The Influence of Auditor State-Level Legal Liability on Conservative Financial Reporting in the Property-Casualty Insurance Industry

Abstract

SUMMARYThis paper provides the first evidence that state-level liability standards affect auditor behavior. We hypothesize that auditors demand more conservative reporting when their insurance clients are domiciled in states with more stringent standards for third-party claims against the auditor for negligence. To test this hypothesis, we analyze a sample of 3,107 loss reserve observations from 1993 through 2004. Our sample is restricted to private insurers that operate in a single state to control for auditor liability under statutory law and to reduce the possibility of forum shopping by plaintiffs. Consistent with Petroni (1992), we find that financially struggling insurers tend to under-reserve. This behavior is attenuated when the insurer is domiciled in a state that uses either the Restatement of Torts or the reasonable foreseeability standard to determine the auditor's liability to third parties. Compared to the case where the auditor's liability is defined by the legal concept of privity, these standards impose greater legal costs on auditors for ordinary negligence.JEL Classifications: M41; M42; G22; K13.