Earnings Management and Subsequent Risk Assessments: Evidence from the Property-Casualty Insurance Industry

This paper investigates circumstances under which earnings management influences subsequent risk assessments. We predict and find a positive association. That is, earnings management is positively related to an increase in perceived risk in a subsequent period, although our findings are nuanced. Specifically, we examine the association between earnings management and a decline in and Best's Capital Adequacy Relativity (BCAR) and the regulatory-based Risk-Based Capital (RBC) in subsequent periods. In a sample of property and casualty insurance companies during the period of 2008-2012, we estimate the level of earnings management for each firm in that sample year and use it to predict declines in assessed risk in the following period. We find that subsequent BCAR ratings are statistically sensitive to earnings management, while the more mechanical RBC appears not to be statistically associated. However, in a subsample of firms nearing financial distress, we find that both BCAR and RBC are subsequently statistically associated with earnings management. Although perhaps not intended to be a standalone predictor of insolvency, both measures appear to provide important information to both regulators, investors, customers and other stakeholders. We note limitations, including a relatively brief sample, and mention that the RBC formula has since been revised.