994). Industry regulation focuses on the nancial solvency of insurers and on the rates they are permitted to charge. Although each state has an insurance commission, regulatory efforts are coordinated through the National Association of Insurance Commissioners (NAIC). Furthermore, solvency and rate regulation apply to all insurers, and we are aware of no evidence to suggest that this varies with organizational form. Thus, although we expect tax status and regulation to inuence earnings management behavior of P&C insurers, we do not expect these factors to induce differences between insurers with different organizational forms. This discussion motivates our third set of hypotheses, also stated in null form: H3a: Public insurers do not manage the loss reserve accrual to avoid losses or to manage earnings outside the region immediately around zero. H3b: Private insurers do not manage the loss reserve accrual to avoid losses or to manage earnings outside the region immediately around zero. H3c: Mutual insurers do not manage the loss reserve accrual to avoid losses or to manage earnings outside the region immediately around zero.
Although proxy ghts to remove existing management are a potential control mechanism, they are expensive and ineffective, and thus are rarely used in practice (Mayers and Smith, 1994).
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Because of the diverse incentive issues discussed above, we do not offer specic alternative hypotheses regarding the pattern of reserve development for each form of ownership. Finally, we examine whether nancial condition, determined using the NAIC system for monitoring nancial health, is related to incentives to manage earnings, both within a narrow interval around zero and over the entire earnings distribution. Prior evidence (e.g., Petroni, 1992) suggests that nancially distressed insurers signicantly understate loss reserve accruals relative to nancially healthy insurers. However, there is no evidence to indicate whether this behavior is uniform over the entire earnings distribution. Thus, we test the following set of hypotheses, stated in null form: H4a: Financially healthy insurers do not manage the loss reserve accrual to avoid losses or to manage earnings outside the region immediately around zero. H4b: Financially distressed insurers do not manage the loss reserve accrual to avoid losses or to manage earnings outside the region immediately around zero. If nancial distress motivates earnings management, then the pattern of reserve development discussed for H1 and H2 will be evident for distressed insurers but not for healthy insurers.

4. Sample and data The primary data source is the 19881998 NAIC Property-Casualty Annual Statement Database.7 The sample is selected using the following criteria: (i) the rm is a stock or mutual company domiciled in the United States, (ii) the rm is not primarily a reinsurer (i.e., direct premiums written are greater than premiums assumed),8 (iii) net income and total assets are available, (iv) the rm reports positive loss reserves, and (v) at least one calendar year of loss reserve development is available. This selection process yields 13,807 rm-year observations for 19881997. To control for extreme errors in the loss reserve accrual, we exclude observations with an original loss reserve estimate that differs from the revised estimated by greater than 50 percent in absolute value. We also exclude observations in the upper or lower one percent of the DEV distribution. The nal sample consists of 11,460 rm-year observations. We control for size differences across observations by scaling net
Data Source: National Association of Insurance Commissioners, by permission. The NAIC does not endorse any analysis or conclusions based upon the use of its data. 8 Loss reserves are generally determined by the insurer that originally writes the business. Thus, rms that are primarily reinsurers have less discretion over the reported loss reserve.
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income by total assets. However, we also calculated our primary results scaling by policyholders surplus and earned premiums, with similar results. Table 1, Panel A presents descriptive statistics for scaled values of reported earnings. The distribution of scaled earnings is relatively stable during the sample period, with a sample-wide mean (median) of 2.5 (2.9) percent of total assets. Our sample consists of relatively fewer loss rms than BD who report negative earnings at the rst quartile in most of their sample years.9 This nding is likely due to solvency regulation in the P&C industry which reduces the likelihood that a rm will report a loss. Table 1, Panel B presents descriptive statistics for loss reserve development (DEV). The results indicate that loss reserves are overstated a mean (median) of 0.2 (0.7) percent of total assets during the sample period. However, there is substantial crosssectional variation; loss reserves are overstated 3.9 percent at the 25th percentile but understated 2.2 percent at the 75th percentile. Loss reserve development also varies across the sample period, with reserves in the early years generally more understated than in the later years. This calendar year pattern is consistent with evidence documented in Beaver and McNichols (1998). Table 1, Panel C presents descriptive statistics for other rm characteristics. Loss rms (LOSS) comprise 19.7 percent of the sample, while nancially distressed rms (DISTRESS) account for 35.3 percent. As in prior research (e.g., Petroni, 1992), we identify insurer-years as nancially distressed if more than one non-reserve ratio used by the NAIC in the Insurance Regulatory Information System (IRIS) is outside the range considered acceptable. Mean (median) total assets (ASSETS) are approximately $288 ($44) million, indicating that the size distribution of the sample is skewed by some particularly large insurers. Approximately two-thirds of the sample write lines of business with a settlement period, or tail (TAIL), of at least 5 years. Relative to total premiums, 11.1 percent of premium revenue, on average, is attributable to workers compensation (WC), 13.0 percent to liability lines (product liability, other liability, and medical malpractice) (LIABILITY), and 35.8 percent to auto lines (AUTO).

5. Results 5.1. Discretionary loss reserve accruals and the distribution of reported earnings Fig. 1 shows the distribution of scaled earnings for all rms in the sample using interval widths of 0.006.10 Assuming a smooth probability distribution, the expected number of observations in an interval is the average of the two adjacent intervals. The difference between the actual and expected number of observations, divided by
Only 1 year in our sample, 1996, has negative earnings at the rst quartile. Despite the slight clustering of loss observations, inferences are unchanged when we exclude 1996 observations from the analyses. 10 Consistent with Degeorge et al. (1999), the interval width is approximately twice the interquartile range of scaled earnings times the negative cube root of sample size.
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W.H. Beaver et al. / Journal of Accounting and Economics 35 (2003) 347376 Table 1 Descriptive statistics for sample of 11,460 observations for the years 19881997 Year N Mean Std. Dev. 0.094 0.061 0.078 0.069 0.072 0.054 0.059 0.062 0.088 0.092 0.075 25% 0.013 0.007 0.005 0.005 0.005 0.006 0.002 0.007 0.002 0.013 0.006 50% 0.035 0.029 0.027 0.025 0.027 0.029 0.023 0.029 0.024 0.035 0.029

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75% 0.060 0.053 0.050 0.047 0.050 0.052 0.045 0.049 0.046 0.055 0.051

Panel A: Scaled values of reported earnings 1988 1035 0.035 1989 1038 0.028 1990 1041 0.024 1991 1061 0.023 1992 1098 0.023 1993 1094 0.027 1994 1149 0.018 1995 1219 0.028 1996 1301 0.017 1997 1424 0.030 Total 11,460 0.025 (DEV) 0.013 0.014 0.010 0.003 0.005 0.009 0.009 0.011 0.010 0.008 0.002

Panel B: Loss reserve development 1988 1035 1989 1038 1990 1041 1991 1061 1992 1098 1993 1094 1994 1149 1995 1219 1996 1301 1997 1424 Total 11,460

0.089 0.089 0.087 0.085 0.077 0.078 0.079 0.073 0.062 0.046 0.077

0.029 0.029 0.033 0.040 0.046 0.049 0.049 0.047 0.038 0.028 0.039

0.000 0.001 0.000 0.002 0.008 0.013 0.013 0.013 0.010 0.008 0.007

0.046 0.045 0.043 0.034 0.023 0.018 0.016 0.013 0.007 0.004 0.022

Panel C: Other rm characteristics LOSS 11,460 0.197 DISTRESS 11,390 0.353 ASSETS 11,460 288.006 TAIL 11,460 0.621 WC 11,460 0.111 LIABILITY 11,310 0.130 AUTO 11,310 0.358

0.398 0.478 1801.169 0.485 0.248 0.262 0.369

0.000 0.000 13.049 0.000 0.000 0.000 0.000

0.000 0.000 44.055 1.000 0.000 0.016 0.237

0.000 1.000 148.716 1.000 0.106 0.099 0.658

Reported earnings is net income, scaled by total assets; DEV is the difference between the developed and originally reported loss reserve, scaled by total assets; LOSS is an indicator variable equal to one if net income less than zero, and zero otherwise; DISTRESS is an indicator variable equal to one if the rm has more than one IRIS ratio outside the range considered acceptable by the NAIC, and zero otherwise; ASSETS is the dollar amount of total assets, in millions; TAIL is an indicator variable equal to one if the rm requires 5 or more years for 75 percent of claims to be paid, and zero otherwise; LIABILITY is net premiums earned for product liability, other liability, and medical malpractice as a percentage of total net premiums earned; WC is net premiums earned for workers compensation as a percentage of total net premiums earned; and AUTO is net premiums earned for private and commercial auto as a percentage of total premiums earned.

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1000 900 800 700 Frequency 600 500 400 300 200 100

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0 -0.21

-0.17

-0.13

-0.08

-0.04

0.00 0.04 0.08 Earnings Interval

0.13

0.17

0.21

Fig. 1. The distribution of reported net income, scaled by total assets. The distribution interval widths are 0.006, and the location of zero on the horizontal axis is marked by the vertical line. The rst interval to the right of zero contains observations in the interval [0.000, 0.006), the second interval contains [0.006, 0.012), and so forth.

the estimated standard deviation of the difference, indicates whether there is a signicant discontinuity in a particular interval. Under the null hypothesis of a smooth distribution, these standardized differences are distributed approximately Normal with mean 0 and standard deviation 1. As expected, we nd a signicant discontinuity in the earnings distribution around zero. Earnings slightly greater than zero occur more frequently than expected given the relative smoothness of the remainder of the distribution (the standardized difference for the rst interval above zero is 4.33).11 To provide evidence on whether insurers manage the loss reserve accrual to avoid reporting losses, we examine the distribution of DEV conditional on the level of scaled earnings. We sort the observations on scaled earnings, and form equal-sized portfolios of 600 observations. The size of the portfolios approximates the number of observations in the rst interval above zero in Fig. 1.12 The portfolio boundaries are dened relative to zero. Under the null hypothesis of no earnings management, DEV is expected to be zero in each of the earnings portfolios. If insurers understate loss reserves to avoid reporting losses, DEV will be signicantly higher in the portfolio immediately above zero compared to the portfolio immediately below zero. Fig. 2 shows the conditional distribution of median DEV. Consistent with predictions, there is an upward shift in DEV in the portfolio immediately to the right of zero. Untabulated statistics indicate that the median difference in DEV between
In untabulated analyses, we also nd evidence of a discontinuity at zero in the distribution of earnings changes (the standardized difference is 2.91), although, consistent with BD, this result is not as signicant as the discontinuity in the distribution of earnings levels. 12 We form equal-sized portfolios rather than use the equally spaced earnings intervals in Fig. 1 to reduce the impact of outliers on intervals in the tails of the distribution that have a small number of observations.
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0.004 0.002 0.000 -0.002 Median DEV -0.004 -0.006 -0.008 -0.010 -0.012 -0.014 -0.016 -3 -2 -1 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Earnings Portfolio

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Fig. 2. The distribution of the median percentage loss reserve development, conditional on the magnitude of scaled earnings. DEV is the difference between the developed and originally reported loss reserve, divided by total assets. Each portfolio contains 600 observations based on the magnitude of scaled earnings relative to zero.

the small loss and small prot portfolios is signicant at the 0.01 level. Although not predicted, we also nd that median DEV is signicantly higher at the 0.01 level in the second portfolio to the right of zero. Over the entire earnings distribution, these are the only two portfolios in which the median loss reserve is understated. There is also evidence in Fig. 2 of an overall negative association between earnings and DEV. The correlation between median portfolio earnings and DEV is negative at the 0.01 level. This nding is consistent with income smoothing; loss reserve accruals are more overstated at higher levels of earnings. Untabulated ndings reveal a similar pattern in the mean loss reserve development, except that mean DEV is positive in the left tail of the earnings distribution. However, inferences remain the same; mean DEV is signicantly higher in the two portfolios to the right of zero than in the portfolio immediately to the left of zero, and there is a signicant negative correlation between earnings and mean DEV. To further test the relation between management of the loss reserve accrual and the distribution of earnings, we estimate the following model: DEVtj;t at b1 NEGATIVEt b2 BELOWt b3 ABOVEt b4 POSITIVEt b5 TAILt b6 TAILSQt b7 WCt b8 LIABILITYt b9 AUTOt et : 2

The intercept varies across years because of calendar year differences in loss reserve development (see Table 1), which may reect common non-discretionary events that ex post cause the average development to be non-zero in a given year. However, the year-specic intercepts may extract discretionary elements of loss reserve development as well. Therefore, we also estimate Eq. (2) without the year effects to examine the sensitivity of the results. The rst four regressors in Eq. (2) are indicator variables

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identifying the position of an observation in the earnings distribution, i.e., to the left of the rst portfolio below zero (NEGATIVE), in the portfolio immediately below zero (BELOW), in the portfolio immediately above zero (ABOVE), and to the right of the rst portfolio above zero (POSITIVE). The remaining variables in Eq. (2) are rm-specic determinants of loss reserve development. Insurers that primarily write long-tailed lines of business have greater exibility to manage loss reserves than do insurers that primarily write short-tailed lines of business. TAIL is an indicator variable equal to one if the rm requires 5 or more years for 75 percent of claims to be paid. Nelson (2000) reports that loss reserves contain an implicit discount to present value, implying that development is increasing in the length of the settlement period, but at a decreasing rate. Thus, we also include the square of the settlement period (TAILSQ). Reserve development also likely varies across lines of business. Following Petroni et al. (2000), we control for three types of business, each measured as the proportion of premiums earned for that business relative to total premiums earned. Loss reserves for workers compensation (WC) policies are typically discounted to present value, and thus we expect positive reserve development for this line. LIABILITY captures lines of business prone to exogenous ex post shocks, i.e., product liability, other liability, and medical malpractice. AUTO captures lines of business less subject to exogenous ex post shocks, i.e., private and commercial auto. Petroni et al. (2000) nd little evidence of a relation between reserve development and LIABILITY, but a generally negative relation between reserve development and AUTO. Table 2 reports regression summary statistics (Panel A) and tests of coefcient restrictions (Panel B). We report results for three specications of Eq. (2): (i) including only the earnings distribution indicator variables; (ii) including the year intercepts and the earnings distribution indicator variables; and (iii) the full model in Eq. (2).13 The rst estimation parallels the analysis in Fig. 2 and allows us to assess the unconditional magnitude of discretionary reserve accruals in each of the four regions of the earnings distribution. Under the null hypothesis of no discretion in any of the earnings portfolios, the coefcient estimates on all four indicator variables are expected to be zero. Including the year intercepts in the second estimation allows us to assess the magnitude of reserve development in each region of the earnings distribution conditional on the average yearly reserve development. For parsimony, we do not tabulate the coefcient estimates on the year intercepts. The nal specication provides additional evidence on the robustness of the earnings distribution results to other determinants of loss reserve development. The results from the estimation of the rst specication indicate that loss reserves are signicantly understated in the left tail of the earnings distribution (NEGATIVE coefcient estimate=0.01, p-value=5.02) and in the region immediately above zero (ABOVE coefcient estimate=0.02, p-value=5.20), and are signicantly overstated in the right tail of the distribution (POSITIVE coefcient
13 We examined all estimations for statistical outliers but none were detected. For comparability, we present results for the sample of observations with all data available to estimate the full model stated in Eq. (2).

W.H. Beaver et al. / Journal of Accounting and Economics 35 (2003) 347376 Table 2 Regression of loss reserve development on earnings portfolios DEVtj;t at b1 NEGATIVEt b2 BELOWt b3 ABOVEt b4 POSITIVEt b5 TAILt b6 TAILSQt b7 WCt b8 LIABILITYt b9 AUTOt et Panel A: Regression summary statistics Excl. year intercepts Variable NEGATIVE BELOW ABOVE POSITIVE TAIL TAILSQ WC LIABILITY AUTO Adjusted R2 N Coefcient 0.01 0.00 0.02 0.01 t-statistic 5.02 1.06 5.20 7.44

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Including year intercepts Coefcient 0.03 0.02 0.03 0.01 t-statistic 8.67 5.09 8.18 3.89 Coefcient 0.03 0.02 0.03 0.01 0.02 0.01 0.01 0.03 0.01 0.05 11,310 t-statistic 7.92 4.84 7.80 3.90 8.58 4.90 4.54 11.40 6.34

0.01 11,310

0.02 11,310

Panel B: Tests of coefcient restrictionsa Restriction F-statistic All equal ABOVE=BELOW NEGATIVE=POSITIVE 33.10 8.57 57.71

p-value o0.01 o0.01 o0.01

F-statistic 35.47 7.20 64.84

p-value o0.01 o0.01 o0.01

F-statistic 31.91 7.76 58.23

p-value o0.01 o0.01 o0.01

DEV is the difference between the developed and originally reported loss reserve, divided by total assets. NEGATIVE is equal to one if the observation is to the left of the rst portfolio below zero; BELOW is equal to one if the observation is in the rst portfolio below zero; ABOVE is equal to one if the observation is in the rst portfolio above zero; and POSITIVE is equal to one if the observation is to the right of the rst portfolio above zero. Each portfolio contains 600 observations, based on the magnitude of scaled earnings relative to zero. The control variables are dened as follows: TAIL is an indicator variable equal to one if the rm requires 5 or more years for 75 percent of claims to be paid, and zero otherwise; TAILSQ is the square of the number of years required for 75 percent of estimated claims to be paid; LIABILITY is net premiums earned for product liability, other liability, and medical malpractice as a percentage of total net premiums earned; WC is net premiums earned for workers compensation as a percentage of total net premiums earned; and AUTO is net premiums earned for private and commercial auto as a percentage of total net premiums earned. a p-values for the test of the restriction ABOVE=BELOW are one-sided; all others are two-sided.

estimate=0.01, p-value=7.44). Moreover, small prot rms signicantly understate loss reserves relative to small loss rms. The tests reported in Panel B formally reject the null hypothesis that ABOVE=BELOW at less than the 0.01 level. Conditioning on the average yearly reserve development increases the coefcient estimates on the earnings distribution indicator variables, consistent with the samplewide negative reserve development reported in Table 1. However, we continue to nd

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incremental reserve management associated with the distribution of reported earnings. Development is positive and signicant in all regions of the earnings distribution, but the magnitude of the reserve understatement is greatest for small prot rms and for rms in the left tail of the earnings distribution. Moreover, the difference in coefcient estimates between the ABOVE and BELOW portfolios remains signicant at less than the 0.01 level. In addition, the least protable rms understate reserves relative to the most protable rms, allowing us to reject the null hypothesis that NEGATIVE=POSITIVE at less than the 0.01 level. This evidence is consistent with rms exercising discretion over the loss reserve accrual to smooth earnings. The last two columns in Table 2 report the estimation of the full model in Eq. (2). The results for the earnings distribution indicator variables are virtually unchanged from the previous model, indicating that the relation between discretionary loss reserve accruals and the distribution of earnings is robust to other signicant determinants of loss reserve development. Although not the focus of our analysis, the coefcient estimates on the control variables are generally consistent with expectations. To summarize, in all three specications reported in Table 2 we reject the null hypothesis that ABOVE=BELOW at less than the 0.01 level, consistent with rms managing reserves to avoid reporting a loss. In all three specications we also reject the null hypothesis that NEGATIVE=POSITIVE at less than the 0.01 level, consistent with income smoothing. To further assess the relation between loss reserve development and the distribution of reported earnings, we estimate a variant of Eq. (2) that allows for separate coefcient estimates on each of the earnings portfolios. We estimate this model for the three specications in Table 2, and plot the earnings portfolio coefcient estimates in Fig. 3. The pattern of loss reserve development across the earnings distribution is strikingly similar in all three specications. All three models reveal an upward shift in DEV in the two portfolios to the right of zero, and an overall negative association between DEV and reported earnings. The coefcient estimates for the model including only the year intercepts as controls and the model including all controls are nearly identical in all portfolios, and differ from the coefcient estimates in the no controls specication by an amount that is relatively constant across all portfolios. Thus, the results reveal a systematic pattern of loss reserve development across the earnings distribution that is robust to several control variables.14 If the discontinuity in the earnings distribution is induced by discretion, then the distribution of pre-managed earnings should be smooth around zero. We calculate pre-managed earnings by subtracting the discretionary loss reserve
14 To examine the effect of tax status on loss reserve development, we dene a dummy variable equal to one for rms with high tax rates, identied, as in Petroni (1992), as insurers that are currently paying taxes. We nd that although insurers with high tax rates understate reserves less than insurers with low tax rates, inclusion of the tax control variable in Eq. (2) does not alter our ndings concerning the pattern of loss reserve development across the earnings distribution (results not tabulated). However, estimating Eq. (2) separately for the high and low tax subsamples reveals that overstatement of loss reserves in the right tail of the earnings distribution is primarily due to insurers with high average tax rates.

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0.050 0.040 0.030 Coefficient Estimates 0.020 0.010 0.000 -0.010 -0.020 -0.030 -3 -2 -1 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Earnings Portfolio all controls year intercepts no controls

361

Fig. 3. Coefcient estimates from a regression of DEV on earnings portfolio indicator variables (PORTFOLIO), year intercepts, and control variables for rm-specic determinants of loss reserve development, as follows: X DEVtj;t at gi PORTFOLIOi;t b1 TAILt b2 TAILSQt b3 WCt
i

b4 LIABILITYt b5 AUTOt et The variables are dened in Table 2. Results are plotted for three specications including: (i) all controls, (ii) only the year intercepts, and (iii) no controls.

accrual for year t (i.e., RESERVEtj;t RESERVEt;t ) from reported earnings in year t.15 Fig. 4 compares the distribution of pre-managed earnings to that of reported earnings previously shown in Fig. 1. Consistent with expectations, there is no evidence of a discontinuity around zero in the distribution of pre-managed earnings.16 Fig. 4 also indicates that the distribution of pre-managed earnings is more dispersed than that of reported earnings, as evidenced by the higher density of observations in both tails of the distribution. This nding is consistent with insurers exercising discretion over the loss reserve accrual to smooth reported earnings.
There are at least two concepts of pre-managed earnings in a world where discretion occurs in multiple years. The rst concept assumes that managers exercise discretion not only over loss reserves incurred in year t but also over development of reserves incurred in prior years. This is the measure of loss reserve development used to adjust reported earnings in Fig. 3. The second concept assumes that managers do not exercise discretion over losses incurred prior to year t. Thus, reported earnings for year t are adjusted to eliminate discretion only on losses incurred in year t, i.e., there is no catch-up adjustment for prior years incurred losses. Because there are plausible arguments for this alternative denition of pre-managed earnings, we also examine its distribution. Consistent with our primary results, untabulated ndings reveal no discontinuity around zero. 16 Degeorge et al. (1999) suggest that deation can lead to a spurious buildup in the density at zero. However, this does not appear to explain our results because we deate both reported earnings and premanaged earnings, yet only nd a discontinuity at zero in the distribution of reported earnings.
15

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1000 900 800 700 600 500 400 300 200 100 0 -0.21 -0.17 -0.13 -0.08 -0.04 0.00

Frequency

0.04

0.08

0.13

0.17

0.21

Earnings Interval

Fig. 4. The distribution of reported net income (shaded) and pre-managed net income (bars), scaled by total assets. Pre-managed net income is equal to reported net income less the discretionary loss reserve accrual (i.e., the difference between the developed and originally reported loss reserve). The distribution interval widths are 0.006. The rst interval to the right of zero contains observations in the interval [0.000, 0.006), the second interval contains [0.006, 0.012), and so forth.

However, as discussed above, reserve development naturally reects ex post surprises. Thus, even if management provided unbiased estimates of policy losses, there would be greater dispersion in pre-managed earnings due to the development surprises. To summarize the ndings reported in this section, we report evidence suggesting that rms understate the loss reserve accrual to avoid reporting small losses. More generally, we nd that the loss reserve accrual is managed over the entire distribution of reported earnings, rather than exclusively or primarily in the region around zero. Firms in the left tail of the earnings distribution understate reserves relative to those in the right tail of the earnings distribution, consistent with income smoothing but inconsistent with P&C rms taking an earnings bath.

5.2. Ownership structure and the distribution of reported earnings In this section, we examine the effect of ownership structure on management of the loss reserve accrual and the distribution of reported earnings. We determine ownership structure from information reported in the annual editions of Bests Insurance Reports. Consistent with Mayers and Smith (1994), we classify rms according to the ownership structure of the ultimate owner(s). If the ultimate owners are the policyholders, we classify the rm as a mutual. We also classify the rm as a mutual if it is organized as a stock company but the majority of its shares are owned by a mutual. Mayers and Smith (1994) report that the activities of stock companies owned by mutuals are more like those of mutuals than stock companies. If the ultimate owner is included in the CRSP database or the EDGAR system of Securities and Exchange Commission lings, we classify the rm as public. Finally, if Bests Insurance Reports indicates that ownership rests with an individual, family,

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private consortium, etc., or we cannot locate the rm or its ultimate owner on CRSP or EDGAR, we classify the rm as private. Although the classication of insurers organizational structure is consistent with prior work, there are limitations to this approach in our research context. First, we cannot rule out the possibility that some of the rms we classify as private because of a lack of evidence to the contrary are actually public or owned by a mutual. Second, because of data constraints, we conduct our tests at the level of the individual insurance company rather than at the level of the ultimate owner(s). Although this approach has the advantage of categorizing rms according to their actual business activities rather than their nominal ownership structure (Mayers and Smith, 1994), it may not capture the entity at which the incentives to manage earnings operate. This limitation affects all three categories of ownership structures, although possibly to different degrees. Finally, our analysis of public insurers is based on earnings and loss reserves reported according to SAP rather than GAAP. Although SAP and GAAP measures of earnings and loss reserves are highly correlated, our tests of earnings management by public companies may be less powerful if their focus on managing GAAP numbers is not well captured by SAP. Table 3 reports descriptive statistics for public, private, and mutual insurers. The sample observations are divided fairly evenly between the three ownership types, although private and mutual insurers are somewhat more prevalent than public insurers. Whether measured by the level of scaled earnings or the incidence of losses, public insurers are more protable than private insurers, which are in turn more protable than mutual insurers. However, the greater degree of reserve overstatement exhibited by mutuals, median DEV for mutuals is 0.012, compared to 0.005 for public rms and 0.002 for private rms, suggests that pre-managed earnings are more similar across the organizational types.17 Private insurers are classied as nancially distressed more frequently than either public or mutual rms. Private insurers are also smaller than either public or mutual insurers. Consistent with prior research (e.g., Mayers and Smith, 1988; Lamm-Tennant and Starks, 1993; Harrington and Danzon 1994), mutual insurers, on average, write less long-tailed and LIABILITY lines of business that are prone to exogenous ex post shocks. This nding suggests that the greater magnitude of reserve development for mutuals is not due to their writing these less predictable lines of insurance. Fig. 5 shows the scaled earnings distributions of public (Panel A), private (Panel B), and mutual (Panel C) insurers. For all three ownership structures, there is evidence of a discontinuity at zero. The standardized difference is 1.96 for public rms, 3.79 for private rms, and 2.15 for mutual rms.18 Surprisingly, the
17

For example, median net income before loss reserve development would be 0.041 (0.036 plus 0.005) for public insurers compared to 0.035 (0.023 plus 0.12) for mutual insurers. 18 We also examined the earnings distribution of publicly-traded P&C insurers (SIC code 6331) using data obtained from Compustat on earnings determined using GAAP. Consistent with the ndings reported in Fig. 5, we nd evidence of a signicant discontinuity in the distribution of earnings immediately around zero.

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Table 3 Descriptive statistics for public, private, and mutual insurers for the years 19881997 Public Variable NI DEV LOSS DISTRESS ASSETS TAIL WC LIABILITY AUTO N 2923 2923 2923 2897 2923 2923 2923 2884 2884 Mean 0.036 0.001 0.144 0.337 511.891 0.643 0.152 0.147 0.358 Median 0.036 0.005 0.000 0.000 113.788 1.000 0.003 0.052 0.216 Std. Dev. 0.071 0.079 0.351 0.473 1930.324 0.479 0.273 0.242 0.363 Private N 4039 4039 4039 4014 4039 4039 4039 3979 3979 Mean 0.025 0.005 0.206 0.411 100.533 0.659 0.111 0.163 0.408 Median 0.029 0.002 0.000 0.000 29.700 1.000 0.000 0.010 0.280 Std. Dev. 0.091 0.085 0.405 0.492 238.161 0.474 0.262 0.295 0.402 Mutual N 4498 4498 4498 4479 4498 4498 4498 4447 4447 Mean 0.019 0.011 0.224 0.312 310.856 0.573 0.084 0.091 0.312 Median 0.023 0.012 0.000 0.000 33.800 1.000 0.000 0.014 0.191 Std. Dev. 0.059 0.066 0.417 0.463 2393.738 0.495 0.210 0.236 0.336

NI is net income, scaled by total assets; %DEV is the difference between the developed and originally reported loss reserve, divided by total assets; LOSS is an indicator variable equal to one if net income is less than zero, and zero otherwise; DISTRESS is an indicator variable equal to one if the rm has more than one IRIS ratio outside the range considered acceptable by the NAIC, and zero otherwise; ASSETS is the dollar amount of total assets, in millions; LIABILITY is net premiums earned for product liability, other liability, and medical malpractice as a percentage of total net premiums earned; WC is net premiums earned for workers compensation as a percentage of total net premiums earned; and AUTO is net premiums earned for private and commercial auto as a percentage of total premiums earned.

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Panel A: Public Insurers

250 200 Frequency 150 100 50 0 -0.21 -0.17 -0.13 -0.08 -0.04 0.00 0.04 0.08 0.13 0.17 0.21 Earnings Interval

Panel B: Private Insurers

350 300 250 Frequency 200 150 100 50 0 -0.21 -0.17 -0.13 -0.08 -0.04 0.00 0.04 0.08 0.13 0.17 0.21 Earnings Interval

Panel C: Mutual Insurers

450 400 350 300 Frequency 250 200 150 100 50 0 -0.21 -0.17 -0.13 -0.08 -0.04 0.00 0.04 0.08 0.13 0.17 0.21 Earnings Interval

Fig. 5. The distribution of reported net income, scaled by total assets, for private, public, and mutual insurers. The distribution interval widths are 0.006, and the location of zero on the horizontal axis is marked by the vertical line. The rst interval to the right of zero contains observations in the interval [0.000, 0.006), the second interval contains [0.006, 0.012), and so forth.

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0.020 0.015 0.010 0.005 Median DEV 0.000 -0.005 -0.010 -0.015 -0.020 -0.025

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-3

-2

-1

10

11

12

13

14

15

16

17

Earnings Portfolio Public Private Mutual

Fig. 6. The distribution of the median percentage loss reserve development conditional on the magnitude of scaled earnings. DEV is the difference between the developed and originally reported loss reserve, divided by total assets. Each portfolio contains 140 public, 225 private, or 260 mutual observations based on the magnitude of scaled earnings relative to zero.

discontinuity is most pronounced for the sample of private rms, although this result also reects differences in sample size.19 It is also possible, as discussed above, that some public and mutual rms have been misclassied as private. Fig. 6 shows the conditional distribution of median DEV for the three ownership types. There is a signicant upward shift in DEV in the portfolio immediately to the right of zero for public companies (p-value=0.03) and mutuals (p-value=0.05). Median DEV is also signicantly higher in the second portfolio to the right of zero for both public companies (p-value=0.02) and mutuals (p-value=0.08). In contrast, it does not appear that private insurers understate the loss reserve accrual to avoid reporting losses, as the difference in reserve development between small loss and small prot rms is not signicant at conventional levels (p-value=0.32). Fig. 6 also reveals an overall negative association between earnings and DEV for both public and private insurers, consistent with managing loss reserves to smooth earnings. In contrast, the association between earnings and median DEV is insignicant for mutuals, although untabulated results indicate that the association is signicantly negative for mean DEV. Consistent with the evidence in Table 3, the loss reserves of mutual insurers are overstated in all earnings portfolios, and are
19 Ceteris paribus, the standardized difference increases approximately linearly with the square root of sample size. Thus, the difference in the size of the public and private samples is expected to cause the standardized differences to differ by a factor of 1.18 (the square root of 4039C2923). The observed factor is 1.93 (3.79C1.96). The difference in the size of the mutual and private samples is expected to cause the standardized differences to differ by a factor of 1.06, compared to an observed factor of 0.57.

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overstated relative to the reserves of public and private insurers in all earnings portfolios except those in the extreme right tail of the earnings distribution. The overstatement of reserves by mutuals across the earnings distribution is consistent with their incentive to lower earnings to reduce the amount of dividends paid to policyholders. Table 4 presents regression summary statistics from the estimation of a modied version of Eq. (2) that allows separate slope coefcients on the earnings distribution indicator variables for public, private, and mutual insurers. As in Table 2, we report results for three specications of Eq. (2). The ndings from the rst estimation including only the earnings distribution indicator variables show that loss reserves of public companies are signicantly understated in the region just above zero, but are not signicantly different from zero at the 0.05 level in other regions of the earnings distribution. Moreover, the data reject the hypothesis that ABOVE=BELOW for public companies at less than the 0.01 level. There is also evidence of higher loss reserve development in the region immediately above zero for mutuals, although we are only able to reject the hypothesis that ABOVE=BELOW at the 0.09 level. In contrast to these results, we are unable to reject the hypothesis that ABOVE= BELOW for private companies. Thus, the discontinuity in the earnings distribution of private insurers does not appear to be due to management of the loss reserve accrual. However, it is possible that private insurers use other means to avoid reporting losses. For all three types of insurers, there is evidence that the least protable rms understate loss reserves relative to the most protable rms. We reject the null hypothesis that NEGATIVE=POSITIVE at less than the 0.05 level, suggesting that income smoothing behavior, perhaps to reduce taxes, is signicant and pervasive regardless of ownership structure. The second estimation in Table 4 includes year-specic intercepts to control for calendar year differences in loss reserve development. The estimated coefcients increase due to the inclusion of the year effects, but otherwise lead to similar inferences. The nal specication includes additional control variables, and indicates that the earnings distribution results are robust to other determinants of loss reserve development. 5.3. Financial condition and the distribution of reported earnings In this section, we examine the effect of nancial condition on management of the loss reserve accrual and the distribution of reported earnings. Consistent with prior literature (e.g., Petroni, 1992), we classify insurer-years as nancially distressed if there is more than one non-reserve IRIS ratio outside the range considered acceptable by the NAIC.20 All other insurer-years are classied as healthy.
20 A. M. Best, the most prominent insurance rating agency, uses several IRIS ratios along with other measures to assess nancial health. Petroni (1992) reports that IRIS ratios and A. M. Best ratings produce similar classications of nancially healthy and nancially distressed rms. As with IRIS, A. M. Best uses the same measures to assess nancial health for all organizational types. Due to missing IRIS data in 1988, the analyses in this section are based on 11,390 observations.

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Table 4 Regression of loss reserve development on earnings portfolios for public, private, and mutual insurers DEVtj;t at b1 NEGATIVE ownt b2 BELOW ownt b3 ABOVE ownt b4 POSITIVE ownt b5 TAILt b6 TAILSQt b7 WCt b8 LIABILITYt b9 AUTOt et Panel A: Regression summary statistics Excl. year intercepts Variable NEGATIVE public BELOW public ABOVE public POSITIVE public NEGATIVE private BELOW private ABOVE private POSITIVE private NEGATIVE mutual BELOW mutual ABOVE mutual POSITIVE mutual TAIL TAILSQ WC LIABILITY AUTO Adjusted R2 N Coefcient 0.01 0.01 0.03 0.01 0.03 0.02 0.02 0.01 0.01 0.01 0.01 0.01 t-statistic 1.73 1.46 5.12 1.43 8.45 2.84 4.45 0.88 1.75 1.64 0.32 10.57

Including year intercepts Coefcient 0.02 0.03 0.05 0.01 0.04 0.03 0.04 0.01 0.01 0.01 0.02 0.01 t-statistic 4.78 3.60 6.90 4.50 10.65 5.04 6.60 5.01 2.72 1.64 2.93 0.16 Coefcient 0.03 0.03 0.05 0.02 0.05 0.04 0.04 0.02 0.01 0.01 0.02 0.01 0.02 0.01 0.01 0.04 0.02 0.06 11,240 t-statistic 5.55 3.97 7.36 5.98 11.74 6.40 7.77 6.97 3.51 2.34 3.76 1.74 7.21 4.35 2.50 13.56 9.26

0.02 11,240

0.04 11,240

Panel B: Tests of coefcient restrictionsa Restriction F-statistic Public All equal ABOVE=BELOW NEGATIVE=POSITIVE Private All equal ABOVE=BELOW NEGATIVE=POSITIVE Mutual All equal ABOVE=BELOW NEGATIVE=POSITIVE 11.00 6.20 4.44 27.27 0.91 64.64 5.91 1.81 8.52

p-value o0.01 o0.01 0.02 o0.01 0.17 o0.01 o0.01 0.09 o0.01

F-statistic 11.66 5.37 6.00 27.35 0.94 65.83 7.00 1.21 11.27

p-value o0.01 0.01 o0.01 o0.01 0.17 o0.01 o0.01 0.14 o0.01

F-statistic 9.88 6.02 4.61 28.45 0.64 68.97 5.52 1.66 7.68

p-value o0.01 o0.01 0.02 o0.01 0.21 o0.01 o0.01 0.10 o0.01

See Table 2 for variable denitions. own indicates the ownership structure of the rm (i.e., public, private, or mutual). a p-values for tests of the restriction ABOVE=BELOW are one-sided; all others are two-sided.

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Fig. 7 shows the distribution of reported earnings for rms classied as healthy (Panel A) and distressed (Panel B). Not surprisingly, the vast majority (approximately 85 percent) of healthy insurers report positive earnings. However, a substantial proportion (approximately 45 percent) of distressed insurers also report positive earnings. Several of the IRIS ratios ag results that indicate increased risk of insolvency due to overly aggressive business practices that increase earnings in the short run. The histograms in Fig. 7 indicate that regardless of nancial condition,

Panel A: Healthy Insurers

800 700 600 Frequency 500 400 300 200 100 0 -0.21 -0.17 -0.13 -0.08 -0.04 0.00 0.04 0.08 0.13 0.17 0.21 Earnings Interval

Panel B: Distressed Insurers

250 200 Frequency 150 100 50 0 -0.21 -0.17 -0.13 -0.08 -0.04 0.00 0.04 0.08 0.13 0.17 0.21 Earnings Interval

Fig. 7. The distribution of reported net income, scaled by total assets. Financial condition is determined using the nine non-reserve ratios employed by the NAICs Insurance Regulatory Information System (IRIS). Firm-years with more than one unusual ratio are considered distressed; the remaining rm-years are considered healthy. The distribution interval widths are 0.006, and the location of zero on the horizontal axis is marked by the vertical line. The rst interval to the right of zero contains observations in the interval [0.000, 0.006), the second interval contains [0.006, 0.012), and so forth.

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0.005 0.000 -0.005 Median DEV -0.010 -0.015 -0.020 -0.025

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-6 -5 -4 -3 -2 -1

4 5 6 7 8 Earnings Portfolio Healthy

10 11 12 13 14 15 16 17

Distressed

Fig. 8. The distribution of the median percentage loss reserve development conditional on the magnitude of scaled earnings. DEV is the difference between the developed and originally reported loss reserve, divided by total assets. Each portfolio contains 375 healthy or 235 distressed observations based on the magnitude of scaled earnings relative to zero.

there is evidence of a discontinuity at zero. The standardized difference is 3.70 for healthy rms and 2.80 for distressed rms.21 Fig. 8 shows the conditional distribution of median DEV for the healthy and distressed insurers. Consistent with Fig. 7, there is a greater proportion of distressed (healthy) observations in the left (right) tail of the distribution. However, conditional on the level of earnings, the reserve development pattern of healthy and distressed insurers is similar. There is an upward shift in DEV for healthy and distressed insurers in the portfolio immediately to the right of zero, signicant at less than the 0.01 level for healthy insurers and the 0.04 level for distressed insurers. DEV is also signicantly higher in the second portfolio to the right of zero for both types of insurers. Finally, there is evidence of a signicant negative association between earnings and DEV for both types of insurers, consistent with managing the loss reserve accrual to smooth earnings. Table 5, Panel A presents regression summary statistics from the estimation of a modied version of Eq. (2) that allows separate slope coefcients on the earnings
21 Untabulated analysis indicates that inferences are not sensitive to dening distressed rms as having two, three, or four unusual IRIS ratios. In addition, our ndings are robust to the exclusion of one IRIS ratio, the 2-year overall operating ratio, whose unusual range is dened according to whether the rm was unprotable, on average, over the past 2 years. Specically, a result for this ratio that is above 100 percent indicates a loss and is considered outside the usual range. This ratio is also used by A. M. Best in assessing protability. Including this ratio may bias towards rejecting the null hypothesis of a smooth earnings distribution for the distressed sample.

W.H. Beaver et al. / Journal of Accounting and Economics 35 (2003) 347376 Table 5 Regressions of loss reserve development on earnings portfolios for healthy and distressed insurers DEVtj;t at b1 NEGATIVE fcont b2 BELOW fcont b3 ABOVE fcont b4 POSITIVE fcont b5 TAILt b6 TAILSQt b7 WCt b8 LIABILITYt b9 AUTOt et Panel A: Regression summary statistics Excl. year intercepts Variable NEGATIVE healthy BELOW healthy ABOVE healthy POSITIVE healthy NEGATIVE distressed BELOW distressed ABOVE distressed POSITIVE distressed TAIL TAILSQ WC LIABILITY AUTO Adjusted R2 N Coefcient 0.01 0.01 0.02 0.01 0.01 0.01 0.02 0.01 t-statistic 1.29 0.41 3.92 8.16 4.82 1.14 3.40 1.41

371

Including year intercepts Coefcient 0.02 0.02 0.03 0.01 0.03 0.02 0.03 0.01 t-statistic 4.30 3.52 6.43 2.64 8.35 4.22 6.01 4.96 Coefcient 0.02 0.02 0.03 0.01 0.02 0.02 0.03 0.01 0.02 0.01 0.02 0.03 0.01 0.05 11,240 t-statistic 4.18 3.39 6.02 2.56 7.48 3.81 5.80 4.46 8.31 4.95 4.98 10.53 5.61

0.01 11,240

0.02 11,240

Panel B: Tests of coefcient restrictionsa Restriction F-statistic Healthy All equal ABOVE=BELOW NEGATIVE=POSITIVE Distressed All equal ABOVE=BELOW NEGATIVE=POSITIVE 14.97 5.70 11.00 10.24 3.02 22.33

p-value o0.01 0.01 o0.01 o0.01 0.04 o0.01

F-statistic 14.80 4.72 10.41 9.84 2.78 21.89

p-value o0.01 0.02 o0.01 o0.01 0.05 o0.01

F-statistic 13.30 4.37 9.69 9.47 3.46 21.07

p-value o0.01 0.02 o0.01 o0.01 0.03 o0.01

See Table 2 for variable denitions. fcon indicates the nancial condition of the rm (i.e., healthy or distressed). Insurer-years are classied as nancially distressed if more than one IRIS ratio is outside the range considered acceptable by the NAIC. All other insurer-years are classied as nancially healthy. a p-values for tests of the restriction ABOVE=BELOW are one-sided; all others are two-sided.

distribution indicator variables for the healthy and distressed insurers. The results of the rst estimation including only the earnings distribution indicator variables show that the magnitude of reserve development for healthy and distressed insurers is similar across all regions of the earnings distribution, although, as shown in Panel B of Table 5, the difference in reserve development between small prot and small loss rms is more signicant for healthy insurers.

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The similarity in the reserve development of healthy and distressed insurers appears to contradict widely documented evidence that distressed insurers understate loss reserves relative to healthy insurers (e.g., Petroni, 1992; Penalva, 1998; Nelson, 2000). However, prior ndings are based on an unconditional comparison of reserve development for healthy and distressed insurers whereas the comparison in Table 5 is conditional on the level of earnings. Because distressed insurers cluster in the NEGATIVE range of the earnings distribution where reserve development is less negative, they will tend to report loss reserves that are understated relative to healthy insurers that cluster in the POSITIVE range of the earnings distribution. In untabulated analysis, we conrm that the healthy insurers in our sample, on average, understate loss reserves signicantly less than distressed insurers. However, conditional on the level of earnings, there is no systematic difference in the reserving behavior of healthy and distressed insurers. The results of the remaining estimations in Table 5 (conditioning on the average yearly reserve development and other control variables) also indicate that healthy rms reporting small prots signicantly understate loss reserves relative to healthy rms reporting small losses. A similar, although less signicant, pattern is observed for distressed insurers. Both types of insurers also appear to manage the loss reserve accrual to smooth earnings, as loss reserve development in the left tail of the earnings distribution is more understated than in the right tail of the distribution. Prior research (e.g., Petroni, 1992) documents a signicant incremental understatement of reserves by insurers close to nancial distress, dened as insurers that would have had more than one IRIS ratio outside the acceptable range if loss reserves were ve percent higher than actually reported. Consistent with prior research, we nd that insurers close to nancial distress understate loss reserves to a greater extent than insurers classied as distressed (results not tabulated).22 However, allowing separate slope coefcients on the earnings distribution indicator variables for insurers close to nancial distress does not alter any of the conclusions from Table 5. In addition, insurers close to nancial distress also appear to manage earnings to avoid losses, although the result is less signicant than for either the healthy or distressed rms. Because nancially distressed insurers are less likely to manage earnings to avoid losses, and a greater proportion of private insurers are classied as nancially distressed (see Table 3), it is possible that our previous nding that private insurers do not manage loss reserves to avoid losses is confounded by the effects of nancial distress. Thus, as additional sensitivity analysis we estimate the ownership structure model in Table 4 excluding all observations classied as nancially distressed. The untabulated results of this analysis reveal that our previous ndings are robust, suggesting that differences in loss avoidance behavior across ownership types are not due to differences in nancial health.

22 Because we manually collected IRIS ratio information for 1988 and the data are not available to calculate the ratios assuming loss reserve are ve percent higher than actually reported, we exclude this year from this analysis.

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6. Conclusion We examine the relation between the distribution of reported earnings and loss reserve development, a common measure of managerial discretion in the propertycasualty insurance industry. First, we investigate whether there is evidence of a discontinuity in the earnings distribution in the region immediately around zero, and, more importantly, whether insurers avoid reporting losses by managing the loss reserve accrual. Thus, our study differs from prior research (e.g., Burgstahler and Dichev, 1997; Degeorge et al., 1999) that infers earnings management from attributes of the reported earnings distribution. We nd that slightly positive earnings occur more frequently than expected given the relatively smooth bell-shaped distribution of reported earnings. Moreover, we document that this cluster of rms signicantly understates the loss reserve accrual. Although not predicted, we also nd that rms in the second earnings interval above zero signicantly understate reported loss reserves. Adjusting reported earnings for managers discretionary behavior produces a pre-managed earnings distribution that is smooth around zero. We also investigate the pattern of accrual management over the entire earnings distribution. This analysis combines desirable features of traditional earnings management research that directly measures discretionary accruals for a select sample of rms and the more recent literature on earnings distributions that tests for irregularities indicative of earnings management in a broad sample of rms. We nd evidence of signicant earnings management in the right tail of the reported earnings distribution that is at least as great as that in the region immediately above zero. Specically, rms in the right tail of the earnings distribution signicantly overstate the reserve accrual relative to rms in the left tail of the distribution. This evidence is consistent with income smoothing by P&C rms; there is no evidence of rms managing loss reserves to take an earnings bath. To assess how earnings management behavior varies with ownership structure, we partition the sample into public, private, and mutual rms. Consistent with income smoothing, we nd signicant overstatement of reserves in the right tail of the earnings distribution relative to the left tail for all three ownership structures. We also nd signicantly higher loss reserve development in the region immediately above zero relative to the region immediately below zero for public and mutual companies. However, there is no signicant difference in loss reserve development between private companies with small prots and those with small losses. Our nal analysis explores the relation between nancial condition and earnings management over the entire earnings distribution. Partitioning the sample into nancially healthy and nancially distressed insurers based on a widely used measure of nancial condition (e.g., Petroni, 1992), we nd that loss reserve management to avoid losses is more pronounced in the sample of healthy insurers. Outside of this region of the earnings distribution, we nd that nancial condition has little effect on earnings management. Holding nancial condition constant, we nd that both the sample of nancially distressed insurers and the sample of nancially healthy insurers understate loss reserves in the left tail of the earnings distribution relative to

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the right tail. However, because distressed insurers are more predominant in the left tail of the distribution while healthy insurers are more predominant in the right tail, the loss reserves of nancially distressed rms are more understated, on average, than those of healthy rms.

Appendix Illustration of regulatory claim loss data from the 1992 Statutory Annual Statement of the Insurance Company of North America.

The upper table shows incurred losses by the year in which the losses were incurred (accident year) and evaluation date (calendar year). For example, the row corresponding to 1983 contains incurred losses for accidents that happened in 1983, as reported in each calendar year from 1983 to 1992. At the end of 1983, estimated incurred losses for 1983 accidents were $972,817; by the end of 1992, the

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estimate was revised upwards to $1,237,866. Total incurred losses for a given calendar year are the sum of all accident year losses in that column. Similarly, the lower table shows cumulative paid losses by accident year and calendar year. For example, at the end of 1983 the insurer had paid $373,137 for claims on accidents that happened in 1983; by the end of 1992, the insurer had paid a total of $1,176,220 for claims on accidents that happened in 1983. Total cumulative paid losses for a given calendar year are the sum of all accident year paid losses in that column. Subtracting each column in the lower table from the same column in the upper table gives the loss reserve reported at the end of that calendar year. For example, the loss reserve for 1987 reported in 1987, i.e., RESERVE1987,1987, is $2,856,782. Subtracting the cumulative claim payments for a given calendar year from the revised estimate of that years incurred losses gives the developed reserve. For example, the revised estimate of the loss reserve for 1987 reported in 1992, i.e., RESERVE1992,1987, is $3,466,296. Comparing the originally reported reserve to the developed reserve indicates the amount by which the originally reported reserve was understated or overstated. In this case, the loss reserve reported in 1987 was understated by $609,514.

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