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13th June 2018
Fitch says a change in accounting for equity securities is adding volatility to 2018 net earnings for many (re)insurance companies that report under U.S. GAAP
A change in accounting for equity securities is adding volatility to 2018 net earnings for many (re)insurance companies that report under U.S. GAAP, particularly those with significant allocations to equity investments, Fitch Ratings says.
As part of efforts to promote convergence of the US with international accounting practices, as of 1st January this year, companies must recognize changes in the fair value of equity investments through their income statement. Previously, companies were allowed to reflect these changes directly onto the balance sheet through accumulated other comprehensive income(AOCI). Gains and losses on equity investments were only recognized through the income statement when those were realized through a sale or impairment.
FASB states in the updated guidance that the change is intended to improve financial reporting by providing relevant information about an entity's equity investments and reducing the number of items that are recognized in other comprehensive income.
As equities are among the more volatile asset classes in insurers' investment portfolios, Fitch believes that operating earnings, rather than net earnings, will be an increasingly useful measure to observe relative company performance. Operating earnings removes the impact of realized and unrealized gains and losses that run through the income statement. In calculating fixed charge coverage, Fitch will continue to focus on operating EBIT and will exclude the change in fair value of equity securities in the numerator of this ratio as well as realized gains and losses.
Fitch generally excludes after-tax realized gains along with other non-recurring items from its calculation of operating earnings. Management activity to initiate specific investment sales that generate gains and losses within a period is viewed to fall outside of core insurance activities. Similarly, changes in equity market values and unrealized gain/loss levels over a period are also less related to underwriting and investment income for assets supporting loss reserves, and are greatly affected by external investment market changes.
An analysis of a group of 38 property/casualty (re)insurers' financial results reveals that reported pre-tax income(PTI) of $6.3bn for this group in first-quarter 2018(1Q18) would be approximately $9bn higher excluding this accounting change. This group reported a 59% decline in reported PTI between 1Q18 and 1Q17. Adjusted to exclude the accounting change, PTI increased by 8% for the period versus 1Q17. The adjusted value allows for a consistent comparison to the prior year period as the FASB guidance does not allow restatement of prior year figures.
With the equity markets generally declining in the first quarter(1.6% decline in the S&P 500), 32 of the 38 companies that were reviewed reported a reduction in earnings from a decline in fair value of equities. Two companies with above industry average equity allocations, Cincinnati Financial Groups in PTI from their reported to adjusted values estimated at -134% and -124%, respectively, showing the newly introduced volatility on their income statements.
If the accounting rule had been in effect for full-year 2017, property/casualty (re)insurers would have experienced a significant earnings benefit given the generally strong performance of equities during the year(19.4% increase in S&P 500). Fitch estimates that the group of 38 insurers would have reported an approximate $33bn boost to pre-tax earnings from unrealized gains in equities for full-year 2017. BRK represented the largest component of the gain at around $29bn, which was approximately 122% of the company's full year PTI. CINF's unrealized equity gains were approximately 112% of reported PTI.
In reviewing 1Q18 income statements for the group, Fitch observed differences in how companies present the change in fair value of equities. Some companies listed the change as a separate line item, while others included it with realized gains and still others embedded it in investment income. These are inconsistencies in geography that do not affect reported earnings.
In 1Q18, balance sheet entries also changed as companies effectively realized the cumulative effect of after-tax gains and losses from equities by shifting them into retained earnings from AOCI. Once again, this was a change in geography where the components of shareholders' equity changed but the overall level was unaffected.
Individual property/casualty insurers' asset allocation to equity securities and other risk assets can vary widely. Measurement of total investment return including interest and dividend income and realized and unrealized investment gains provides the best reflection of overall investment performance and volatility. The risk appetite for equity investments also has a strong influence on growth in shareholders' equity and book value per share for insurers.
Nearly all of the publicly held property/casualty (re)insurers classify equity securities in their investment portfolios as available-for-sale. Exceptions include several reinsurers based in Bermuda, and domestic insurers ProAssurance Corporation and Mercury General Corporation, which already report equity fair value changes through the income statement with the use of the 'Trading' classification. These companies did not report a meaningful change in reported 1Q18 PTI, but will now have more comparable investment related earnings volatility with the wider GAAP filing property/casualty industry.
Fitch Trends(308 articles)