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NTU Management Review Vol. 34 No. 1 Apr. 2024

incentive to manipulate earnings (via over- or under-reserving of loss reserves) to gain
10
larger compensation; this is against stockholders’ interests. Over-reserving leads to lower
reported earnings and potentially lower stock prices.
11
In this study, we define the loss reserve error in terms of the difference between the

original report of total incurred losses in year t and an updated or developed estimate of
the same incurred losses five years later. This definition is consistent with most of the
12
extant literature (e.g., Petroni, 1992; Nelson, 2000; Gaver and Paterson, 2004, 2014).
The value for the loss reserve error is scaled by admitted assets. We make a distinction in
the analysis for publicly-traded insurers using in-house actuaries to certify loss reserves in
the pre- versus post-SOX periods. To identify any differences in the use of in-house and
external actuaries with respect to SOX, we conduct an analysis of publicly-traded insurers
using external actuaries to certify loss reserves in the pre- versus post-SOX periods as

well.
Estimation is first conducted using feasible generalized least squares (FGLS) with AR
(1) autocorrelation and fixed year effects on all available observations, which is consistent

with prior literature (e.g., Grace and Leverty, 2010, 2012). We also conduct Chow
tests to determine whether it is appropriate to pool weak and healthy insurers together.
Then, we use Propensity Score Matching (PSM) to find pairs of insurers with matching
characteristics (except for the use of an in-house actuary to certify loss reserves) The PSM
sample is used as an alternative sample of insurers to analyze.

likely to be affected by managerial incentives.
10 That is, they indicate that restricted stock awards may induce managers to engage in earnings-de-
creasing behavior (or over-reserving). Also, structured bonus plans may lead to earnings decreasing
or earnings increasing behavior (i.e., over-reserving or under-reserving). (See Eckles et al. (2011), p.
766, for example.)
11 Under-or over-reserving has an economic impact beyond consideration of managerial behavior. Over-
reserving misstates the financial position of the insurer too and results in reduced, current taxes. Thus,
over-reserving has implications for the imposition of taxes on insurers compared to other commercial
and individual taxpayers. Over-reserving in rate-regulated lines of insurance such as workers
compensation and automobile liability results in lower reported income for these lines and can be
used as the basis for insurers seeking a (premium) rate increase.
12 Prior studies find that in the automobile liability market (one of the most important short-tail line of
business in P-C insurance), 97-100% of the original claims are settled within five years after the loss
was incurred (Smith, 1980).

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