Is Sarbanes-Oxley Insurance Risky?

The Sarbanes-Oxley Act of 2002 (SOX)—whose chief sponsors, former Sen. Named for Paul Sarbanes (D–Md.) and former Rep. Mike Oxley (R–Ohio)—intended to restore public trust in transparency. After the collapse of WorldCom and Enron Corporation, trading companies revealed that auditors had certified financial statements that overstated the companies’ assets and grossly understated their liabilities.

But, of course, “transparency” is not the same as sensible security and harmony. In the insurance industry, more specifically, transparency does not necessarily equal creditworthiness.

A New paper Martin Grace of Temple University and Juan Zhang of Eastern Kentucky University look at how property and liability insurers have responded to SOX’s enhanced disclosure and attestation requirements and new audit rules subsequently adopted by state insurance regulators. The latter is closely modeled on SOX, but has also been applied to non-public insurance companies, primarily mutuals.

They reach a counterintuitive conclusion: greater disclosures have made insurers less cautious in their underwriting practices.

Grace and Zhang focus on the impact that the annual internal control reports required by both Section 404 of SOX and the National Association of Insurance Commissioners’ (NAIC’s) Model Audit Rule (MAR) have had on insurers’ potential for “conditionally conservative” accounting practices. , in which unrealized losses are recognized more quickly than unrealized gains. Because both Section 404 and MAR impose penalties for financial misconduct that apply individually to CEOs and CFOs, it would be reasonable to assume that the provisions would force regulated entities to be conservative in their financial reporting.

In fact, that’s what Gerald Lobo of the University of Houston and Jian Chow of the University of Hawaii at Mānoa discovered. 2010 paper In Journal of Accounting, Auditing and Finance. Looking at a set of public companies listed in Canada and the United States, they found that companies with U.S. arms, and therefore subject to SOX, were more likely to understate the amount of “differential” accruals they report. In the pre-SOX era, the effect was most pronounced among companies that had been more aggressive in recognizing such accruals, which were easily manipulated.

But Lobo and Chow’s studies did not focus on any particular sector and Grace and Zhang were able to use firm-specific information on agglomeration to determine the extent to which conditional conservatism prevails using industry- and market-based indicators. Loss-advancement disclosures of property and liability insurers are reported in Schedule P in Part 2 of the NAIC Statutory Annual Report.

Under the NAIC’s statutory accounting principles, insurers are required to make annual updates to their estimates of losses from a given accident year over the past 10 growth years. Because not all claims are reported during the coverage period, and because reported claims can take years to settle, indemnity-balance estimates become more accurate over time, as claims are paid and more information is known about the amount of “true” losses.

When this information becomes available, insurers may be surprised with the “good news” that they are initially overbooked for an accident year, or the “bad news” that they are short of reserves. Under conditional conservative accounting, they move immediately to address deficiencies, but wait to release excess “slack” reserves until the apparent “good news” is verified—That isWhen all losses are paid.

But Grace and Zhang found that the effect of improved financial transparency rules is that insurers use less conditional conservatism, release reserves more quickly in “good news” and take required reserves more quickly in “bad news.” They have seen a particularly strong effect since the NAIC promulgated the Model Audit Rule, which was adopted in 2010 in all states except Alaska, which adopted it in 2011, and New Hampshire, which adopted it in 2017. Colombia also adopted the rule in 2011.

The authors theorize that this effect is due to the fact that the safe harbor that SOX Section 404 and MAR provide fund managers may reduce their prior incentive to adopt conservative underwriting practices.

“In other words, advance reporting requirements will help insurers convince state commissioners that their accounting is correct; As a result, insurers may not have to react quickly to expected losses in the absence of new rules,” write Grace and Zhang. “Insurers may consider compliance with SOX Section 404 and MAR as conditional conservative strategic alternatives to dealing with state commissioners and rating agencies.”

In a sense, Grace and Zhang’s findings suggest that the accounting reforms of the 2000s did precisely what they were designed to do: make firms’ financial reporting more accurate and transparent. When insurers practice conditional conservatism, the effect is to inflate their reserves and thus distort the value of the firm.

But those distortions can increase debt by providing a buffer against future unexpected losses—especially catastrophes or major lawsuits. After the post-Enron reforms, state insurance regulators may have more closely copied an audit model designed to provide accurate valuations of public companies.