Loss Reserve Error in the Brazilian Insurance Market: empirical evidence of the response to economic and tax regulations.
| Autor | Curvello, Rodrigo da Silva Santos |
1 Introduction
Earnings quality may be impacted by aspects related to the management of reported accounting numbers because their informative content is directly related to the subjective component of profit, i.e. accruals, which increase or decrease the information asymmetry between the firm and the market (Lopes & Martins, 2005).
Investigating managerial discretion in relation to accruals becomes even more relevant if viewed from the perspective of the potential impact on risk-based economic regulation (supervision). This supervisory model addresses the solvency of insurers by comparing regulatory capital, based on the risks to which insurers are exposed, with their available capital, defined as the difference between the accounting balances of eligible assets and liabilities (Melo & Neves, 2012).
Among the liabilities reported by insurers are the technical reserves related to claims (losses), whether these are reported by insureds (Outstanding Claims Provision--OCP) or not (Incurred But Not Reported Loss--IBNR). These reserves are initially measured by estimate and subsequently revised as new information becomes available on the severity and rate of reported losses until they are actually settled. In the international literature, the amount added or subtracted from the initial measurement is called the loss reserve error (Grace & Leverty, 2012).
As noted by Rodrigues (2008), the amounts recorded in such reserves directly affect the net income of insurers and, therefore, the equity used for measuring their solvency, thus also affecting the reviews.
In addition, since 2008, this kind of measurement has been used as a parameter for several supervisory measures in the Brazilian insurance market (CNSP Resolution No. 178, of 2007). Thus, managers who work in this market may be encouraged to manage their earnings in order to avoid drawing the regulatory authority's attention to a potential difficulty in making future payments in connection with incurred liabilities.
Also, the corporate income tax (IRPJ) and social contribution on net profits (CSLL) regulations stipulate that the technical reserves recorded by insurers shall be deducted in the determination of taxable income (Decree No. 3000, 1999). Therefore, as reported in the study by Gaver and Paterson (1999), managers may use the discretion inherent to the measurement of claim reserves with the intention of reducing income tax payments.
In view of the above, this study intends to answer the following research question: is there any evidence that Brazilian insurers manage earnings through claim reserves as a response to economic and tax regulations?
Therefore, the main objective of this research is to investigate whether the insurers that operate in property and casualty insurance adopt the practice of managing accounting information by means of claim reserve accounts (OCP and IBNR) in response to the risk-based economic regulations and income tax regulations imposed by the federal government.
It is important to mention that this research differs from that of Rodrigues (2008), mainly due to the use of the loss reserve error as a dependent variable in the proposed model and the model proposition that considers joint tax and regulatory incentives and income smoothing, as considered in international studies. Moreover, in this study, unearned premium reserves (UPR) were not used because they differentially affect insurers' results due to the accrual basis and the recognition formula established in SUSEP's rules, with less discretion except as to current risks with policies not yet issued.
In this sense, the research is potentially capable of filling gaps in the understanding of the subject at the national level, due to the lack of Brazilian research that use specific accruals models in which the dependent variable comprises estimation errors to study the impacts and aspects that affect managers' opportunistic behavior regarding the measurement of insurance claim reserves.
2 Theoretical Framework
2.1 Regulation in the Brazilian insurance market
Preliminarily, it is necessary to clarify what is being referred to as economic regulation. According to Posner's studies, "properly defined, the term refers to taxes and subsidies of all sorts as well as to explicit legislative and administrative controls over rates, entry, and other facets of economic activity" (Posner, 1974, p. 335).
Among the theories of regulation is the Public Interest Theory, for which regulation allows private initiative to respond by supply, but restricts the choices of regulated companies, deciding on pricing, the entry and exit of companies in the market, and the establishment of products and services, among others (Stigler, 1971).
This theory resembles the private powers of the National Council for Private Insurance (Conselho Nacional de Seguros Privado--CNSP), including: (a) establishing general norms of accounting and statistics to be observed by insurance companies; and (b) limiting the capital of insurance and reinsurance companies. It should be emphasized that while the CNSP regulates the market, the Superintendency of Private Insurance (Superintendencia de Seguros Privados--SUSEP) supervises and issues instructions via circular newsletters (Decree-Law No. 73, 1966).
A mechanism to reduce informational asymmetry and delimit the capital of supervised parties allows the State to monitor the liquidity, solvency, and investments of those parties, especially the assets legally related to technical provisions, in addition to preserving the interests of consumers, promoting the stability of that market, and ensuring the liquidity and solvency of the companies that make up the market, thus ensuring balanced expansion and functioning.
In response to the financial crises that occurred in the 2000s, the supervisory mechanisms of the global insurance market have undergone significant changes with the prospect of adopting the Solvency II project. According to the European Insurance and Occupational Pensions Authority (EIOPA, 2013), "The Solvency II project aims to review the prudential regime for insurance and reinsurance companies in the European Union.". Directive 2009/138/EC of the European Parliament and of the Council of the European Union, approved in November 2009 and in force since 1/1/2016, establishes the project guidelines.
In general, three pillars support the project: a quantitative pillar with calculation methodologies for capital requirements based on underwriting, credit, operational, and market risks and technical provisions (Pillar 1); a qualitative one with guidelines for supervisory activities and controls based on these risks (Pillar 2); and a final one associated with the disclosure of information, including financial reporting (Pillar 3).
At this point, it is appropriate to establish the relationship between the accounting information of the insurance market and the economic regulation currently practiced.
Since 2008, according to CNSP Resolution No. 178 (2007), the Minimum Capital Requirement (MCR) has been compared to the Capital Resources Available (CRA)--an adjusted equity measure--and, if the balance is positive, there is sufficiency in the solvency parameter; otherwise, there is insufficiency. Depending on the number of months of insufficiency in the parameter, the regulator may initiate actions in order for the company's capital to return to the desired level (CNSP Resolution No. 282, 2013).
Therefore, the ratio is determined by calculating the CRA, which is the equity minus assets that are not accepted by the regulator to meet obligations assumed in the event of oscillations and adverse situations (CNSP Resolution No. 222, 2010). As equity is the residual interest in the company's assets, after deducting all its liabilities, it suffers all sorts of interference from the discretion exercised over the accounting measurements performed (Accounting Pronouncements Committee [Comite de Pronunciamentos Contabeis--CPC], 2011).
It is important to highlight the regulatory and solvency frameworks of the studied market: risk-based capital requirement rules have been implemented since 1/1/2008, but a good part of risk capital has only been required since January of 2011, and international accounting standards were applied as of 1/1/2010 to consolidated balance sheets and as of 1/1/2008 for individual balance sheets, with a more intense adoption in 2009 (Susep Circular No. 355, 2007; Susep Circular No. 356, 2007; Susep Circular No. 408, 2010; CNSP Resolution No. 178, 2007).
Among the accounting standards adopted are Technical Pronouncement CPC 11--Insurance Contracts, equivalent to the international standard IFRS 4--Phase I, whose main objective was to specify the accounting recognition for insurance contracts by any entity that issued them. It is recalled that the structural changes were postponed to phase II of the comprehensive insurance project, expected for the first half of 2017. Thus, the phase I regulations only introduced limited improvements in accounting for these contracts and encouraged more efficient explanatory note disclosure, capable of more clearly identifying and explaining the values resulting from these contracts in the financial reporting of these companies based on minimum information on the uncertainties in cash flows, risk, and equity position. In Brazil, CPC 11 was initially applied in the preparation of the consolidated statements for 2010 and the individual statements of 2011. Among the additional disclosures required is the claims development table, used in this research as a data source for the calculation as detailed in Appendix A. For Zsoldos (2014), insurers are exposed to the insurance underwriting risk, where the threat of an inadequate technical provision constitutes the most relevant portion. The liability adequacy test (LAT) would be one tool to mitigate this danger of insolvency.
Among other contributions from phase I, Costa (2005)...
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