ARIA 2021 Annual Meeting

Martin Grace, Fox College of Business, Temple University; James Leverty, University of Wisconsin

Financial reporting standards require property-liability insurance companies to disclose year-by-year revisions of their estimated future claim payments. These revisions have inspired researchers to use the industry to measure and investigate managerial discretion.  The most widely used measure of managerial discretion in the insurance literature is reserve error --  the difference between a firm’s estimate of losses reported in the current period and a revised estimate reported in the future. We argue that the reserve error does not comport with how insurers establish loss reserves. Moreover, the reserve error uses reported numbers representing ex post information (i.e., information after the manager exercised decision). The measure is also greatly influenced by intervening events that are outside the control of management. We propose a new measure of managerial discretion that is consistent with reserving practices at insurance companies. The new measure captures the distinction between choice and decision while also accounting for the latitude that managers have in making their decision. We compare the two measures and find that our new measure is consistent with the hypothesized incentives to practice discretion.