The determinants of auditor choice and audit pricing among property-liability insurers

Audit fee research has shed light on the relationship between unobserved audit effort and underlying factors such as incentive conflicts, risk and complexity, and auditor reputation. However, few studies have examined the audit fee within the context of a specific industry, particularly a regulated industry such as insurance. This paper presents an endogenous switching model derived from a sample of 2993 US property-liability firm-years for insurers filing required Annual Statements in years 2006 and 2007. A first-stage auditor choice regression (Big 4 versus Non-Big 4) is followed by a second-stage model of the audit fee, with separate equations for Big 4 and Non-Big 4 clients. The results indicate that both choice and the fee depend on industry-specific client characteristics. Insurance-related measures of risk and complexity are associated with the choice of a large auditor, while opportunistic behavior and owner-manager incentive conflicts are associated with the choice of a smaller auditor. Insurers that resemble typical Big 4 clients are subject to a large-auditor premium, while those that resemble typical Non-Big 4 clients are subject to a Non-Big 4 auditor premium. Auditors profit from their pricing strategies, since the main drivers of the Big 4 premium (the Non-Big 4 premium) are the factors that led the insurer to choose the large auditor (the smaller auditor) in the first place.