Presented at National Taiwan University 2012/03/15

1. Reserve Management, Audit Committee Characteristics: Evidence from U.S. Property-Liability Insurance CompaniesWen-Yen HsuYenyu (Rebecca) HuangGene Lai Presented at National Taiwan University 2012/03/15

2. Outline • Introduction • Hypothesis Development • Methodology • Results • Policy Implications and Conclusions

3. Introduction (1) - Background • Background • Regulators have expressed great concern over corporate governance after Enron, WorldCom • An effective audit committee of board of directors is the frontline to constrain managers’ misappropriate discretion such as earning management • The formation of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees (BRC (1999)), later certain provisions in the Sarbanes-Oxley Act of 2002 (SOX) and U.S. SEC (2003).

4. Introduction (2) - Purpose • Purpose of this study • To examine the relation between reserve management and a set of audit committee characteristics of property-liability insurers. Those characteristics are believed to improve the effectiveness of corporate audit committee in constraining earnings management by BRC (1999), SOX (2002) and SEC (2003)

5. Introduction (3) • To avoid the drawbacks of the prior studies • The loss reserve in the insurance industry is a specific and the largest liability on insurer balance sheets • Regulatory disclosures are unique to the industry and allow the comparison of reserve estimation error to ex post outcomes. This provides an objective measure of the bias.

6. Introduction (4) - Results • Our results support several policies of the BRC (1999), SOX (2002), or SEC (2003), regarding the improvement of the effectiveness of corporate audit committees • Larger audit committee size • More audit committee accounting expertise • More audit committee diligence

7. Introduction (5) - Contribution • This is the first study to examine the relation between audit committee and reserve management while controlling for other corporate governance and firm-specific characteristics for U.S. property-liability insurers • We examine two measurements • Accuracy: under-reserving and over-reserving • Conservatism

8. Hypothesis 1 • Reserve estimate accuracy and audit committee independence: • Positive for understaters • Ambiguous of overstaters (reputation loss and/or litigation) • Reserve estimate conservatism and audit committee independence: • Positive (reputation loss and/or litigation)

9. Hypothesis 2 • Reserve estimate accuracy and audit committee size: • Positive (capacity) • Negative (slow speed of decision and/or free rider) • In summary, ambiguous (both for understaters and overstaters) • Reserve estimate conservatism and audit committee size: • Positive (large committee need to compromise and difficult to accept risky projects)

10. Hypothesis 3 • Reserve estimate accuracy and audit committee accounting expertise: • Positive (more accurate) • Reserve estimate conservatism and audit committee accounting expertise: • Positive

11. Hypothesis 5 • Reserve estimate accuracy and audit committee with at least an independent blockholder (5%): • Positive for understaters • Cannot be predicted for overstaters (accuracy vs. tax benefits) • Reserve estimate conservatism and audit committee with at least an independent blockholder : • Positive

12. Methodology (1) • Sample : 1,926 stock property-casualty insurers U.S. firm-years (Panel data). • Fixed effects vs. random effects: Our results of Hausman tests suggest using fixed effects models. • Period : 1996-2001 (2007) • Data Base : NAIC and U.S. SEC EDGAR

13. Methodology (2) Accuracy /ERRORi,t/ = αt + UNDER x [β1Audit Committee variablesi,t + β2Corporate Governance variablesi,t + β3WEAKi,t + β4LENTGHi,t + β5MALi,t+ β6SIZEi,t] + OVER x [β7Audit Committee variablesi,t + β8Corporate Governance variablesi,t + β9WEAKi,t +β10LENTGHi,t + β11MALi,t+ β12SIZEi,t] + β13Yeart + β14Firm Fixed Effectsi + εi,t (1) Conservatism ERRORi,t = αt + β1Audit Committee variablesi,t + β2Corporate Governance variablesi,t + β3WEAKi,t + β4UNDERi,t x LENTGHi,t + β5OVERi,t x LENTGHi,t + β6MALi,t + β7SIZEi,t + β8 Yeart + β9Firm Fixed Effectsi + εi,t (2)

14. Reserve Error • A positive (negative) value of ERRORi,t indicates insurer i has understated (overstated) reserves. ERRORi,t = (RESERVEi,t+5 - RESERVEi,t)/ ASSETSt where RESERVEi,tis insurer i’s estimate of loss reserves reported in year t and RESERVEi,t+5is the developed reserves at year t+5 for insurer i for loss reserves reported in year t.

15. Summary Statistics

16. Table 4 Accuracy

17. Results (1)

18. Table 6 The percentage of each of four audit committee characteristics that meets BRC recommendations by year

19. Table 7 Accuracy

20. Table 8 Dependent variable ERROR

21. Results (3) • The results of Tables 7 & 8 are similar to those of Tables 4 & 5 • Tables 7 & 8 use the variables defined by BRC • Minimum audit committee size • Minimum accounting expertise • Minimum number of audit committee meetings

22. Conclusions • Our results show firms with the following audit committee characteristics have more accurate reserve estimation for overstaters and more conservative in loss estimation: • Larger audit committee size • More audit committee accounting expertise • More audit committee diligence

23. Policy Implications • Our results also suggests that the requirements by BRC (1999), SOX (2002) and SEC (2003) on corporate audit committee are reasonable