Bank-centric Accounting Rule Makes Insurers Hike Loss Reserves

Insurance giants like Metlife Inc., American International Group Inc., and Prudential Financial Inc. are about to set aside higher reserves to cover credit losses under new accounting rules they must follow this quarter.

The increases under the new CECL standard—for current expected credit losses—make up a small part of insurers’ balance sheets. But the numbers, and how they fluctuate, can shine a light on something investors, analysts, and rating agencies care deeply about: how insurers manage risk.

“We want to see how strong the company’s risk management program is,” said George Hansen, senior research industry analyst at ratings agency AM Best. “And that they’re taking corrective action if they’re in a problem market.”

Insurers take money from customers, make promises of future payouts, and then invest the premiums in vehicles like mortgages to generate enough returns to fulfill the promises. The types of investments matter, as do changes in their value. Value fluctuations will get captured under the new accounting like never before.

If an insurer invests in a batch of commercial mortgages in a part of the country where unemployment is expected to spike, it will have to book expected losses on those loans instead of waiting for a customer to miss payments. Analysts can scrutinize the changes and ask questions.

“These kinds of numbers will help us because we’ll see the impact much sooner,” Hansen said.

Two Main Ways

Large publicly traded companies must calculate losses under the new accounting method for their first-quarter financial statements this spring. The rules, produced by the Financial Accounting Standards Board, target much-criticized accounting that masked deep losses on bank balance sheets during the 2008 financial crisis.

Banks will experience the most dramatic changes to their financial reporting, but the rules apply to almost all businesses.

Starting with their first-quarter filings, businesses no longer can wait for signs of trouble before booking losses. Instead, they now must anticipate losses better, considering historical patterns and conditions at the time they write a mortgage or extend credit to a customer to buy a truck or flat-screen TV.

The result: Almost all businesses expect to recognize losses much earlier than they ever have. They also expect ups and downs from quarter to quarter in that loss line.

For insurers, CECL applies to many assets on their books, but it mostly affects two classes.

The first is mortgages and other loans. Any mortgage an insurance company invests in now has to be evaluated to consider expected future losses.

The second is unique to the insurance sector and how companies insure their own businesses. Insurers buy separate policies from reinsurance companies to cover their losses and manage their risks. The money the reinsurance companies pay them is called receivables or recoverables. Under CECL, insurers must estimate the chances of reinsurers not paying them, and then book losses.

Of the large insurance companies that have signaled what to expect in their first quarter reports, most point to mortgages as the reason credit losses will increase. Metlife, AIG, and Prudential all called out losses on mortgage loans. Reinsurance receivables won’t be material, most say so far.

That’s because of the nature of how insurers make deals with reinsurance companies, said Imran Makda, assurance partner at BDO USA LLP.

“They ensure they enter into reinsurance arrangements with other insurance companies that have strong capital provisions and strong ratings,” Makda said. “We historically have not seen significant losses.”

With little loss history and few indicators that things will go south with reinsurers in the future, large insurance companies have given no signs they expect big changes with losses on these assets. Only AIG made a passing reference in its annual report, saying its loss reserve would increase because of commercial mortgage loans and, “to a lesser extent,” reinsurance receivables.

Must Be Evaluated Anyway

Even if the expected losses from reinsurance receivables are tiny or nonexistent, companies must go through the accounting exercise anyway, and must have evidence to back up the estimates. This gives some insurers heartburn.

One company, for example, told its trade association that in its decades of doing business it has never experienced losses on reinsurance receivables. But under CECL, it may have to, said Phil Carson, general counsel for the American Property Casualty Insurance Association.

“They are just loath to record losses on the type of business that, because of its experience, just doesn’t generate losses,” Carson said.

Any movement—no matter how miniscule—could draw scrutiny to the company’s reinsurance risk, he said.

“Reinsurance is a key element of how we manage our business,” Carson said. “Anything that affects how we report or that diminishes the value of reinsurance receivables on our balance sheet will always attract a lot of attention and concern.”

Life Versus Property and Casualty

The type of product an insurer offers also plays a role in how the new accounting rules shake out.

For the most part, insurance companies that sell long-term policies like life and annuities are going to be more affected than companies that write automobile or fire policies. Progressive Insurance Co., which caters to auto and homeowners insurance coverage, said in its March 2 annual report that it would record no allowance for credit losses under the new accounting method.

That’s because insurers tend to match their risk exposure to similarly timed investments, said BDO’s Makda.

To oversimplify, life insurers, whose obligations can last decades, tend to invest in long-term assets like portfolios of mortgages. Insurers that focus on auto policies may invest in stocks. Equity securities, which include common stocks and mutual funds, are measured at fair value under U.S. accounting rules, so they aren’t affected by the CECL rule change.

Many insurers also invest in bonds, which also don’t get measured under the new accounting method.

The results are intuitive for anyone who has been following the nuts and bolts of the new accounting standard. The longer the term of an asset, the greater potential for things to go wrong in the future.

That means any company dealing with claims that take a while to get settled may have to book more credit losses up front.

“The longer the term, the credit risk related to those contracts would be a little bit longer or higher, just by the pure nature of it,” Makda said.

What Insurers Are Saying

Insurers won’t have firm numbers on CECL’s impact until the end of the first quarter. In their 2020 annual reports, however, major companies offered widely varying previews.

AIG said the change, driven by commercial mortgage loans, would reduce retained earnings by $650 million—a small fraction of its reported $23 billion at the end of 2019. Prudential said it would decrease its retained earnings by $100 million. It reported $32 billion in retained earnings in its most recent filing.

MetLife’s preview put the size of its loss allowance into perspective compared with its $80 billion in mortgage holdings. Its current loss allowance represents less than half a percentage point of the investments affected by CECL. Under the new accounting, the allowance will increase to nearly 1%.