Asbestos and Environmental Reserves Increases and Shareholder Wealth L. Lee Colquitt Robert E. Hoyt Kathleen A. McCullough Auburn Univ. Univ. of Georgia Florida State Univ. Casualty Loss Reserve Seminar September 23, 2002 Arlington, VA

Research Purpose and Motivation Potential uncertainty as to the actual asbestos and environmental (A&E) liability of insurers given the current legal environment and differing contract interpretations Significant A&E reserving activity by insurers during the years 1992 through 2000

Research Purpose and Motivation Estimates in 2001 that insurers are underreserved for A&E by $57B (A.M. Best) The market reaction to A&E liability reserving by insurers has not been studied Present study evaluates the effect of A&E liability reserve changes on insurer stock prices

Prior Research A&E reserves and the industry Standard & Poor’s (1995) Anderson (CPCU Journal, 1996) Simpson (Best’s Review, 1996) American Academy of Actuaries Environmental and Mass Tort Liability Work Group (Best’s Review, 2001) Coyle (S&P’s Ratings Direct, 2001)

Prior Research Discretion in reporting reserves Smith (Journal of Risk and Insurance, 1980) Weiss (Journal of Risk and Insurance, 1985) Grace (Journal of Risk and Insurance, 1990) Petroni (J. of Accounting and Econ., 1992) Gaver and Paterson (Contemporary Accounting Research, 1999) Christensen, Hoyt, and Paterson (Journal of Business Finance and Accounting, 1999)

Prior Research Transparency of financial accounting information (financial opacity) Fenn and Cole (J. of Financial Economics, 1994) Avila and Eastman (J. of Risk and Insurance, 1995) Polonchek and Miller (J. of Risk and Ins., 1996)

Prior Research Event study methodology Asquith, Burner, and Mullins (Journal of Financial Economics, 1983) Asquith and Mullins (J. of Financial Econ., 1986) Henderson (Journal of Risk and Insurance, 1990) Cagle (Journal of Insurance Regulation, 1996)

Empirical Hypotheses (Effect of A&E Liability Reserve Increases) H01: No effect x the announcement contains no new information H02: Positive excess returns x the announcement causes the market to reduce its estimate of future liability or reduces the variance in its estimates of future liability H03: Negative excess returns x the announcement causes the market to increase its estimate of future liability

Empirical Hypotheses (Effect of A&E Liability Reserve Increases) Impact on Stock Price: Positive Announcing firm: - the market overestimated the expected A&E liability for the insurer - the market had adjusted for the expected A&E liability but it expects that the announcement will decrease taxes Non-announcing firm: - the market overestimated the expected A&E liability for the entire industry

Empirical Hypotheses (Effect of A&E Liability Reserve Increases) Impact on Stock Price: Negative Announcing firm: - the market underestimated the expected A&E liability for the insurer Non-announcing firm: - the market underestimated the expected A&E liability for the entire industry

Empirical Hypotheses (Effect of A&E Liability Reserve Increases) Impact on Stock Price: No effect Announcing firm: - the market has already properly assessed the A&E liability for the insurer Non-announcing firm: - the market has already properly assessed the A&E liability for the insurer - (if found with a positive move in stock price for the announcing firm, this is supportive of the tax hypothesis)

Annual Statement A&E Exhibit (Footnote 24) Five-year A&E reserves and payments history Effective for 1995 annual statements Additional information available to the market

Event Dates (pre-footnote 24) Event Date Amt of increase ITT Hartford 10/1/92 $582 M Aetna 2/3/93 $180 M CNA 2/8/93 $1.5 B Travelers 10/14/93 $325 M Swiss Re America 4/12/95 $700 M Fireman’s Fund 6/23/95 $800 M Aetna 7/13/95 $750 M Cigna 10/2/95 $1.2 B Nationwide 12/12/95 $1.1 B American Re 1/30/96 $587 M Aetna 2/8/96 amt unknown

Event Dates (post-footnote 24) Event Date Amt of increase Reliance Group 6/27/96 $134 M Allstate 10/9/96 $245 M ITT Hartford 10/21/96 $543 M Reliance Group 6/15/99 amt unknown AIG 10/27/00 amt unknown

Market Model Rit = i + i Rmt + it , i = i = t = 1,…,T where Return on shares of insurer i at time t, (Pricet+1 – Pricet + Dividend)/Pricet The CRSP equally-weighted market return at time t i = A coefficient representing the return of insurer i that is independent of the market i = A constant representing the market sensitivity of insurer i Number of time periods An error term

Excess Returns ARit = Rit – (i + i Rmt ) Abnormal Returns (AR): Cumulative Abnormal Returns (CAR):

Data Daily stock returns for 25 insurers from 1992 through 2000 (CRSP Tapes) 50 largest writers of “other liability” Traded on one of the open stock exchanges Referenced in 1995 S&P environmental liability report Daily equally-weighted market returns based on CRSP market index

Results Cumulative Abnormal Returns for Announcing Insurers (Insurer’s own announcement) Announcing Insurer CAR (-1,0) Event Date Aetna -.0283 2/3/93 CNA -.0317 2/8/93 Travelers .0129 10/14/93 Fireman’s Fund (Allianz) -.0046 6/23/95 Aetna -.0313 7/13/95 CIGNA -.0008 10/2/95 Aetna -.0103 2/8/96 Reliance Group .0186 6/27/96 Allstate .0296 10/9/96 ITT Hartford -.0144 10/21/96 Reliance Group++ -.2222 6/15/99 AIG -.0532 10/27/00

Results CNA Announcement (2/8/93) Insurer CAR (-1,0)* Aetna -.0095 AIG -.0238 CIGNA -.0224 Fireman’s Fund -.0161 Reliance .0193 Travelers -.0294 Average CARs for -.0139** non-announcing insurers * CARs for the announcing insurers are significant at p=.01 ** CARs for the non-announcing insurers are significant at p=.05 For the other 14 announcements (other than CNA and Swiss Re) the CARs for the announcing and non-announcing insurers are not statistically significant

Swiss Re Announcement (4/12/95) Results Swiss Re Announcement (4/12/95) Insurer CAR (-1,0)* AIG -.0268 Allstate -.0123 Aetna -.0062 CIGNA -.0140 CNA -.0064 Fireman’s Fund .0009 Reliance -.0290 Travelers -.0124 Average CARs for .0090 non-announcing insurers * CARs for the announcing insurers are significant at p=.01 For the other 14 announcements (other than CNA and Swiss Re) the CARs for the announcing and non-announcing insurers are not statistically significant

Summary Negative cumulative abnormal returns for the announcing firms observed for nine out of twelve total announcements (seven significant) Negative cumulative abnormal returns for the announcing firms observed for six out of seven pre-footnote announcements (85.7%) Negative cumulative abnormal returns for only three out of five post-footnote announcements (60%)

Summary Contagion effect observed for two watershed announcements (CNA and Swiss Re – both pre-footnote 24) No contagion effect observed in any other announcements (including the post-footnote 24 period) Some evidence of pre-footnote 24 “house-cleaning”

Implications for Actuaries Market does not fully detect A&E underreserving Accurate reserve statements are critical Insurers have an incentive to understate or delay A&E reserve increases Actuaries must be aware of this potentially conflict in incentives

Future Research Expand sample to observe effects of recent announcements on stock prices (2001) Utilize data in A&E exhibit (footnote 24) to refine exposure assessment