Juan Zhang's Abstract
Accounting conservatism can be unconditional or conditional. Unconditional conservatism refers to the overstatement of liabilities regardless of news and creates a cushion against future losses. In contrast, conditional conservatism means that firms use lower verification standards for reporting expected losses than gains. Rather than being used as a cushion, conditional conservatism provides timely information about bad news in the financial report; thus, it may reduce the information asymmetry between the firm and outside parties. In this paper, we focus on conditional conservatism and investigate whether it can reduce the insolvency risk of the property-liability insurance companies. Due to its informational role, conditional conservatism may alleviate the tension between insurers and regulators and hence decrease the probability of insurers receiving regulatory action. The P&L insurance industry is a perfect industry setting for studying accruals because we can track the development of accruals of specific insurance policies for ten years. The data enable us to develop a new measure of conditional conservatism, which is the concavity of the loss development curve. Compared to the traditional model, the new measure can explore time-series and cross-sectional variations in conditional conservatism and is independent of an insurer’s initial reserving strategy. We find that conditional conservatism reduces the probability of insurers being deemed as financially impaired. We also use the financial strength rating to proxy insolvency risk. The result shows that relative to the industry median firm, conditionally conservative insurers are more likely to have a superior rating and less likely to have a vulnerable rating.