The Impact of Asbestos and Environmental Reserves Increases on Shareholder Wealth

Abstract

Between 1992 and 2001 significant reserves increase announcements were made by several major property/liability insurers. These reserves increases were for the purpose of recognizing expected asbestos and environmental (A&E) liability. Although most analysts agree that U.S. insurers are underreserved for asbestos and environmental liability, how the market reacts to an insurer's announcement of an increase in these reserves has not been analyzed. An insurer that is significantly underreserved is likely to be viewed by the market as lacking financial stability for the long term. However, when a company increases its reserves, there is a charge to income and a reduction in capital. If surplus is diminished sufficiently as a result of the increased reserving, regulatory attention and eroding shareholder and market confidence could result as well. By calculating the sample insurers' cumulative abnormal returns surrounding the largest asbestos and environmental reserves increase announcements made between 1992 and 2001, the study estimates and documents the market's reaction to these reserves increase announcements. We further explore the potential impact of additional asbestos and environmental liability exposure reporting requirements. Starting with 1995 statutory annual accounting statements, Footnote 24 required additional reporting by insurers of their asbestos and environmental liability exposure (1995 statements were publicly available by the end of the first quarter of 1996). When looking at reserves increase announcements prior to this additional reporting requirement, we find that most insurers announcing large increases in asbestos and environmental reserves prior to 1996 experience a significant reduction in stock price in the days surrounding their announcement. However, consistent with the notion that the additional accounting disclosure requirements after 1995 (Footnote 24) provide valuable information on insurers' exposure, we find that the announcement of A&E reserves increases after 1995 had no statistically significant effect on the market value of announcing insurers.

Adverse Selection and the Opaqueness of Insurers

“…Among the practices they observe for selected L-H insurers are deliberately simplistic discounting of reserves, illegitimate surplus relief reinsurance, and commission financing schemes, all of which promote understated reserve liabilities and overstated surplus. Colquitt, Hoyt, and McCullough (2006) explain how managers of property-liability insurers are able to use greater discretion in setting loss reserves, which results in information asymmetry in investment markets. Polonchek and Miller (1996) provide empirical evidence regarding greater information asymmetries with respect to the assets and liabilities of insurers compared to banks.…”

Information and Insurer Financial Strength Ratings: Do Short Sellers Anticipate Ratings Changes?

“…Their results show the price of insurance is inversely related to the riskiness of the firm, and that these results are stronger for long‐tail lines of business than for short‐tail lines. Colquitt, Hoyt, and McCullough () indicate P/C insurers increase the information asymmetry by utilizing greater discretion in setting loss reserves.…”

What Do We Know About Market Discipline in Insurance?

“…Babbel and Merrill (2005) note in this context that the opaqueness and complexity of insurance contracts allow managers to create illusory values. Considering asbestos and environmental reserves, Colquitt et al (2006) document that the market is not consistently able to detect large misstatements of loss reserves of property–liability insurers adequately. Polonchek and Miller (1996) find greater information asymmetries with respect to the assets and liabilities of insurers compared to banks, and Morgan (2002), in a study of disagreement among rating agencies, provides evidence that insurers can be more opaque than banks.…”