Property-Liability Insurers’ Discretionary and Nondiscretionary Loss Reserve Error: Relation with Investor Sentiment

Abstract

We examine whether investor sentiment is associated with loss reserve estimates of property-liability (P/L) insurers. Using the Michigan Consumer Confidence Index as a proxy for sentiment, we find that the level of investor sentiment is negatively associated with discretionary component of loss reserve error. In contrast, our evidence does not suggest a similar relationship hold for investor sentiment and nondiscretionary loss reserve error. Further analysis indicates that stock insurers are more sensitive to investor sentiment than mutual insurers, in terms of discretionary component of loss reserves. The results are consistent with our hypothesis that P/L insurers cater to investors’ optimism (pessimism), driven by investor sentiment, via discretionary loss reserve claims. For robust test, we also measure investor sentiment by using two alternative proxies: the Conference Board Consumer Confidence Index, and the index in the stock market developed by Baker and Wurgler (2006, 2007). The results are consistent. Our study discovers a new rationale for why insurers may use discretion over their loss reserves.