Actuarial Implications of Changes in Financial Reporting on Insurer Investments and Earnings Management

The Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2016-01 which requires firms to report unrealized gains and losses on availablefor-sale (AFS) equity securities in net income. Previously, these gains and losses were reported in other comprehensive income and were not recognized in net income until the investments were sold. The rule change begs the question of whether insurers increased their earnings management discretion (largely via loss reserves) to offset the reduced discretion in terms of recognizing investment income. We examine how earnings reclassification impacts firms' investment strategy and earnings management behavior around earnings reports. Using data from US insurers, we find that firms decrease their equity holdings while increasing holding periods on equity securities following the adoption of this new standard. These results suggest that ASU 2016-01 shifts firms' investment focus from short-term financial reporting to long-term investment income maximization goals. We also find evidence that this rule update changes firms' earnings management behavior in that the rule change removes firms' incentives to cherry-pick sales of equity. We document that public insurers are involved in less gain trading to avoid reporting losses following the rule adoption. Instead, we find evidence that public insurers are more likely to use discretion over reported loss reserves to manage reported earnings after the rule change.