Fair Values of Equity and Debt Securities and Share Prices of Property-Liability Insurers

Abstract

Introduction This study assesses the relation between fair values of equity and fixed maturity debt securities and share prices of property-liability insurers. The results provide the first evidence on the valuation implications of financial statement disclosures regarding fair value estimates for the majority of assets held by insurers. This evidence is important because, beginning with financial statements for year-end 1994, the Financial Accounting Standards Board's (FASB) Statement of Financial Accounting Standards No. 115 (SFAS 115), Accounting for Certain Investments in Debt and Equity Securities, requires formal balance sheet recognition of fair values for considerably more investment securities than was previously the case. The new accounting standard could have a substantial impact on earnings, assets, and capital of property-liability insurers because investment securities comprise over 60 percent of the total assets of a typical property-liability insurer. The economic consequences of balance sheet recognition of fair values for investment securities are debated widely. The controversy centers primarily on whether fair value estimates for investment securities are sufficiently reliable to be valuation-relevant. Advocates of fair value accounting, including former Securities Exchange Commission (SEC) Chairman Breeden, assert that recognition of fair values will enhance the relevance of information in financial statements (Wall Street Journal, January 8, 1992). Opponents, including Federal Reserve Board Chairman Greenspan and various representatives of the financial services industry, assert that estimates of fair values of thinly-traded securities will be unreliable and, thus, valuation-irrelevant (Wall Street Journal, November 8, 1990). In addition, opponents assert that fair value accounting will induce additional volatility in earnings and capital measures that does not reliably reflect underlying economic volatility, leading to inefficient capital allocation decisions by investors and excessive intervention by regulators.(1) The FASB (1980) cites relevance and reliability as the two principal criteria for choosing among accounting alternatives. The FASB defines relevant information as that which is capable of influencing decisions, and reliable information as that which is verifiable. These two characteristics are clearly not independent. In this setting, fair values of key assets such as investments are likely to be considered relevant by investors, if disclosed fair values are sufficiently reliable.(2) Since fair values must be estimated for certain securities, estimation error could impair the value-relevance of related disclosures.(3) This study tests the relevance and reliability of fair value disclosures by analyzing their association with share prices of property-liability insurers. Prior research on accounting for investments, which has focused primarily on banking, has shown that fair value estimates help explain bank share prices.(4) However, prior work does not detect a link between fair value gains and losses and bank stock returns, perhaps because of measurement error in changes in fair value estimates (Barth, 1994). The insurance industry is a more powerful setting to test the valuation implications of fair value disclosures, because bank investment portfolios only range from 14 to 21 percent of total assets and almost exclusively include fixed maturity securities. We find that fair value disclosures for certain types of investment securities are important determinants of share prices and returns of property-liability insurers. In particular, our evidence suggests that property-liability share prices can be explained by fair values of equity securities, which have traditionally been recognized on the balance sheet, and fair values of U.S. Treasury securities, which have been disclosed in footnotes. We also find that fair value disclosures for other types of investment securities (e. …