Sarbanes-Oxley Act of 2002 (SOX)—named for its principal sponsors, former Sen. Paul Sarbanes (D–Md.) and former Rep. Mike Oxley (R–Ohio) – was intended to restore confidence in the transparency of publicly traded companies after the collapses of WorldCom and Enron Corp. revealed that their auditors had certified financial statements that overstated the companies’ assets and grossly understated their liabilities.
But, of course, “transparency” is not quite the same thing as regulatory certainty and soundness. In the field of insurance, more specifically, transparency does not necessarily equal solvency.
A new article by Martin Grace of Temple University and Juan Zhang of Eastern Kentucky University looks at how property and casualty insurers have responded to the enhanced disclosure and attestation requirements, both from SOX itself and for new auditing rules subsequently adopted by state insurance regulators. The latter were closely modeled on SOX, but were also applied to non-public insurance companies, primarily mutuals.
They arrive at a counterintuitive conclusion: more open disclosures have made insurance companies less cautious in their reservation methods.
Grace and Zhang focus on the impact that annual internal control reports required under both Section 404 of SOX and the National Association of Insurance Commissioners (NAIC) Model Audit Rule (MAR) have had on insurers̵7; likelihood of adopting “conditionally conservative” accounting practices, where unrealized losses recognized faster than unrealized gains. Since both Section 404 and MAR create penalties for financial improprieties that may apply personally to CEOs and CFOs, it would be reasonable to assume that the rules would make regulated companies more likely to be conservative in their financial reporting.
Indeed, that is what Gerald Lobo of the University of Houston and Jian Zhou of the University of Hawaii at Mānoa found in a 2010 paper in Journal of Accounting, Auditing and Finance. Looking at a set of public companies listed in both Canada and the US, they found that companies with US arms, and therefore subject to SOX, became much more likely to reduce the amount of “discretionary” accruals they reported, with the effect being the most pronounced among companies that were most aggressive in admitting such accruals—which can be easily manipulated—in the pre-SOX period.
However, while Lobo and Zhou’s research did not focus on a particular sector and used industry-wide and market-based indicators to assess the degree to which conditional conservatism was exercised, Grace and Zhang were able to use firm-specific information on accruals—specifically, property and casualty insurance information on loss trends, as reported in schedule P, Part 2 of NAIC’s Statutory Annual Report.
Under the NAIC’s statutory accounting principles, insurers must make annual updates to their estimates of incurred losses from a given accident year for each of their last 10 performance years. Because not all claims are reported during the coverage period and reported claims can take years to settle, estimates of loss reserves will become more accurate over time as claims are paid and more information about the amount of “true” losses becomes known.
When this information becomes available, insurance companies may be surprised by “good news” that they initially reserved for a particular accident year or by “bad news” that they have a reserve shortfall. Under conditionally conservative accounting, they would move to address deficiencies immediately, but wait to release excess “slack” reserves until the apparent “good news” can be verified –i.ewhen all losses are paid.
But Grace and Zhang find that the effect of improved financial transparency rules has been that insurers use less conditional conservatism, release reserves more quickly on “good news” and are less quick to take required reserves for “bad news.” They find a particularly strong effect since the NAIC issued the model revision rule, which was adopted in nearly all states in 2010, except for Alaska, which adopted it in 2011, and New Hampshire, which adopted it in 2017. Puerto Rico and the District of Columbia also adopted the rule in 2011.
The authors theorized that what drives this effect is that the safe harbor that SOX Section 404 and MAR provide to financial managers may reduce the incentive they previously had to adopt conservative booking practices.
“In other words, the advance reporting requirements may help insurers convince state commissioners that their reporting is accurate; as a result, insurers do not have to react to expected losses as quickly as they did in the absence of the new rules,” write Grace and Zhang. “Insurers may consider compliance with SOX Section 404 and MAR and conditional conservatism strategy reimbursements to deal with the state commissioners and credit rating agencies.”
In one sense, Grace and Zhang’s findings suggest that the accounting reforms of the 2000s did exactly what they were intended to do: make corporate financial reporting more accurate and transparent. When insurers practice conditional conservatism, the result tends to be to inflate their reserves and therefore distort the value of the company.
But these distortions will also tend to improve solvency by providing a buffer against future unexpected losses – especially catastrophes or large lawsuits. By being swept up in the post-Enron reforms, state insurance regulators may have copied too closely an audit model designed to provide more accurate valuations of public companies, rather than one appropriate to their role as regulators.
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