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Audit committee characteristics and loss reserve error

Fang Sun
Department of Economics, CUNY, New York, New York, USA

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Received 6 January 2011 Reviewed 31 March 2011 Accepted 1 May 2011

Xiangjing Wei
Department of Business and Economics, Wilson College, Chambersburg, Pennsylvania, USA, and

Yang Xu
School of Business, University of Kansas, Lawrence, Kansas, USA
Abstract
Purpose The purpose of this paper is to investigate two audit committee characteristics independence and expertise of the audit committee and the property-liability insurers nancial reporting quality, which is proxied by loss reserve error. Design/methodology/approach The authors hypotheses are tested using multivariate analysis where the loss reserve error is the dependent variable, and audit committee independence, and four types of audit committee nancial expertise (accounting, nance, supervisory, and insurance expertise) are the testing variables. Findings It is found that accounting, nance, and insurance nancial expertise are associated with more accurate loss reserve estimate. In contrast, a supervisory nancial expertise and an independence audit committee are not found to be associated with better loss reserve quality. Research limitations/implications The sample includes publicly-held property-liability insurers. Although the results from publicly-held insurers could provide a good laboratory for such investigation in all insurers, they might be limited due to different organization structures of public vs private insurers. Practical implications The implications of the study are important for the SEC and NAIC. The results suggest that the requirements on the audit committee nancial expertise would be necessary, even in highly regulated industry, such as property-casualty insurance. Originality/value The paper contributes to the extant literature by studying audit committee characteristics in the insurance industry. It also contributes to the extant literature on audit committee effectiveness by decomposing the nancial expertise into four types of nancial expertise (accounting, nance, supervisory, or insurance expertise) and investigates which (if any) of these four types of expertise really drives the improvement of loss reserve quality. Keywords United States of America, Audit committees, Insurance companies, Financial reporting, Loss reserve error, Audit nancial expertise, Audit accounting expertise, Audit insurance expertise, Property-liability insurer Paper type Research paper

1. Introduction In this paper, we investigate the relationship between the audit committee composition independence and expertise and the property-liability insurers nancial reporting quality, which is proxied by loss reserve error. In June 2006, the National Association of Insurance Committee (NAIC) revised the Annual Financial Reporting Model Regulation (FRMR) in response to the Sarbanes-Oxley act (SOX) enacted in 2002.

Managerial Auditing Journal Vol. 27 No. 4, 2012 pp. 355-377 q Emerald Group Publishing Limited 0268-6902 DOI 10.1108/02686901211217978

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Under the new standards, all insurance companies are imposed to designate an audit committee and, for insurers with more than $500 million in premiums, 75 percent or more audit committee members must be independent. These SOX-like requirements anticipate that the audit committee and their individual directors take a more effective role in managing and monitoring the nancial condition of insurers. While SOX requirements could facilitate non-insurance industry in improving the quality of nancial reporting (Beasley, 1996; Dechow et al., 1996; Klein, 2002a, b; Carcello and Neal, 2003; Abbott et al., 2004), there are a number of reasons to suspect that imposing the SOX-like requirements on insurers is appropriate. Chief among them is the statutory accounting principle (SAP) which is more conservative than generally accepted accounting principles. Furthermore, compared with the non-insurance SOX compliant entity, an insurance company is subject to a far greater degree of oversight and nancial regulation by insurance commissioners. For example, state insurance commissioners have the authority to require any information they nd necessary to protect policyholders and to ensure a companys solvency. Thus, more regulations for such an already heavy regulated industry could add un-necessary cost while create less benet. Besides the SAP and heavy regulation, another issue arises from the different corporate structures the insurance industry holds. The insurance industry includes not only publicly held companies but also the mutual and private companies. The distinctive corporate structures between publicly held companies and private rms imply different technology of corporate governance control. For example, the non-transferable ownership rights of a mutual and a private rm restricts the effectiveness of such control mechanisms as managerial equity ownership and stock based compensation, etc. The reduced effectiveness of the publicly held rms related control implies a relative more important control role of independence member and nancial expertise in committees of non-stock rms. However, compared with public-held insurers, mutual and private insurers have less agency problem between owners and policyholders because, for the mutual, the owners are also policyholders, leading to a projection that a mutual insurer requires less monitoring mechanism than the publicly held rm. Thus, far, the literature has almost no analysis, either theoretical or empirical, about the relation between audit committee composition (independence and expertise) and the property-liability insurers loss reserve estimate. The purpose of our research is to ll out this gap. Although FRMR applies to both public insurance companies and mutual and privately owned companies[1], due to data availability, we focus our study on the publicly held insurers. Since all of rms including private and mutuals belong to one special industry insurance industry which subjects to heavier regulation, complex business operation and strict accounting system, we project that publicly held insurers could provide a good laboratory for testing the effectiveness of FRMR. Using a sample of 98 publicly traded property-liability insurers in the years 2003, we rst examine the association between audit committee independence and loss reserve error of insurers. We then examine the relation between nancial expertise and discretionary loss reserve error of insurers. We nd that accounting, nance, and insurance nancial expertise are associated with more accurate or conservative loss reserve estimate. In contrast, we nd that a supervisory nancial expertise, or a independence audit committee are not associated with better the loss reserve quality. These ndings are consistent with prior non-insurance industry research suggesting that rms with specialist auditors in its audit committee have lower level of discretionary

accruals compared with those whose audit committees have no specialist (Balsam et al., 2003). These ndings suggest that audit committees with nancial expertise with hands-on experience of preparing nancial statements, or industry experience, are better able to monitor the nancial reporting than those have no such experience. These ndings are consistent with prior literatures (Dhaliwal et al., 2006; Carcello et al., 2006) suggesting that adopting narrower versions of the denition that capture accounting and nance expertise. Our study makes the following primary contributions to the existing literature. First, we evaluate the association between the audit committee characteristics and accuracy of loss reserve estimate in property-liability insurance industry. Although a growing number of literatures studied the relation between the audit committee composition and earnings quality, to our best knowledge, the literature has almost no analysis, either theoretical or empirical, on such a relation in the heavily regulated insurance industry. Second, SAP accounting system and restrictive regulation environments of insurance industry provide a more powerful setting in which to test the effectiveness of the role of audit committees as mechanisms to enhance nancial reporting. Different from GAAP, losses in SAP are not discounted, biasing the results against nding large error. This makes our results more robust. Third, we decompose the nancial expertise into four types of nancial expertise: accounting, nance, supervisory, and industry expertise and investigate which (if any) of these four types of nancial expertise really drives the improvement of loss reserve quality. Our paper provides evidence that audit committee members with direct experience in creating nancial reports, and members with nance industry experience are better able to curb the discretionary loss reserve error of insurers than the members that have no such backgrounds. Finally, examining a single industry-insurance industry, and hence a homogeneous sample of rms, avoids the potentially confounding effects that industry-specic factors could have on research results. The remainder of the paper is organized as follows. Section 2 provides background information. Section 3 provides a review of related literature and developed hypotheses. Section 4 presents research methodology. Section 5 explains empirical results. Section 6 concludes. 2. Background Inspired by SOX, in June 2006, NAIC revised FRMR and set particular requirements for the audit committee in Section 14. In the revised FRMR, NAIC requires all insurers with certain premium standard designate an audit committee. Besides that, identical to the requirement imposed by SOX, NAIC has independence requirements on the committee members. Although the requirements are not as strict as those listed by SOX that require the audit committee be entirely composed of independent, NAIC set the percentage of the audit independence based on the prior year direct written and assumed premium. For example, for insurers with more than $500 million in prior year direct written and assumed premium, a super majority (75 percent or more) of members must be independent, for insurers with less than $500 million but greater than $300 million in prior year direct written and assumed premium, a majority (50 percent or more) of members must be independent, and for insurers with less than $300 million

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in prior year direct written and assumed premium, no requirements are imposed on the number of independent members. In order to be considered independent, as NAIC dened in Section 14C:
[. . .] a member of the Audit committee may not, other than in his or her capacity as a member of the Audit committee, the board of directors, or any other board committee, accept any consulting, advisory or other compensatory fee from the entity or be an afliated person of the entity or any subsidiary thereof.

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These FRMR requirements are similar to those imposed on publicly held companies in 2002 by SOX except that SOX applies to all public rms while FRMR applies to all insurers which include mutuals and private insurers. The provision has caused much controversy (Andreason, 2005; Fitzgerald, 2004). Observers argue that SOX was legislatively imposed in response to very specic abuses by public companies outside of the insurance industry, and it is improper to impose SOX on the insurance industry through non-legislative action, particularly in view of the heavy nancial regulation that already exists in this industry (Fitzgerald, 2004). Further the independence requirement for audit committee directors might pose serious problems for non-prots and mutual entities that often are required by statute or their corporate articles and bylaws to have customers or service providers as directors (Fitzgerald, 2004). Finally, the distinctive corporate structure between publicly held companies and private rms clouds the effectiveness of the sox-like requirements. Insurance industry includes both private rms and publicly held rm which have distinctive corporate structure. Distinctive corporate structure implies different technology of corporate governance control. For example, the non-transferable ownership rights of a mutual or a private rm restrict the effectiveness of such control mechanisms as managerial equity ownership, etc. The reduced effectiveness of the publicly held rms related control implies a relative more importance control role of independent member and nancial expertise in committees of non-stock rms. However, compared with public-held insurers, mutual and private insurers has less agency problem between owners and policyholders because for the mutual, the owners are also policyholders, leading to a projection that a mutual insurer requires less monitoring mechanism than the publicly held rm. 2.1 Loss reserves Under SAP accounting, loss reserves are insurers estimated liability for unpaid claims on all losses that occurred prior to the balance sheet date. Loss reserves are collectively the largest liability on a property-liability insurance companys balance sheet. Gaver and Paterson (2004) report that loss reserves account for 53 percent of total liabilities. Loss reserves could adversely affect the nancial strength of the insurer and possibly lead to insolvency (Weiss, 1985), thus accuracy of loss reserves is an important concern to both regulators and stockholders of property-liability insurers. However, estimation of loss reserves is highly subjective because not all claims for current period losses are le by the balance sheet date. Even for claims led in the current period, the ultimate cash settlement could be quite different in amount or delayed for several years. The accounting matching principle requires insurers to match claim losses with related premium revenues in order to report protability during a special time interval. Although the premiums are recognized in the year incurred, the majority claims will

remain outstanding for several years. To estimate the amount an individual claim will ultimately cost, typically an insurers actuaries generate predictions about future loss payments and expenses and recommend a range to management, who then chooses the actual loss reserve levels to be reported. Therefore, the unique aspect of the loss reserve allows insight into the reserve bias. For example, Petroni (1992) examines whether insurers that are nancially weak underestimate their reserves. She nds that nancially troubled insurers underestimate reserve in order to avoid detection by regulatory authorities. Beaver et al. (2003) also provide empirical evidence that property-liability insurers use reserve estimation practices to manipulate reported earnings. Using a methodology similar to Beaver et al. (2003) and Gaver and Paterson (2004) further improves the loss reserve manipulation by showing the empirical results that weak insurers adjust their loss reserve to evade regulatory intervention. In a more recent study, Gaver and Perterson (2007) also proves that insurance companies intentionally bias reported loss reserves to conceal nancial distress. In this study, we extend the prior research by addressing the impact of certain audit committee characteristics identied by FRMR (2006) and SOX (2002) on the audit committees effectiveness in improving the property-liability insurers nancial reporting quality. The nancial reporting quality is proxied by loss reserve errors and the audit committee quality is measured with the committee size, committee independence, and the committee nancial expertise. 3. Literature review and hypotheses 3.1 Independence Reforms introduced by the FRMR require greater audit committee independence. The intuition behind this is that an independent auditor committee makes better monitors. For example, NYSE Listing Guide stated that [. . .] comprised solely of directors independent of management and free from any relationship that would interfere with the exercise of independent judgment as a committee member[2]. However, empirical evidence on whether independent members play an effective monitoring role is mixed: while some studies report a positive association between the two, others conclude the opposite. For example, Beasley (1996) and Dechow et al. (1996) show that a higher level of outside directors on the board decrease the likelihood of fraudulent information in the rms nancial statements. In addition, Klein (2002a, b) nds that independent audit committees are less likely to be associated with the abnormal accruals. Further, Carcello and Neal (2003) document a positive relation between audit committee independence, governance expertise, and lower stockholdings and the auditor dismissals following new going-concern reports. Finally, Abbott et al. (2004) found a signicant and negative association between the occurrence of restatement and the corporate audit committee independence. Whereas those papers have reported evidence supporting the independent director to facilitate the internal monitoring, nonetheless, many other studies persist in a board with high insider representation and some studies support this strategy. For example, Fama and Jensen (1983) proposed that inside directors provide valuable information to boards because inside directors possess more rm-specic industry visions. Consistent with Fama and Jensen (1983) and Bhagat and Black (2002) suggest that inside and afliated directors play valuable roles that may be lost in a single-minded drive for greater board independence. Further, Klein (2002a, b) found a positive market reaction

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to whose boards signicantly increase their percentages of insiders on some special committees. The absence of monitoring effectiveness of the independence of its board members has also been conrmed by Agrawal and Chadha (2005). When Agrawal and Chadha (2005) investigate the relation between the governance mechanisms and the incidence of an earnings restatement, they found that the independence of boards is essentially unrelated to the probability of a company restating earnings. A popular explanation of the inconsistent results is the reverse-causality effect: rms that perform poorly increase the proportion of outsiders in the board instead of board independency causing poor nancial outcomes. However, Bhagat and Black (2002) do not support the reverse-causality effects. Bhagat and Black (2002) found that low-protability rms with more independent board members do not achieve improved protability when they respond to their business troubles by following conventional wisdom and increasing the proportion of independent directors on their boards. The absence of clear evidence on the role of independence board could also be partly explained by the intrinsic difculty in dening the independence. For example, the seemly independent directors might not be independent. Again, Bhagat and Black (2002), dividing independent directors into outsiders with and without afliation with the company, nd a negative association between the board dependent and rm performance. As the sign of the coefcient on independence is not clear a priori, we test the following hypothesis in null: H1. There is no relation between the proportion of independent audit committee members and loss reserve accruals. 3.2 Financial expertise Both NAIC and SOX do not require a rm to include a nancial expert on its audit committee. But SOX mandates that the rm discloses in its lings whether the committee has such an expert, and if not to explain why. As well, in Model Section 14A of FRMR, the audit committee of an insurer is required to:
[. . .] be directly responsible for the appointment, compensation and oversight of the work of any accountant (including resolution of disagreements between management and the accountant regarding nancial reporting) for the purpose of preparing or issuing the Audited nancial report or related work pursuant to this regulation.

Obviously, the implication of FRMR is that audit committee members nancial background is an important factor impacting the nancial reporting quality. The intuition behind this is that in order to fulll their responsibilities for monitoring internal control and nancial reporting, audit committee members should possess the necessary expertise. Thus, in our second hypothesis, we test whether a nancial expert will improve the monitoring effect of an insurer. Previous research on the monitoring effect of nancial expertise provides mixed results. For example, Carcello and Neal (2003) examine the relation between an audit committee with greater nancial expertise and the likelihood that the company will dismiss its auditor for issuing a going-concern report. They fail to nd evidence that the percentage of audit committee members with nancial expertise impacts the auditor dismissals. However, other literatures, for example, Bryan et al. (2004) among others, proved that an audit committees with nancially literate are signicantly likely

to be associated with the earnings informativeness and transparency. Further, Krishnan (2005) reports a positive relation between the audit committees with nancial expertise and the incidence of internal control problems when she tests the association between audit committee quality and the internal control. Other literatures such as Abbott et al. (2004) and Farber (2005) also document negative relation between the nancial expertise in audit committees and the instances of earnings restatements and lower occurrence of nancial fraud. Carcello et al. (2006) indicate that the controversial denition of nancial expert could partly explain the inconsistent results. Some studies provide evidence supporting this argument. Krishnan (2005) and Dhaliwal et al. (2006) report that nancial expertise, measured using a strict denition based on accounting/auditing experience, is associated with less earnings management. Further, DeFond et al. (2005) report positive market effects of accounting nancial experts appointments. By contrast, they nd that the market does not signicantly react to the appointment of non-accounting nancial experts, including persons with experience as CEO and/or president. Davidson et al. (2004) also document that the market signicantly rewards companies for the appointment of accounting nancial experts, but shows marginal or no reaction to appointment of audit committee members with corporate nancial management or nancial statement analysis expertise. Dhaliwal et al. (2006) divided the nancial expertise into three types: accounting, nance, and supervisory expertise and investigate the association between the three types of audit committee nancial expertise and accruals quality, they nd accounting expertise is signicant positively related to the accruals quality but no signicant association between accruals quality and the presence of nance or supervisory expertise in audit committees. We follow Dhaliwal et al. (2006) to dene accounting expert, nancial expert, and supervisory expert: . Accounting expert all directors who currently have (or have previously had) work experience as certied public accountants, chief nancial ofcers, vice presidents of nance, treasurer, nancial controllers, or any other major accounting positions. . Financial expert all directors who have work experience as investment bankers, nancial analysts, or any other nancial management roles. . Supervisory expert all directors who have work experience as chief executive ofcers or company presidents; a current or retired senior manager in another rm (i.e. a CEO, chairman of the board, president, chief operating ofcer, or vice president). Besides accounting, nance, and supervisory expertise, we further recognize one more category nancial expertise: insurance expertise. We dene insurance expert as following: . Insurance expert all directors who have experience with insurance industry, a fellow of the Society of Actuaries, a member of the American Academy of Actuaries, MD, Insurance Commissioner, Chartered Underwriter and, Claims Committee. We propose that the accounting experts and insurance experts could help prevent nancial scandals and ensure a better monitoring effect, however, we have no predication on the monitoring effect of supervisory and nancial experts.

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Our second set of hypotheses is stated as follows: H2a. There is no relation between the presence of a nance expert in the audit committee and the loss reserve error. H2b. There is a negative relation between the presence of an accounting nancial expert in the audit committee and the loss reserve error. H2c. There is a no relation between the presence of a supervisory expert in the audit committee and the loss reserve error. H2d. There is a negative relation between the presence of an insurance expert in the audit committee and the loss reserve error. 4. Research methodology 4.1 Sample and data The sample for this study draws from the pubic traded stock property-casualty insurance companies operating in the USA in 2003. The sample includes only insurers domiciled in the USA since the behavior of foreign insurers is likely to be confounded by foreign regulation. The primary source of data for loss reserve error is the regulatory annual statements schedule P led by insurers with the NAIC. The unique aspect of this dataset is that it contains each insurers gradual settlement of claims over time and records all revisions of the loss reserve estimate. Revisions, known as development, provide an indication of wither the previously reported amount was under- or over-stated. Data availability limits the loss reserve analysis to the four-year period 2003-2007. To be included in the sample, we use the similar selection criteria as Beaver et al. (2003): . Firm is a domestic public traded stock company. We classify an insurer as a publicly held rm if the ultimate owner is included in the CRSP database or the EDGAR system of Securities and Exchange Commission lings. . Firm is not primarily a reinsurer (i.e. direct premiums written are greater than premiums assumed). . Net income, cash from operations, and total (admitted) assets are available. . The rm does not cede all of its premiums to other insurers (i.e. the rm reports positive loss reserves). After imposing the screen, 189 public insurers were initially selected. Data about boards and board audit committees were hand-collected from SEC-led proxy statements. We use SIC code 6331 to obtain the property-liability rms listed on the SEC in year 2003 through year 2005. The SEC-led proxy statement discloses whether rms have a standing audit committee and if a committee exists. Firms are required to disclose its members, and the number of times the committee met during the last scal year. In addition, the proxy statement also disclose each directors name, business background, other current directorships, family relationships between any director, nominee or executive ofcer, signicant current or proposed transactions with management, signicant business relationships with the rm, and number of shares held. We gather the nancial ratings for each insurer from Bests Insurance Reports Property-Casualty. After matching with these three dataset, the nal sample includes 98 rms.

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4.2 Variable construction 4.2.1 Loss reserve error measurement. In the literature, loss reserve error is most commonly calculated as the difference between insurers revised estimate of the cumulative claim losses outstanding disclosed in year t j and the originally reported estimate of cumulative claim loss reserve at the end of year t, e.g. Petroni (1992), Petroni and Beasley (1996), Beaver et al. (2003) and Grace and Leverty (2010). So positive reserve errors are associated with under-reserving and negative reserve errors with over-reserving. Due to data availability, we examine four years of reserve development, so j is four. In order to reduce problems of heteroskedasticity to allow cross-sectional comparability, and more importantly to reect the errors importance relative to the nancial statements taken as a while, we follow Petroni (1992), Petroni and Beasley (1996), Beaver et al. (2003) and Grace and Leverty (2010), to scale loss reserve errors by total admitted assets[3]: LossReserveErrori;t Loss Reservei;tj 2 Loss Reservei;t TotalAssetsi;t

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where Loss Reservei,t is the loss reserve for insurer I reported in yeart t, and Loss Reservei,t j is the revised estimate of the year t loss reserve reported in year t j. Details on how to calculate the loss reserve error using actual rm data are available in Table I. Table I, excerpted from the Statutory Annual Statement of Tower Insurance Company of New York, provides an example of how to calculate the loss reserve errors. The loss reserve error that we examine in this paper is measured as the difference between total losses incurred in a given calendar year and a revised estimate of total losses incurred fours calendar years in the future. The estimate of total incurred losses for a given calendar year is the sum of the losses in the column of that year. For Tower Insurance Company of New York, at the end of 2003, the estimated losses for all years up to and including 2003 totaled $47.881 million (the sum of the italicized values in column 7 2003). By the end of 2007, the estimate for the same loss period had been increased to $59.173 million (the sum of the italicized values in column 11 2007). Accordingly, Tower Insurance Company of New Yorks loss reserve error for is $11.292 million ($59.173 million 2 $47.881 million), indicating that Tower Insurance Company of New York under-estimated their reserves by $11.292 million. 4.2.2 Independent variables. The primary variable of interest is audit committee independence and its four types of nancial expertise. To mitigate biased coefcients and the mis-estimation of the impact of different characteristics of audit committees, we include control variables that are related to determining loss reserves from prior research. The control variables are meant to capture inuences on loss reserve errors that are unrelated to testing variables. Studies indicate that loss reserve errors are related to the complexity of insurers type of business written, e.g. Weiss (1985). Petroni (1992) and Petroni and Beasley (1996) nd that insurers with long-tailed product lines tend to have more pronounced reserved errors. Following them, we include LENGTH and MAL two control variables. LENGTH is included because the longer the claim cycle, the more difcult it is to forecast total claims. It is dened as claim loss reserves expressed as a percentage of total liabilities. MAL is the percentage of net premiums written for malpractice.

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1 Accident year 4,744 2,543 2,856 2,633 3,206 3,667 2,852 3,588 4,245 3,266 2,988 4,037 5,292 4,132 12,154 2,815 4,001 5,326 4,073 12,236 13,998 $47,881 4,832 5,339 5,546 5,432 5,397 6,032 6,454

1. Prior

2. 1998 3. 1999 4. 2000 5. 2001 6. 2002 7. 2003 8. 2004 9. 2005 10. 2006 11. 2007

Notes: The table is excerpted from the schedule P, part 2 of the 2007 Tower Insurance Company of New York Annual Statement; all dollar amounts are in thousands; the loss reserve error that we examine in this paper is measured as the difference between total losses incurred in a given calendar year and a revised estimate of total losses incurred fours calendar years in the future; the estimate of total incurred losses for a given calendar year is the sum of the losses in the column of that year; for Tower Insurance Company of New York, at the end of 2003, the estimated losses for all years up to and including 2003 totaled $47.881 million (the sum of the italicized values in column 7 2003); by the end of 2007, the estimate for the same loss period had been increased to $59.173 million (the sum of the italicized values in column 11 2007); accordingly, Tower Insurance Company of New Yorks loss reserve error for is $11.292 million ($59.173 million 2 $47.881 million), indicating that Tower Insurance Company of New York under-estimated their reserves by $11.292 million

Table I. Excerpt from the 2007 Annual Statement of Tower Insurance Company of New York 3 1999 NAIC property-liability annual statement: schedule P: part 2 summary Incurred losses and allocated expenses reported at year end ($000 omitted) 4 5 6 7 8 9 10 11 2000 2001 2002 2003 2004 2005 2006 2007 6,371 3,631 3,825 4,928 3,898 11,991 14,313 25,665 3,857 4,034 5,061 4,147 12,374 13,089 23,948 88,373 3,988 4,164 5,146 4,786 13,811 13,885 23,757 83,279 121,813 4,084 4,195 5,184 7,350 16,580 15,409 24,022 75,950 118,936 118,136 $59,173

2 1998

4,352

2,144

Beasley and Petroni (1996) suggest that the amount of malpractice insurance written is positively related to the loss reserve estimation error. Prior research has also identied other variables that potentially affect loss reserve estimation error. The rst is insurer size; Aiuppa and Trieschmann (1987) argue that larger insurers should report more accurate reserves because they have stronger actuarial staffs and are more diversied. But both Pentroni (1992) and Weiss (1985) nd no relation between insurer size and loss reserve estimation error. The second is nancial solvency. Harrington and Danzon (1994) nd that rms with weak safety (solvency) incentives under-report reserves to increase rm growth. They also discover that these rms attempt to hide their under-reserving with reinsurance. We account for growth using the one-year percent increase in net premiums written and reinsurance usage with the percent of gross premiums written ceded to reinsurers. We include nancial distress measured as the A.M. Best ratings as our control variable. A.M. Best has six level ratings to insurers with different nancial conditions: A and A (excellent), B (very good), B (good), C (fairly good), and C (fair). Following [. . .] we assign 1 to all rms with a rating of A 2 , A, A , or A , 2 to B , B , B or B 2 , and 3 to C , or C or below. Following Grace and Leverty (2010), we also account for differences in product and geographical diversication. Product diversication is measured using the product line Herndahl Index, which is calculated as the sum of the squared percentage of premiums earned by an insurer in each of the 26 lines of P/L insurance. Geographical diversication is gauged using the geographical Herndahl Index, the sum of the squared percentage of business written in each of the 50 states and the District of Columbia. Petroni and Beasley (1996) nd that nancially troubled insurers with Big Eight auditors are associated with signicantly more conservative reserve estimates. 4.2.3 Multivariate models. We use ve multivariate regression models to test our two sets of hypotheses. Specically, we use model 1 to test the relation between loss reserve error and audit committee independence, models 2-5 to test audit committee nancial expertise: LossReserveError i b0 b1 AudInd i b2 LENGTH i b3 MALi b4 ReInsurancei b5 Big 4i *Distressi b6 GROWTH i b7 GeoHerfindahl i b8 ProdHerfidahl i b9 SIZE i 1i LossReserveError i b0 b1 AudInd i b2 TestingVariable AudAcctExpi ; AudFinExpi ; AudSupExpi ; AudInsExpi b3 LENGTH i b4 MALi b5 ReInsurancei b6 Big 4i *Distressi b7 GROWTH i b8 GeoHerfindahl i b9 ProdHerfidahl i b10 SIZE i 1i where: Models 2 ~ 5

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Model 1

LossReserveError the difference between insurer is revised estimate of the cumulative claim losses outstanding disclosed in year t 4 (2007) and the originally reported estimate of cumulative

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AudInd

claim loss reserve at the end of year t 2003. Positive reserve errors are associated with under-reserving and negative reserve errors with over-reserving. indicative variable, which equals to 1 if the percentage of insurer is independent members in its audit committee is greater than 50 percent, 0 otherwise. The member (director) is identied as independent if she/he is not a current/former employee of insurer i, free of relative relationships with its employee, and has no any business dealings with the insurer i, including accepting any consulting, advisory or other compensatory frees. indicative variable, which equals to 1 if there is at least one accounting expert in insurer is audit committee, 0 otherwise. An accounting expert is dened as who currently has (or previously had) work experience as certied public accountants, chief nancial ofcers, vice presidents of nance, treasurer, nancial controllers, or any other major accounting positions. indicative variable, which equals to 1 if there is at least one nance expert in insurer is audit committee, 0 otherwise. A nance expert is dened as who currently has (or previously had) work experience as investment bankers, nancial analysts, or any other nancial management roles. indicative variable, which equals to 1 if there is at least one supervisory expert in insurer is audit committee, 0 otherwise. A supervisory expert is dened as who currently has (or previously had) work experience as chief executive ofcers or company presidents; a current or retired senior manager in another rm (i.e. a CEO, chairman of the board, president, chief operating ofcer, or vice president). indicative variable, which equals to 1 if there is at least one insurance expert in insurer is audit committee, 0 otherwise. An insurance expert is dened as who currently has (or previously had) work experience with insurance industry, a fellow of the Society of Actuaries, a member of the American Academy of Actuaries, MD, Insurance Commissioner, Chartered Underwriter and, Claims Committee. claim loss reserves expressed as a percentage of total liabilities. the percentage of net premiums written for malpractice. the percentage of gross premiums written ceded to reinsurers. indicative variable, which equals to 1 if insurer i engaged one of the largest four audit rms (KPMG, Ernst & Young, Deloitte and Touche, Pricewaterhouse Coopers), 0 otherwise.

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AudAcctExp

AudFinExp

AudSupExp

AudInsExp

LENGTH MAL ReInsurance Big4

Distress

based on best letter rating for insurer i, we assign 1 for rating A 2 , A, or A , 2 for B 2 , B, B , or B , and 3 for C , or C or below. one-year percent increase in net premiums written for insurer i. the sum of the squared percentage of premiums earned by insurer i in each of the 26 lines of P/L insurance. the sum of the squared percentage of business written by insurer i in each of the 50 states and the District of Columbia. the natural logarithm of insurer is total admitted assets.

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GROWTH GeoHerndahl ProdHerndahl SIZE

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5. Empirical results 5.1 Descriptive statistics Table II summarizes for the descriptive statistics for our sample. All the continuous variables are presented after winsorizing all the variables at the rst and the 99th percentile to remove the effect of outliers. The results indicate that loss reserves are over-stated a mean (median) of 0.31 (0.29) percent of total assets during the sample period. However, there is substantial cross-sectional variation; loss reserves are over-stated 2.57 percent at the 25th percentile but understated 1.68 percent at the 75th percentile. In terms of rm characteristics, mean or median total assets (SIZE) are approximately about $200 million, indicating that the size distribution of the sample is not skewed by some particularly large insurers. Approximately, two-thirds of the sample write lines of business with a settlement period, or length, of three years. Relative to total premiums, 2.48 percent of premium revenue, on average, is attributable to malpractice, and 38.97 percent ceded to reinsurers. The mean (median) premium growth rate in 2003 is 31.32 (11.13) percent in the sample. The average rm has a product line Herndahl of 0.51, which translates to an average of 1.96 lines of business. The mean geographical Herndahl is 0.52, indicating that the average rm operates in approximately two states. Turning to audit committee characteristics, only three out of 98 insurers independent members in their audit committee is less than 50 percent. About 56.12 percent insurers in the sample have at least one accounting expert on its audit committee, 64.29 percent have at least one nance expert, 75.51 percent have at least one supervisory export, and 61.22 percent have at least one insurance expert. Table III presents the Pearson (above the diagonal) and Spearman (below the diagonal). The Pearson correlations between loss reserve error and AudInd, AudAcctExp, AudInsExp are negative and signicant (at the 0.05 level), which are consistent with our prediction. Nevertheless, the univariate relationships between the loss reserve error and the testing variables are not of central importance, as pairwise correlations may lead to inappropriate inferences since other rm characteristics are not appropriately acknowledged. The correlations, however, display the associations between the various independent variables. There is no large correlation coefcient between independent variables, therefore, the inclusion of all the independent variables in the multivariate models is feasible and accurate. More importantly, the variance ination factors reported in our regressions are less than two for all independent variables, indicating that multicollinearity is not a problem.

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Variables LossReserveError AudInd AudAcctExp AudFinExp AudSupExp AudInsExp LENGTH MAL ReInsurance Big4_Distress GROWTH Prod_Herndahl Geo_Herndahl SIZE

n 98 98 98 98 98 98 98 98 98 98 98 98 98 98

Mean 2 0.0031 0.9694 0.5612 0.6429 0.7551 0.6122 0.4489 0.0248 0.3897 1.7143 0.3132 0.5081 0.5230 19.1046

First quartile 2 0.0257 1.0000 0.0000 0.0000 1.0000 0.0000 0.3611 0.0000 0.1590 1.0000 2 0.0043 0.2366 0.0862 17.8087

Median 2 0.0029 1.0000 1.0000 1.0000 1.0000 1.0000 0.4703 0.0000 0.3765 1.0000 0.1113 0.4710 0.2131 19.1014

Third quartile 0.0168 1.0000 1.0000 1.0000 1.0000 1.0000 0.5417 0.0000 0.6111 2.0000 0.3428 0.7672 0.5103 20.3590

368

Table II. Descriptive statistics

Notes: This table reports summary statistics for the year 2003-2007; LossReserveError is the difference between insurer is revised estimate of the cumulative claim losses outstanding disclosed in year t 4 (2007) and the originally reported estimate of cumulative claim loss reserve at the end of year t 2003; positive reserve errors are associated with under-reserving and negative reserve errors with over-reserving; AudInd is an indicative variable, which equals to 1 if the percentage of insurer is independent members in its audit committee is greater than 50 percent, 0 otherwise; AudAcctExp is an indicative variable, which equals to 1 if there is at least one accounting expert in insurer is audit committee, 0 otherwise; AudFinExp is an indicative variable, which equals to 1 if there is at least one nance expert in insurer is audit committee, 0 otherwise; AudSupExp is an indicative variable, which equals to 1 if there is at least one supervisory expert in insurer is audit committee, 0 otherwise; AudInsExp is an indicative variable, which equals to 1 if there is at least one insurance expert in insurer is audit committee, 0 otherwise; LENGTH is claim loss reserves expressed as a percentage of total liabilities; MAL is the percentage of net premiums written for malpractice; ReInsurance is the percentage of gross premiums written ceded to reinsurers; Big4 is an indicative variable, which equals to 1 if insurer i engaged one of the largest four audit rms (KPMG, Ernst & Young, Deloitte and Touche, Pricewaterhouse Coopers), 0 otherwise; distress is 1 for rating A 2 , A, or A , 2 for B 2 , B, B , or B , and 3 for C , or C or below; GROWTH is one-year percent increase in net premiums written; GeoHerndahl is the sum of the squared percentage of premiums earned by insurer i in each of the 26 lines of P/L insurance; ProdHerndahl is the sum of the squared percentage of business written by insurer i in each of the 50 states and the District of Columbia

5.2 Multivariate results To test our hypotheses, a total of four models are run by using the sample of 98 property-casualty insurers. Table IV contains the estimation results. As observed from Table IV, all of the ve the models are signicant, with F-statistics of 5.95 ( p , 0.0001), 7.64 ( p , 0.0001), 5.82 ( p , 0.0001), 5.30 ( p , 0.0001), and 6.17 ( p , 0.0001), and the adjusted R 2 of 31.48, 40.64, 33.21, 30.73, and 34.77 percent. Model 1 of Table IV reports the results for our H1. From model 1, the coefcient on audit committee size is negative while insignicantly different from 0 at 0.05 level, indicating that rms with independent committee members are more effective in monitoring the internal nancial reporting quality of an insurer. This result supports SOX and NAICs independence requirements on the committee member. However, we need to interpret this nding with caution as almost all insurers audit committee are independent in our sample displayed in Table II.

Variable 2 0.403 2 0.159 0.082 2 0.009 0.028 0.028 0.118 0.021 0.605 0.194 2 0.080 0.043 2 0.036 2 0.135 2 0.119 0.220 2 0.018 0.021 0.042 0.308 2 0.224 2 0.058 2 0.447 2 0.126 2 0.234 2 0.080 0.143 2 0.018 0.381 2 0.071 2 0.139 2 0.169 2 0.123 0.033 2 0.034 2 0.043 2 0.073 0.029 2 0.138 0.074 0.041 2 0.064 2 0.063 2 0.302 0.037 0.102 0.118 0.605 0.021 0.194 0.229 0.229 2 0.183 2 0.031 2 0.065 0.189 0.047 2 0.067 0.191 0.006 0.148 0.082 2 0.065 2 0.247 2 0.190 2 0.304 2 0.137 2 0.092 0.159 0.086 0.035 2 0.192 0.129 0.040 2 0.090 2 0.022 2 0.007 2 0.206 2 0.192 2 0.007 2 0.051 0.174 0.248 0.207 2 0.132 2 0.060 0.245 0.127 2 0.056 2 0.037 2 0.240 2 0.039 0.106 2 0.053 0.165 2 0.001 0.013 0.253 0.126 2 0.070 2 0.097 0.100 0.228 2 0.062 2 0.110 2 0.018 0.022 0.229 0.021 0.298 0.040 0.191 0.136 2 0.055 0.006 0.060 2 0.175 0.219 2 0.080 2 0.169 0.052 2 0.380 0.151 0.294 0.169 0.293 0.310 0.333 0.037 2 0.016 2 0.001 2 0.258 2 0.093 2 0.308 2 0.061 2 0.103 2 0.210 2 0.018 0.252 0.100

10

11

12

13

14

15

1. LossReserveError 2 0.227 2. AudInd 2 0.114 3. AudAcctExp 2 0.567 0.082 4. AudFinExp 2 0.148 2 0.009 5. AudSupExp 2 0.065 0.037 6. AudInsExp 2 0.458 0.102 7. LENGTH 0.059 0.093 8. MAL 0.101 0.097 9. ReInsurance 0.166 0.115 10. Big4 2 0.032 0.228 11. Distress 0.004 2 0.066 12. GROWTH 0.282 2 0.037 13. Prod_Herndahl 0.180 2 0.215 14. Geo_Herndahl 0.158 0.152 15. SIZE 2 0.103 0.118

0.115 2 0.256 2 0.001 2 0.230 0.044 0.120 2 0.430 0.045 0.137 2 0.137 0.060 2 0.036 2 0.178 2 0.183 0.166 2 0.290 0.062 0.044 0.102 0.224 2 0.013 0.291 2 0.016 0.159 2 0.222 2 0.039 2 0.072 2 0.081 0.010 0.240 2 0.289 0.010 0.064 0.184 2 0.016 2 0.139 0.054 2 0.174 0.366 2 0.148 2 0.248 2 0.572

Notes: This table provides pairwise correlations for the sample; Pearson correlations are in the upper triangle (italized) and Spearman correlations are in the lower triangle (unitalized); correlation signicant at the 0.05 level are in bold gures; LossReserveError is the difference between insurer is revised estimate of the cumulative claim losses outstanding disclosed in year t 4 (2007) and the originally reported estimate of cumulative claim loss reserve at the end of year t 2003; positive reserve errors are associated with under-reserving and negative reserve errors with over-reserving; AudInd is an indicative variable, which equals to 1 if the percentage of insurer is independent members in its audit committee is greater than 50 percent, 0 otherwise; AudAcctExp is an indicative variable, which equals to 1 if there is at least one accounting expert in insurer is audit committee, 0 otherwise; AudFinExp is an indicative variable, which equals to 1 if there is at least one nance expert in insurer is audit committee, 0 otherwise; AudSupExp is an indicative variable, which equals to 1 if there is at least one supervisory expert in insurer is audit committee, 0 otherwise; AudInsExp is an indicative variable, which equals to 1 if there is at least one insurance expert in insurer is audit committee, 0 otherwise; LENGTH is claim loss reserves expressed as a percentage of total liabilities; MAL is the percentage of net premiums written for malpractice; ReInsurance is the percentage of gross premiums written ceded to reinsurers; Big4 is an indicative variable, which equals to 1 if insurer i engaged one of the largest four audit rms (KPMG, Ernst & Young, Deloitte and Touche, Pricewaterhouse Coopers), 0 otherwise; distress is 1 for rating A 2 , A, or A , 2 for B 2 , B, B , or B , and 3 for C , or C or below; GROWTH is one-year percent increase in net premiums written; GeoHerndahl is the sum of the squared percentage of premiums earned by insurer i in each of the 26 lines of P/L insurance; ProdHerndahl is the sum of the squared percentage of business written by insurer i in each of the 50 states and the District of Columbia

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Table III. Correlation matrix

MAJ 27,4
Intercept Coefcient t-value p-value VIF AudInd Coefcient t-value p-value VIF AudAcctExp Coefcient t-value p-value VIF AudFinExp Coefcient t-value p-value VIF AudSupExp Coefcient t-value p-value VIF AudInsExp Coefcient t-value p-value VIF LENGTH Coefcient t-value p-value VIF MAL Coefcient t-value p-value VIF ReInsurance Coefcient t-value p-value VIF Big4*Distress Coefcient t-value p-value VIF

Model 1 2 0.0811 (2 1.00) 0.3224 0.0000 2 0.0785 (2 2.22) * * 0.0287 1.1142

Model 2 2 0.0252 (2 0.33) 0.7448 0.0000 2 0.0790 (2 2.40) * * 0.0183 1.1143 2 0.0480 (2 3.82) * * * 0.0003 1.3561

Model 3 2 0.0655 (2 0.81) 0.4201 0.0000 2 0.0822 (2 2.36) * * 0.0207 1.1181

Model 4 2 0.0831 (2 1.01) 0.3159 0.0000 2 0.0784 (2 2.21) * * 0.0297 1.1143

Model 5 2 0.0373 (2 0.46) 0.6490 0.0000 2 0.0763 (2 2.22) * * 0.0293 1.1151

370

2 0.0230 (2 1.81) * 0.0734 1.1436 0.0034 (0.23) 0.8202 1.2114 2 0.0302 (2 2.33) * * 0.0220 1.2606 0.0954 (2.79) * * * 0.0064 1.2330 2 0.1834 (2 3.05) * * * 0.0030 1.3135 0.0619 (2.68) * * * 0.0087 1.2233 2 0.0162 (2 1.90) * 0.0611 1.3043 0.0808 (2.52) * * 0.0135 1.2509 2 0.1627 (2 2.89) * * * 0.0048 1.3258 0.0446 (2.03) * * 0.0453 1.2782 2 0.0182 (2 2.29) * * 0.0246 1.3101 0.0980 (2.90) * * * 0.0047 1.2352 2 0.1992 (2 3.32) * * * 0.0013 1.3419 0.0685 (2.97) * * * 0.0038 1.2550 2 0.0147 (2 1.74) * 0.0859 1.3166 0.0972 (2.76) * * * 0.0071 1.2989 2 0.1850 (2 3.04) * * * 0.0031 1.3313 0.0625 (2.68) * * * 0.0088 1.2366 2 0.0168 (2 1.88) * 0.0640 1.4121 0.0841 (2.50) * * 0.0145 1.2592 2 0.1377 (2 2.23) * * 0.0285 1.4597 0.0551 (2.43) * * 0.0173 1.2442 2 0.0152 (2 1.82) * 0.0715 1.3076 (continued )

Table IV. Empirical results

Model 1 GROWTH Coefcient t-value p-value VIF GeoHerndahl Coefcient t-value p-value VIF ProdHerndahl Coefcient t-value p-value VIF SIZE Coefcient t-value p-value VIF n R2 Adj. R 2 Model F-value Model Pr . F 0.0051 (4.21) * * * 0.0001 1.0614 2 0.0114 (2 3.15) * * * 0.0022 1.0839 0.0290 (1.24) 0.2188 1.3032 0.0064 (1.70) * 0.0925 1.2118 98 0.3784 0.3148 5.9513 0.0000

Model 2 0.0048 (4.25) * * * 0.0001 1.0664 2 0.0100 (2 2.95) * * * 0.0041 1.0968 2 0.0129 (2 0.53) 0.5994 1.6332 0.0069 (1.99) * 0.0502 1.2139 98 0.4676 0.4064 7.6400 0.0000

Model 3 0.0047 (3.91) * * * 0.0002 1.0900 2 0.0111 (2 3.09) * * * 0.0027 1.0867 0.0279 (1.21) 0.2307 1.3041 0.0062 (1.67) * 0.0989 1.2128 98 0.4010 0.3321 5.8237 0.0000

Model 4 0.0051 (4.19) * * * 0.0001 1.0713 2 0.0113 (2 3.07) * * * 0.0028 1.1035 0.0296 (1.25) 0.2146 1.3207 0.0064 (1.68) * 0.0956 1.2126 98 0.3787 0.3073 5.3037 0.0000

Model 5 0.0054 (4.55) * * * 0.0000 1.0760 2 0.0105 (2 2.94) * * * 0.0042 1.0981 0.0067 (0.27) 0.7868 1.5311 0.0057 (1.55) 0.1240 1.2194 98 0.4150 0.3477 6.1707 0.0000

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371

Notes: Signicance at: *0.10, * *0.05, and * * *0.01 levels, respectively; multivariate regression tests of loss reserve error on audit committee characteristics and control variables; sample consists of 98 rms: LossReserveError i b0 b1 AudInd i b2 LENGTH i b3 MALi b4 ReInsurancei b5 Big 4i *Distressi b6 GROWTH i b7 GeoHerfindahl i b8 ProdHerfidahl i b9 SIZE i 1i LossReserveError i b0 b1 AudInd i b2 TestingVariable AudAcctExpi ; AudFinExpi ; AudSupExpi ; AudInsExpi b3 LENGTH i b4 MALi b5 ReInsurancei b6 Big4i *Distressi b7 GROWTH i b8 GeoHerfindahl i b9 ProdHerfidahl i b10 SIZE i 1i

Model 1

Models 2 ~ 5

This table provides results of multivariate regressions examining the magnitude of loss reserve error; the dependent variable is loss reserve error scaled by total admitted assets; LossReserveError is the difference between insurer is revised estimate of the cumulative claim losses outstanding disclosed in year t 4 (2007) and the originally reported estimate of cumulative claim loss reserve at the end of year t 2003; positive reserve errors are associated with under-reserving and negative reserve errors with over-reserving; AudInd is an indicative variable, which equals to 1 if the percentage of insurer is independent members in its audit committee is greater than 50 percent, 0 otherwise; AudAcctExp is an indicative variable, which equals to 1 if there is at least one accounting expert in insurer is audit committee, 0 otherwise; AudFinExp is an indicative variable, which equals to 1 if there is at least one

Table IV.

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372

Table IV.

nance expert in insurer is audit committee, 0 otherwise; AudSupExp is an indicative variable, which equals to 1 if there is at least one supervisory expert in insurer is audit committee, 0 otherwise; AudInsExp is an indicative variable, which equals to 1 if there is at least one insurance expert in insurer is audit committee, 0 otherwise; LENGTH is claim loss reserves expressed as a percentage of total liabilities; MAL is the percentage of net premiums written for malpractice; ReInsurance is the percentage of gross premiums written ceded to reinsurers; Big4 is an indicative variable, which equals to 1 if insurer i engaged one of the largest four audit rms (KPMG, Ernst & Young, Deloitte and Touche, Pricewaterhouse Coopers), 0 otherwise; Distress is 1 for rating A 2 , A, or A , 2 for B 2 , B, B , or B , and 3 for C , or C or below; GROWTH is one-year percent increase in net premiums written; GeoHerndahl is the sum of the squared percentage of premiums earned by insurer i in each of the 26 lines of P/L insurance; ProdHerndahl is the sum of the squared percentage of business written by insurer i in each of the 50 states and the District of Columbia; SIZE is the natural logarithm of insurer is total admitted assets; each of the continuous variables is winsorized at 1 percent and 99 percent to mitigate outliers

Models 2-5 present separate tests on relationship between the magnitude of insurers loss reserve errors and its audit committees accounting expertise, nance expertise, supervisory nancial expertise, and insurance nancial expertise. Model 2 shows that the coefcient on accounting nancial experts is 2 0.0480 which is signicant at 1 percent level, suggesting that accounting nancial experts, having hands-on experience with preparing nancial statements, are better able to monitor the loss reserve management. Model 3 shows that the coefcient on the nance experts is 2 0.0230 is also negative and signicant at 10 percent level, which indicates the presence of nance experts in audit committee also improves loss reserve estimate. Further, model 5 shows that the coefcient on the insurance nancial experts is 2 0.0302 which is signicant at 5 percent level, indicating that nancial experts with insurance knowledge improve the effectiveness in monitoring of the insurers nancial reporting process. In contrast, model 4 shows that the coefcient on supervisory experts is insignicantly different from 0, indicating no systematic relation between loss reserve error and supervisory expertise. Of the control variables, the variables LENGTH, GROWTH, and ReInsurance are all positive and statistically signicant (at least at 5 percent level) across all ve models, while GeoHerndahl is negatively related to loss reserve error (at the 1 percent level). These ndings are consistent with Grace and Leverty (2010). The coefcient on Big4*Distress is negative and signicant different from 0, indicating that within the subset of nancially troubled insurers Big4 auditors are associated with signicantly more conservative reserve estimates. These ndings are consistent with Pentroni and Beasley (1996). Turning to the remaining control variables, we nd no statistically signicant association between ProdHerndahl and loss reserve error, and SIZE are positively related to loss reserve error in four out of the ve models, all at 10 percent level. As the results in Pentroni (1992), MAL is used to control for the amount of malpractice insurance written and its coefcient is allowed to vary across years. In our sample, we nd that MAL is negatively associated with loss reserve error at least 5 percent level in the ve models. In summary, while our empirical results in models 2, 3, and 5 support our hypotheses that nancial expertise with accounting, nance or insurance background is negatively associated with loss reserve error. However, the result from model 4 fails

to prove that supervisory experts are better able to monitor loss reserve error for an insurer. Those ndings are consistent with our expectations. 5.3 Supplemental analysis In addition to above OLS tests, we follow Koenker and Bassett (1982) and Grace and Leverty (2010) to adopt quantile regression for supplemental robust checks. As Grace and Leverty (2010) indicate the incentives for reserve management may vary across reserve error levels. Quantile regression provides snapshots of the relationship between regressors and the dependent variable at different points of its conditional distribution. Thus, quantile regression techniques are not sensitive to outliers or skewness in the dependent variable, as in the following equation: Qt LossReserveError jX ; Z at bt X gt Z 1 where bt is the vector of coefcients for the control variables X at the tth percentile and gt is the coefcient of testing variable at the tth percentile. Table V presents the quantile regression results at the 25th, 50th, and 75th percentiles. We report coefcient as well as Wald test statistic for each interest variable. The quantile regression results show that AudInd variable is not statistically signicant at these three percentile. Suggesting that the OLS may be biased due to extreme values. The sign and statistical signicance of AudAcctExp are consistent across the distribution of loss reserve error. However, the majority of the AudIndsExps response to loss reserve error occurs at the lower quantiles of the loss reserve error distribution, and the coefcient on AudFinExp is statistically signicant at the 50th percentiles, but not at the 25th and 75th percentile. Finally, nowhere on the conditional distribution is

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0.25 coefcient AudInd Wald Test Statistic AudAcctExp Wald test Statistic AudFinExp Wald test Statistic AudSupExp Wald test Statistic AudInsExp Wald test Statistic 2 0.0073 (0.0026) 2 0.0473 (7.1030) * * * 2 0.0284 (2.2126) 2 0.0131 (1.1173) (2 0.0396) (5.6050) * *

Quantiles 0.5 coefcient 2 0.0078 (0.0012) 2 0.0347 (14.0435) * * * 2 0.0202 (5.5542) * * 2 0.0095 (0.3238) (2 0.0267) (7.6026) * * *

0.75 coefcient 2 0.2327 (1.4732) 2 0.0389 (9.7472) * * * 2 0.0052 (0.0966) 2 0.0024 (0.0632) (2 0.0224) (2.1140) Table V. Quantile regression results

Notes: Signicant at: *0.10, * *0.05 and * * *0.01 levels, respectively; this table provides results of multivariate quantile regressions examining the association of the magnitude of loss reserve error and audit committee characteristics; the regressions include a constant term and a set of control variables as in OLS models in Table IV, which are not reported to conserve space

MAJ 27,4

signicant for AudSupExp. Overall the quantile regression estimate conrms our ndings in OLS models. 6. Conclusion In this paper, we investigate the relation between two audit committee characteristics independence and expertise of the audit committee and the accuracy of property-liability insurers loss reserve estimate. Our work is motivated by the regulation set by SOX requiring such characteristics for publicly held insurer companies and by Section 14 of FRMR set by NAIC imposing similar requirements on mutuals and private insurers. Using a sample of 98 publicly traded property-liability insurers in the years 2003, we nd evidence that accounting, nance, and insurance nancial expertise is associated with more accurate or conservative loss reserve estimate. In contrast, we nd that the presence of a supervisory nancial expertise is not associated with better the loss reserve quality. These ndings suggest that audit committees with nancial expertise with hands-on experience of preparing nancial statements, or industry experience, are better able to monitor the nancial reporting than those have no such experience. These ndings are consistent with prior literatures (Dhaliwal et al., 2006; Carcello et al., 2006) suggesting that adopting narrower versions of the denition that capture accounting and nance expertise. When it comes to the audit committee independence, although the model coefcient is negative and signicant at 5 percent level, due to the limitation of our sample, we fail to conclude a statistically signicant association exists between these audit committee independence and the loss reserve error. The implications of our study are important for the SEC and NAIC. Our results suggest that the requirements on the audit committee nancial expertise would be necessary, even in highly regulated industry, such as property-casualty insurance. Also, our ndings, consistent with prior research, show the need for the SEC and NAIC to provide a narrower denition for the nancial expert emphasizes the importance of audit committee directors who have hands-on experience in major accounting positions and who has insurance industry knowledge. Our paper is subject to a number of limitations. First, because of data availability, we limited our sample in publicly held property-liability insurers. Although the results from publicly held insurers could provide a good laboratory for such investigation in all insurers, they might be limited due to different organization structures of different types of insurers. Second, our categorization of audit committee members as the four types of audit nancial expertise is dependent on rms public disclosures. Although rms are required to disclose this information, the quality and transparency of this disclosure is likely to vary across rms.
Notes 1. Insurers having direct premiums written less than $1,000,000 in any calendar year and less than 1,000 policyholders or certicate holders of direct written policies nationwide at the end of the calendar year shall be exempt from this regulation for the year (NAIC, 2006a, b). 2. NYSE Listing Guide, at 6. The American Stock Exchange recommends an audit committee. Starting in 1989, the NASDAQ requires US listed rms to have an audit committee with a majority of its members being independent of management.

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3. There are a number of scaling values observed in the literature: total assets, net premiums earned, or 1.6 (the larger of total admitted assets and net premium written)2/3. Our results are robust to all scaling techniques. References Abbott, L.J., Parker, S. and Peters, G.F. (2004), Audit committee characteristics and restatements, Auditing: A Journal of Practice & Theory, Vol. 23, pp. 69-87. Agrawal, A. and Chadha, P. (2005), Corporate governance and accounting scandals, Journal of Law and Economics, Vol. XLVIII, pp. 371-405. Aiuppa, T.A. and Treieschmann, J.S. (1987), An empirical analysis of the magnitude and accuracy of incurred-but-not-reported reserves, Journal of Risk and Insurance, March, pp. 100-18. Andreason, C. (2005), Will the NAIC knock the SOX off insurers?, Washington Perspective: The Changing Climate of Insurance Regulation, April. Balsam, S., Krishnan, J. and Yang, J. (2003), Auditor industry specialization and earnings quality, Auditing: A Journal of Practice & Theory, Vol. 22, pp. 71-97. Beasley, M. (1996), An empirical analysis of the relation between the board of director composition and nancial statement fraud, The Accounting Review, Vol. 71, pp. 443-65. Beasley, M. and Petroni, K. (1996), Errors in accounting estimates and their relation to audit rm type, Journal of Accounting Research, Spring, pp. 151-72. Beaver, W.H., McNichols, M.F. and Nelson, K.K. (2003), Management of the loss reserve error and the distribution of earnings in the property-casualty insurance industry, Journal of Accounting and Economics, Vol. 35, pp. 347-76. Bhagat, S. and Black, B. (2002), The non-correlation between board independence and long term rm performance, Journal of Corporation Law, Vol. 27, pp. 231-73. Bryan, D., Liu, M. and Tiras, S. (2004), The inuence of independent and effective audit committee on earnings quality, working paper, State University of New York, Buffalo, NY. Carcello, J.V. and Neal, T.L. (2003), Audit committee characteristics and auditor dismissals following new going-concern reports, The Accounting Review, Vol. 78, pp. 95-117. Carcello, J.V., Hollingsworth, C.W., Klein, A. and Neal, T.L. (2006), Audit committee nancial expertise, competing corporate governance mechanisms, and earnings management, working paper, University of Tennessee, Knoxville, TN. Davidson, W.N. III, Xie, B. and Xu, W. (2004), Market reaction to voluntary announcements of audit committee appointments: the effect of nancial expertise, Journal of Accounting and Public Policy, Vol. 23, July, pp. 279-93. Dechow, P.M., Sloan, R.G. and Sweeney, A.P. (1996), Causes and consequences of earnings manipulation: an analysis of rms subject to enforcement actions by the SEC, Contemporary Accounting Research, Vol. 13, pp. 1-36. DeFond, M.L., Hann, R.N. and Hu, X. (2005), Does the market value nancial expertise on audit committees of boards of directors?, Journal of Accounting Research, Vol. 43, pp. 153-93. Dhaliwal, S.D., Naiker, V. and Navissi, F. (2006), Audit committee nancial expertise, corporate governance and accruals quality: an empirical analysis, working paper, University of Arizona, Tucson, AZ. Fama, E.F. and Jensen, M.C. (1983), Separation of ownership and control, Journal of Law and Economics, Vol. 26, pp. 301-25.

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Farber, D. (2005), Restoring trust after fraud: does corporate governance matter?, The Accounting Review, Vol. 80, pp. 539-61. Fitzgerald, K. (2004), Sarbanes-Oxley initiatives at the NAIC, Foley & Lardner LLP.s Legal News Insurance Law Update. Gaver, J.J. and Paterson, J.S. (2004), Do insurers manipulate loss reserves to mask solvency problems?, Journal of Accounting and Economics, Vol. 37, pp. 393-416. Gaver, J.J. and Paterson, J.S. (2007), The inuence of large clients on ofce-level auditor oversight: evidence from the property-casualty insurance industry, Journal of Accounting and Economics, Vol. 43, pp. 299-320. Grace, M.F. and Leverty, J.T. (2010), Political cost incentives for managing the property-liability insurer loss reserve, Journal of Accounting Research, Vol. 48 No. 1, pp. 21-49. Harrington, S.E. and Danzon, P.M. (1994), Price cutting in liability insurance markets, Journal of Business, Vol. 67 No. 4, pp. 511-38. Klein, A. (2002a), Audit committee, board of director characteristics, and earnings management, Journal of Accounting and Economics, Vol. 33 No. 3, pp. 375-400. Klein, A. (2002b), Economic determinants of audit committee independence, The Accounting Review, Vol. 77, pp. 435-52. Koenker, R. and Bassett, G. (1982), Robust tests for heteroskedasticity based on regression quantiles, Econometrica, Vol. 50, pp. 43-61. Krishnan, J. (2005), Audit committee quality and internal control: an empirical analysis, The Accounting Review, Vol. 80, pp. 649-75. National Association of Insurance Commissioners (2006a), Annual Financial Reporting Model Regulation, NAIC, Kansas City, MO, 11 June. National Association of Insurance Commissioners (2006b), Implementation Guide for the Annual Financial Reporting Model Regulation, NAIC, Kansas City, MO, 11 June. Petroni, K.R. (1992), Optimistic reporting in the property-casualty insurance industry, Journal of Accounting and Economics, Vol. 15 No. 4, pp. 485-508. Petroni, K.R. and Beasley, M. (1996), Errors in accounting estimates and their relation to audit rm type, Journal of Accounting Research, Vol. 34, pp. 151-71. SOX (2002), Public Law 107-204, 107th Congress of the United States, 30 July. Weiss, M. (1985), A multivariate analysis of loss reserving estimates in property-liability insurers, Journal of Risk and Insurance, Vol. 52, pp. 199-221. Further reading Beaver, W.H. and McNichols, M.F. (1998), The characteristics and valuation of loss reserves of property casualty insurers, Review of Accounting Studies, Vol. 3, pp. 73-95. Bedard, J., Chtourou, S.M. and Courteau, L. (2004), The effect of audit committee expertise, independence, and activity on aggressive earnings management, Auditing: A Journal of Practice and Theory, Vol. 23, pp. 13-35. Carcello, J.V. and Neal, T.L. (2000), Audit committee composition and auditor reporting, The Accounting Review, Vol. 75, pp. 453-67. DeFond, M.L. and Francis, J.R. (2005), Audit research after Sarbanes-Oxley, Auditing: A Journal of Practice & Theory, Vol. 24, pp. 5-30. Eisenberg, T., Sundgren, S. and Wells, M. (1998), Larger board size and decreasing rm value in small rms, Journal of Financial Economics, Vol. 48, pp. 35-54.

Fama, E.F. (1980), Agency problems and the theory of the rm, Journal of Political Economy, Vol. 88, pp. 288-307. Felo, A.J., Krishnamurthy, S. and Solieri, S.A. (2003), Audit committee characteristics and the perceived quality of nancial reporting: an empirical analysis, working paper, Penn State Great Valley, Malvern, PA. Gaver, J.J. (2000), Earnings management under changing regulatory regimes: state accreditation in the insurance industry, Journal of Accounting and Public Policy, Vol. 19, pp. 399-420. Gaver, J.J. and Paterson, J.S. (1999), Managing insurance company nancial statements to meet regulatory and tax reporting goals, Contemporary Accounting Research, Vol. 16, pp. 207-41. Grace, E. (1990), Property-liability insurer reserve errors: a theoretical and empirical analysis, Journal of Risk and Insurance, Vol. 57, pp. 28-46. Mayers, D., Shivdasani, A. and Smith, C.W. (1997), Board composition and corporate control: evidence from the insurance industry, Journal of Business, Vol. 70, pp. 33-62. Nelson, K.K. (2000), Rate regulation, competition, and loss reserve discounting by property-casualty insurers, The Accounting Review, Vol. 75, pp. 115-38. Petroni, K.R., Ryan, S.G. and Wahlen, J.R. (2000), Discretionary and non-discretionary revisions of loss reserves by property-casualty insurers: differential implications for future protability, risk and market value, Review of Accounting Studies, Vol. 5, pp. 95-125. Xie, B., Davidson, W.N. and DaDalt, P.J. (2003), Earnings management and corporate governance: the role of the board and the audit committee, Journal of Corporate Finance, Vol. 9, pp. 295-316. Corresponding author Fang Sun can be contacted at: fsun@hunter.cuny.edu

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