Throughout 2017 and 2018, the Dow broke numerous records as it soared above 26,000, rising from 25,000 to 26,000 in just seven days. Things were good. Then a mix of things happened last week, causing the Dow to plunge more than 1,000 points in a day – twice – and ending the week just above 24,000. This is referred to in the equity markets as “correction territory,” which is a 10% decline from the previous highs. This type of volatility is exactly what insurance companies need to be aware of as FASB ASU No. 2016-01 becomes effective for public entities in 2018, and non-public entities in 2019.

What gives?

Most indications are that the economy is not in trouble (as it was heading into the stock market crash in 2008). Corporate profits remain strong, global growth is on the upswing, and economic growth is forecasted at a 4% pace in the first quarter, per the Atlanta Federal Reserve. There are numerous theories as to why the drop occurred last week. Most believe there is not one single event, but rather, a line of dominos triggering a wave of sell-offs for the week:

• The January jobs report released on February 2, 2018 showed more jobs were added than expected, and wage growth was stronger than expected.
• Combined with Treasury yields increasing (multi-year highs), the jobs report may have confirmed bond market fears that inflation is on the rise.
• This may have caused markets to predict that the Federal Reserve may raise interest rates more aggressively.
• There are various other factors that played a role in last week’s volatility as well, including the continued impact of the new Tax Cuts and Jobs Act, a possible government shutdown (which was ultimately avoided), and new leadership arriving at the Federal Reserve, among others.

All in all, analysts say we are ending an era of low interest rates at the same time that stock market valuations may be too high, which can lead to increased volatility. One analyst quipped that stock market volatility “is back with a vengeance.” This higher volatility “is here to stay,” another noted, and it is important for insurance companies to understand and pay attention to.

New accounting standard

Beginning in 2018 (public companies) or 2019 (non-public companies), companies will account for changes in fair value of equity securities in their income statements under U.S. GAAP, rather than as changes to other comprehensive income (a component of accumulated other comprehensive income and equity) as they are today. Thus, insurance companies that hold a portfolio of equity securities will be introducing this volatility into their determination of net income. Public business entities are required to adopt this new treatment as of January 1, 2018, by way of a cumulative-effect adjustment to the balance sheet. This is likely a positive position given the strength of the markets at the close of 2017. The Form 10-Q, as of March 31, 2018, could be a different story, however, given all the volatility that continues to occur this year. For non-public entities, the implementation of the new standard is required as of January 1, 2019 (but can be adopted early on January 1, 2018 if desired). Since the same cumulative-effect adoption adjustment to the balance sheet is required, it is very important for non-public insurance companies to monitor the performance of the markets throughout 2018 and adjust their investment strategies accordingly. If volatility and sell-offs continue, unrealized equity positions at the December 31, 2018 mark could look quite different than they did a year prior. The new standard creates a new section within the Accounting Standards Codification, Topic 321, Investments—Equity Securities. Holding gains or losses are now defined as the net change in fair value of a security and does not include dividend or interest income recognized but not yet received or write-downs for impairment. The holding gains or losses shall be included earnings.

What about bond markets?

The accounting for investments in fixed maturity securities is unchanged, but that does not mean there won’t be reasons to monitor the performance of your bond portfolios. As indicated above, changes in interest rates and the performance of stock markets are inherently intertwined with bond market results. There is another important factor to keep in mind as well – and it relates to the Tax Cuts and Jobs Act (“the Act”). Multinational companies such as Apple and Microsoft will now be required to pay a one-time tax on income they’ve previously accumulated overseas. Also, the Act does away with the provision that allowed companies to put off paying taxes on their offshore earnings until they brought the money “home.” Under old tax law, earnings attributed to foreign subsidiaries could be repatriated and remain earmarked as “held overseas” as long as they were invested in U.S. Securities. Because of the new tax law, changes in large corporation treasury fund management could lead to swings in the bond market. For instance, a multinational corporation may no longer tie itself up in knots (cash trapped in a foreign corporation, invested in securities that they can’t use). There is now little incentive under the Act to hoard that type of cash just to avoid the IRS, because taxes will now be paid on those earnings going forward. Estimates put the dollar amount of overseas funds held by multinationals in the trillions, and analysts say that the best use of those funds is to distribute it to shareholders in the forms of buybacks and dividends – which is counter to the White House administration’s promises that the Act will ultimately lead to new jobs and additional investment in business infrastructures.

The bottom line for insurance companies

• Close attention should be paid to performance of stock and bond portfolios in the coming months.
• Stock market volatility is here and likely not going anywhere.
• Volatility is going to impact companies with investments in stocks, especially insurance companies, as going forward, the net changes in fair value will be reported in earnings (net income).
• The transition guidance for the new standard requires a cumulative-effect adjustment to the beginning of period balance sheet, which could look very different for implementation dates 2018 (public) and 2019 (non-public).

For more information, please contact MCM Senior Manager Marcus Bickwermert via e-mail or phone (502.882.4412).

Sources:

Bloomberg Business Week – “When Apple’s Cash Comes Home” Jan. 22, 2018

www.bloomberg.com – “What Just Happened? Six Views on How the Correction Finally Came” Feb. 8, 2018

money.cnn.com – “Stocks flew too close to the sun. Now what?” Feb. 9, 2018

finance.yahoo.com – “This past week’s stock market chaos, explained” Feb. 10, 2018