Stock Options and Reserve Errors

1
Stock Options and Reserve Errors

• Mark Browne
• Yu-Luen Ma
• Ping Wang

2
Motivation for Study

• Enron
• WorldCom
• Tyco
• Qwest
• Hundreds of others in 2002!!

3
Research Question

• Are stock options associated with reserve errors
  of P/C insurers?

4
Literature Review

• Anderson (1973)
• Weiss (1985)
• Grace (1990)
• Petroni (1992)
• Petroni and Beasley (1996)
• Anthony and Petroni (1997)
• Petroni, Ryan, and Wahlen (2000)

5
Data Sources

• Stock Options
• NAIC Data
• 1993-1998
• Stock and mutual companies
• Companies that underwrite more than 25 of their
  business in surety, credit, accident and health,
  workers compensation or reinsurance are not
  included in our sample

6
Source of Options Data (contd)

• In last fiscal year,
• Whether firm granted stock options
• Whether executives exercised options
• Realized dollar value by exercising options

7
Source of Options Data

• SEC website (www.sec.gov)
• Form DEF 14A filed annually by firms
• Info about executive compensations,
• including stock options

8
Hypotheses

• Two conflicting hypotheses
• Firms that offer stock options are more likely to
  under reserve
• Firms that offer stock options have smaller
  reserve errors

9
Factors Affecting Reserve Errors
10
Descriptive Statistics
11
Average Size of Reserve Errors
12
Empirical Model

• Errori Reseti,j Resdevi, j3.
• ?ERRORi,t? ? UNDERi,t ?1STOCKOPTIONi,t
  ?2TAXi,t ?3SMOOTHi.t ?4MUTUALi,t ?5UIi,t
  OVERi,t ?6STOCKOPTIONi,t ?7TAXi,t
  ?8SMOOTHi.t ?9MUTUALi,t ?10UIi,t
  ?11LONGTAILi,t ?12SIZEi,t ?3GROUPi,t ei,t
• Reserve errors are scaled by
• (1) Total admitted assets (ERROR1)
• (2) 1.6 x maxadmitted assets, net premium
  written2/3 (ERROR2)

13
Conclusion

• Insurers offering stock options have smaller
  reserve errors
• Insurers use reserves to smooth financial
  statements
• Overstated reserves are greater for mutual
  insurers

14
Empirical Results Using Heteroscedasticity-Consist
ent Estimators
ERROR2
ERROR1
Variable
Standard Errors
Coefficient
Standard Errors
Coefficient
-4.96
-3.07
Intercept
0.20
Under Reserve
STOCKOPTION
-0.48
-0.53
0.23
TAX
-1.31
-1.36
0.69
SMOOTH
-1.77
-2.42
1.32
MUTUAL
-0.25
-0.43
0.12
UI
3.09
8.51
0.78
Over Reserve
STOCKOPTION
0.05
0.02
0.05
TAX
-0.89
-1.22
0.27
SMOOTH
0.01
-0.49
0.47
MUTUAL
0.05
-0.12
0.04
UI
-0.69
4.36
0.53
LONGTAIL
0.01
0.05
0.01
GROUP
-0.02
-0.11
0.05
SIZE
0.37
0.01
0.01
0.25
0.06
Adjusted R-Sq