The International Accounting Standards Board has acknowledged that it is not realistic to demand that insurance companies change to fair value accounting from 2005 and has divided its project into two phases - a decision appreciated by the insurance industry. Phase 1 will serve as a transition. There will be certain changes, in particular far-reaching disclosure requirements.
The starting point for the IASB's phase 2 deliberations is the asset and liability model, a static accounting concept focusing on the balance sheet. This model defines the annual profit as the difference in assets and liabilities between two reporting dates. Another focus of the board had been the strategy of valuing all financial instruments at fair value and recognising all changes in market value in the income statement. In response to extensive criticism from virtually all the parties involved,, Financial Instruments: Recognition and Measurement, as currently under revision, will essentially retain the basic concept of dividing financial instruments into different categories that are either measured at fair value or on an amortised cost basis. Changes in market value only have to be included in the net profit or loss for instruments classified as 'trading'.
Changes in the value of investments classified as 'available for sale' can continue to be recognised directly in equity without affecting earnings.
With this background one might question why fair value accounting should continue to be pursued for insurance contracts given that these are considered to be financial instruments. It would imply that the generally long-term portfolio of an insurance company has to be accounted for like the trading portfolio of a bank. Is this a true and fair view of the underlying business model?
Such an accounting policy would have the following consequences for insurance companies. The projected profit arising from an insurance contract with, for example, a term of 30 years would already have to be fully recognised at inception of the contract. Unlike tradable securities, profit projections arising from insurance contracts have no intersubjective market value that is verifiable. According to the IASB, the fair value should therefore be based on entity-specific assumptions about future cashflows as well as actuarial assumptions (interest rates, cancellations, mortality). This reveals parallels with business appraisal methods based on management's subjective assumptions on the future. Useful information for the investor?
In theory it is! But is this really a benchmark for the success or failure during a reporting period?
Financial reporting based on this concept should be rejected for a number of reasons. Fair values that are based on actuaries' forecasts rather than on verifiable market values are not very useful. (And this does not reflect on my high appreciation for the actuarial profession). Upfront profit recognition on long-term insurance contracts leads to artificial volatility in earnings. This is because even if the long-term assumptions were correct on average, periodic changes (for instance in interest rates) will deviate from this average and lead to a revaluation with effects on earnings that may be substantial.
A higher level of volatility - caused 'artificially' by accounting policies - will lead to higher capital costs and put the insurance industry at a competitive disadvantage on the capital markets. It is obvious that this will cause a change in product design. It would have a negative impact, particularly on long-term pension products. Surely the aim of accounting principles should not be to influence or indeed change the business model.
Finally, at inception of the contract, profit has quite simply not been earned. It therefore does not belong in the financial statements.
The IASB has considered the arguments against fair value accounting for insurance companies in some depth. While retaining the basic principle, the IASB decided that at inception of a contract a gain may not be recognised.
It may well be that the Enron and WorldCom scandals have contributed to this change in position. However, even if this decision should in principle be endorsed, it leaves many questions open. In particular, the IASB states simultaneously that acquisition costs should be expensed immediately, while a precautionary adjustment should be included when discounting expected future cashflow.
While the precautionary accounting smacks of the German Commercial Code, these proposals prompt not only theoreticians to query the conformity with fair value, but also practitioners to question the accounting entries.
That is because calculating the discounted value of future cashflows inevitably leads to an earnings balance. Irrespective of whether this balance is set to zero by 'cautious' selection of assumptions or by means of setting up a provision - after all, the intention is not to recognise a net gain in the first period - the big question as to how this balance should be distributed over the residual term remains unanswered. What could be more obvious than releasing the balance based on the actual development of earnings?
Without wishing to enter into a dogmatic discussion of accounting principles, it seems reasonable to presume that the IASB's proposals are not so very far apart from the accounting principles currently used in the insurance industry. I am forced, therefore, to question the precise purpose of a (superficial) change in accounting methods that requires the insurance industry to undertake an unprecedented change in systems that will be extremely expensive, with the end result effectively the same.
Despite all the understandable criticism of the fair value approach it nevertheless offers strategic solutions for some weaknesses in current accounting practices. Currently, asset liability matching is not reflected in financial reporting. Furthermore, accounting for embedded options certainly needs to be reviewed, given that in financial terms they are essentially derivatives.
Regardless of the future direction of accounting, there are two fundamental requirements that need to be met. First, each fundamental accounting change requires an adequate transition phase and testing period. As an initial step, additional information provided in the notes to the financial statements is more appropriate than an immediate change in the accounting system.
Second, restricting fair value accounting to the insurance sector goes against the objective of standardising international accounting principles across all sectors. If fair value is to be adopted, then it should be applied to all sectors and to all assets and liabilities.
The discussion will continue and the IASB has proved a number of times that it is willing to address well-founded concerns.