Fair Value Accounting for Property-Liability Insurers and Classification Decisions under FAS 115

Abstract

The first objective of this study is to describe the substantial differences across property-liability insurers in accounting classification decisions for fixed maturity securities during 1991–1995. This period includes the years before adoption, upon initial adoption, and after adoption of Statement of Financial Accounting Standards No. 115 (FAS 115, “Accounting for Certain Investments in Debt and Equity Securities”). The second and more important objective of this study is to test two risk-based explanations for differences in investment classification decisions under FAS 115. Under this new standard, firms are required to classify fixed maturity investment securities into trading portfolios, available-for-sale portfolios, or held-to-maturity portfolios. These classification decisions determine whether these securities are recognized at fair value or historical cost. On one hand, the decision to classify securities as available-for-sale rather than held-to-maturity (and thus apply fair value accounting) increases the time-series volatility of key accounting numbers such as owners' equity and total assets, which may be costly for insurers with low tolerance for accounting volatility. On the other hand, the choice to classify securities as available-for-sale (and thus apply fair value accounting) reduces liquidity risk because the accounting standards (and SEC enforcement practices) limit management's ability to sell securities that are not recognized at fair value. The empirical analyses examine whether the security classification decisions of the sample property-liability insurers are associated with firm specific characteristics that reflect liquidity risk and the tolerance for accounting volatility. The findings show that managers of property-liability insurers make tradeoffs between liquidity risk and concerns about accounting volatility when making investment classification decisions under FAS 115.

The Reliability of Fair Value versus Historical Cost Information: Evidence from Closed-End Mutual Funds

“…In contrast, prior to SFAS No. 115, banks and property casualty insurers reported most investment securities at cost on the face of the balance sheet with fair value measures being disclosed either parenthetically or in the notes (Godwin, Petroni, and Wahlen [1998]). …”

Fair Value Reclassifications of Financial Assets During the Financial Crisis

“…Godwin et al (1998) find that liquidity risk is negatively associated with, and tolerance for income volatility is positively associated with the probability of a proper--11 -ty-liability insurer applying fair value accounting to fixed maturity investment securities. Gramlich et al (2001) examine the reclassification of short-term obligations into long-term categories and report evidence consistent with firms opportunistically managing balance sheet ratios.…”

The Relationship Between Large Banks Investment In Available-For-Sale Securities And The Interest Rate Risk Of Their Securities

“…The classification of securities as HTM creates liquidity risk because the SEC restricted the ability to sell HTM securities, while the classification of securities as AFS reduces liquidity risks (Godwin et al, 1998). The positive relationship between AFS securities ratio (to securities or total assets) and the interest rate risk of securities may be explained by coordinated risk management theory.…”