Review of Accounting Studies, 5, 95–125 (2000)
2000 Kluwer Academic Publishers, Boston. Manufactured in The Netherlands.
Discretionary and Non-Discretionary Revisions of
Loss Reserves by Property-Casualty Insurers:
Differential Implications for Future Proﬁtability,
Risk and Market Value
KATHY R. PETRONI
Michigan State University
STEPHEN G. RYAN
New York University
JAMES M. WAHLEN
Abstract. We develop and estimate a PC-industry speciﬁc model in which proxies for both discretion and non-
discretion are used to partition loss reserve revisions into discretionary and non-discretionary components. The
use of such proxies enables us to test directional hypotheses about the relations between the revision components
and future proﬁtability, risk and market value. We predict and ﬁnd that discretionary revisions are negatively
associated with future proﬁtability, positively associated with ﬁrm risk, and negatively associated with market-to-
book ratios. We predict and ﬁnd that non-discretionary revisions are positively associated with future proﬁtability
and risk but are not associated with market-to-book ratios.
Keywords: Discretionary accruals, valuation, property-casualty insurance, risk, loss reserves
Prior empirical research ﬁnds that capital markets price estimates of the discretionary and
non-discretionary components of accruals differently. For example, using the Jones (1991)
model of the accrual components on a broad sample of ﬁrms, Subramanyam (1996) ﬁnds
that share returns are less positively associated with discretionary accruals than with non-
discretionary accruals. Using bank-industry speciﬁc models of the allowance for loan
losses, Beaver and Engel (1996) ﬁnd that market values are negatively associated with
non-discretionary allowances but insigniﬁcantly or positively associated with discretionary
allowances. In this study, we extend this research to revisions of loss reserves by property-
casualty (PC) insurers. The loss reserve (the reported liability for unpaid claims) is by far
the largest liability of the typical PC insurer. Loss reserve estimation involves considerable
judgment and uncertainty, and so revisions of loss reserves are frequent and often large.
These revisions are also observable, because the Securities and Exchange Commission re-
quiresthatPCinsurersdisclosein their annual 10-Kﬁlings the reported lossreserves foreach
of the prior nine years and reestimates of these reserves in each year up to the current year.
We refer to loss reserve revisions as non-discretionary if they unbiasedly reﬂect new infor-
mation about claims and as discretionary if they reverse bias in initial loss reserve estimates.