Happy (and Not So Happy) New Year Changes for Insurer Investments

By Alton Cogert | acogert@saai.com

Happy New Year!

As 2018 dawns, insurers face some rather interesting changes, real or potential, that can cause a slight rethinking of investment strategies. And, of course, these will not apply to all insurers, or all insurers in the same way. So, please remember to always contact a professional before acting on any of these ideas.

Financial Reporting of Investments

Up first and, for some, coming out of left field, is ASU 2016-1. This Accounting Standards Update for GAAP filers will generally require insurer investments in most equities to be marked to market with changes in value recognized through net income (not other comprehensive income). Of course, this ASU is quite a bit more complicated than that, but therein lies one of the major issues for insurers. Realizing this will result in greater volatility of earnings, you might already be pining for the ‘good old days’ of 2017. This ASU is applicable for public entities starting in 2018. All other entities will have to wait until 2019 before seeing their GAAP net income go through this accounting induced volatility ringer.

If your company has a non-US parent, it is probably filing financials that are consolidated with your parent under International Financial Reporting Standards and your company is subject to IFRS 9 on Financial Instruments. Starting January 1, IFRS 9 generally requires gains and losses on equities to be recognized through the income statement.

For fixed income, IFRS 9 requires an allowance for credit losses equal to twelve months of expected credit losses, until there is a significant increase in credit risk, at which point lifetime expected losses are recognized. So, the next time your investment manager says, ‘we never take credit losses,’ you have every right to look at them cross eyed. Your response might be ‘Well, somebody takes credit losses, because we have to reserve for them.’ In other words, like a commercial bank must have a reserve for loan losses, insurers must have a reserve for bond losses. Those corporate bonds don’t provide a premium interest rate over US Treasuries just because it is a tradition. There are imbedded losses which now must be considered in the financials.

But wait, you might say, that only applies to international firms. We don’t consider such things in the good old U.S. of A. ASU 2016-13, Financial Instruments – Credit Losses, has its own take on handling current expected credit losses (CECL). This ASU requires that the full amount of expected credit losses (not just losses expected in the next year) be recorded for all financial assets measured at amortized cost. Once that reserve is set up, changes in it will go through net income. For publicly held insurers, this ASU is effective in 2020 and for all other insurers it will be effective in 2021. So, you have at least two more New Year’s eves to enjoy before CECL interferes with your revelry and income statement.

Risk Based Capital Ratios

At Strategic Asset Alliance, the insurance investment specialist, we have always been careful to defer detailed questions about income taxation of insurers to the tax experts. And, we shall continue to do so. However, there are times when a material change occurs for which we should not remain silent. And, this is one of those times.

If you have been anywhere near an information source over the last two weeks, you are well aware that the top corporate tax bracket is being reduced from 35% to 21%.

There are many instances where this will impact investments. Of course, there will be a varied impact on the net income earned by each of the companies’ bonds and equities we invest in. However, more directly, for insurers the lower tax rate will mean:

  • A lower value of that strange looking item, if you have it on your books, called, ‘Deferred Tax Asset.’ One would expect that a write down of that asset would ultimately result in a reduction in surplus (Statutory accounting) or shareholders’ equity (GAAP). This would have the unintended consequence of reducing the risk based capital ratio used by both the regulators (NAIC) and rating agencies. So, let’s cheer a lower tax rate while moaning about a lower BCAR.
  • C-1 factors in the NAIC’s risk based capital model are designed to be after tax. A lower tax rate means that there is less of a cushion against those expected loss factors, so please do not be surprised if this topic is taken up at the next NAIC meeting (or prior). Life insurers take note, while P/C insurers need to worry less here due to the covariance factor for investments in their RBC calculation. And, speaking of risk based capital factors, let’s not forget…
  • The newly unveiled AM Best BCAR model includes various factors for investments which are all after-tax, as well. A lower tax rate means those factors will undoubtedly be adjusted upward. And, once again, due to the way the BCAR calculation is structured, the impact of this would be felt more by Life insurers than P/C insurers. But, P/C insurers won’t get off that easily, because of what the new tax law does with tax-exempt municipal income.

Municipal Bonds

The P/C proration on tax-exempt muni income has been increased from 15% to 25%, so that the effective tax rate on tax-exempt municipals for P/C companies remains at 5.25% (=25% x 21%). While this may have proven Congress’ arithmetic skills, it causes a change in relative attractiveness of tax-exempts and taxables, to the detriment of municipals.

In this example, we’ve chosen an arbitrary pre-tax yield on munis of 2.5% and ask the question, “What yield on taxables is equivalent to the muni yield, after tax, and how do the yields compare to each other?”

As you can tell, the bottom line is that before New Years Day, the muni need only yield greater than 69% of the taxable to be more attractive, solely from a yield perspective. However, Happy New Year to municipalities who want to issue tax-exempt bonds, your hurdle has now grown to 83% for a P/C insurer.

Of course, insurers make up about 20% of muni market investors, so the market impact of a less interested group of P/C insurers may not make a great difference in the overall performance of that asset class. However, from the P/C insurer’s perspective, it truly is a new day.

Adding to that theme, the new tax bill has eliminated the corporate alternative minimum tax (AMT). Those days of finding the ‘optimal’ muni allocation that minimizes AMT and regular income tax have apparently gone the way of the dodo bird. So, put down your pencils and spreadsheets. There is no need to perform that infamous ‘cross over’ analysis. A tax-exempt muni either makes sense or does not based upon a host of factors, adjusted for tax, of course.

We’ve Only Just Begun

To be sure, over the next few months, expect to see a lot of interesting papers and ideas about these and other related areas. It will be up to you and your trusted advisors to sift through these ideas and decide how they might impact your company’s investment strategies. However, one thing seems certain. We have indeed entered the land of unintended consequences.