a case study in insurance
The Geneva Association, which is a well-known research and development laboratory as well as advanced training centre of the global insurance industry,
provides an example on the need for the sort of studies I suggest. The Association has discussed the International Financial Reporting Standards and their effects on insurance, reinsurance, financial services and the wider economy at its 30th General Assembly meeting of June 2003. Its members have been working inten- sively on the subject of accounting standards because, in their opinion, the then existing accounting systems were not as efficient as they should be.18
As is to be expected, when professionals engage in discussion with a far-reaching after-effect, this leads to the identification of important issues that require further research attention. An interesting point made during the 30th General Assembly was that, in the past, the most common reaction from an economist, when faced with technical accounting problems, has been indifference. More recently, however,
● The issue of accounting and its standards shot up on the list of top priori- ties in the insurance and financial services industry, and
● The economic implications of IFRS accounting rules have been seen as both important and challenging, with possibly enormous impact on the industry.
To better appreciate the interest expressed by the insurance and reinsurance sec- tor of the economy, it should be recalled that in 1997 the former International Accounting Standard Committee had started to work on an international stan- dard for insurance contracts. In May 2002, IASB decided to continue that work, splitting it in two phases:
● Insurance Phase 1, as an interim step for developing a standard, and
● Insurance Phase 2, for tentative development of a fair value model for assets and liabilities arising from an insurance contract.
Phase 1 was committed to introducing a fair valuation of assets (under IAS 39) while liabilities valuation remained based on local standards, none of which today reflects fair value. The Association believes that this mixed approach does not allow for risk matching across asset and liability values, nor for consistency.
On the other hand, one should remember that the famous A/L acid testfor fore- casting a company’s default point(DP) is based precisely on that dual standard:
● Assets at market value
● Liabilities at book value.
The point some insurers make is that valuation of assets and liabilities should reflect the specific, long-term nature of the insurance business. They also note that application of fair value measurements, envisaged in Phase 2, will affect the nature of the products that are sold, particularly so in life insurance, probably because of
introducing short-term volatility in an industry that has generally a very long-term view – and business models which reflect this longer-term approach.
Clearly enough, there exist two different viewpoints. If we were in the immedi- ate post-World War II years, or even in the 1980s, the aforementioned argument would have been correct. But not today because, since the 1990s, insurance com- panies have considerably increased their risk appetite. First by loading them- selves with equities (particularly British insurers) and getting hurt when the bubble burst. Then, after year 2000, by:
● Getting active in derivatives games and tricks like prepays,19and
● Going into credit derivatives in a big way as protection sellers – a highly risky short-term horizon which contradicts the longer-term perspective and is not their business.
Nobody said that the introduction of a full fair value accounting system – which is modern and dynamic – might not have some unwanted consequences. Quite likely it will lead to an increase in the cost of capital for the industry, thereby repositioning insurance and reinsurance capacities. Given the fact that insurance companies are long-term investors will also have an impact on equity markets and their volatility, making more evident the result of market slump as portfolios are marked to market.
The good news is that the fair value accounting model will produce financial statements which are much more effective at distinguishing good company per- formance from bad. This is a major ‘plus’, assisting in good governance and out- weighing likely (but not certain), bad news.
Insurers generally say that they support the objective of developing high quality international accounting standards, that can improve financial reporting world- wide. At the same time, however, they express concern about whether the insur- ance contracts project of IASB, currently under study, will result in the required high quality accounting standards for insurance.
Some insurance experts seem to question an ‘experimental approach with unfore- seeable consequences’. This is not a rational reaction. As we will see in Chapter 15, experimentation is a basic ingredient of modern management. Behind this worry lies another one: that, in the current business environment, a fundamental change in accounting standards for a large industry, like insurance, may affect:
● Whole national economies, and
● Global investment and commerce.
There is a contradiction here. On one hand, insurers and re-insurers want the new accounting standards by IASB to go far enoughand deep enoughin solving current and future problems of accounting insufficiency. And on the other, they are afraid that if they do go far enough and deep enough, they will upset the industry and ‘whole national economies’.
It is not easy to reconcile these two positions, but it is reasonable to expect that once past the resistance to the novelty of IFRS, and most particularly IAS 39, the senior management of most companies (and of whole industry sectors) will appreciate the assistance on decision support they are getting from the new accounting rules.
In fact, this is already happening. The insurers’ rather negative position is chang- ing, as reflected in an article by Dr Joachim Kửlschbach, in the Geneva Association’s monthly bulletin of June 2005.20In the January 2005 meeting of the Association, Kửlschbach says, IASB reviewed the project plan for Phase 2 and decided to take a fresh look at financial reporting by insurers, including:
● The aim of close interaction with the FASB, and
● Support for IASB/FASB convergence.
According to Kửlschbach, IASB has tentatively decided that claims liabilities should be discounted, and they should include a provision for risk and uncer- tainty. This is subject to the general requirement on materiality. Stand-ready obli- gations will be measured either at the unearned portion of premiums received, potentially less acquisition cost; or prospectively as future obligations, including discounting and risk provisions. Issues currently under discussion include:
● Revenue recognition
● Performance reporting
● Financial instruments, and
● Revisions to IAS 39 clauses for insurance firms.
An Insurance Working Group (IWG) set up by IASB in 2004, as support to the handling of technical questions in both non-life and life insurance topics, worked on some of 14 issues identified by the International Accounting Standards Board. Four models discussed by IWG are:
● Lock in
● Amortized cost
● Current entry value, and
● Current exit value.
The preferred models seem to be those including discounting of insurance lia- bilities and provisions for risk. There seem to be strong arguments for discount- ing, but concerns were raised over the uncertainty of estimating claim liabilities, and of adding a series of discounting assumptions.
In connection to gain or loss on initial recognition, some IASB members report- edly favoured a loss to be recognized at inception since that shows the true eco- nomic position. This is opposed by the insurance industry because, in its opinion, accounting would not reflect economic reality when the contract, which was intended to be profitable, would be shown as making a loss at incep- tion. (A similar issue exists in banking in connection to recognizing new loans in the banking book.)
What the reader should appreciate from these 2005 references concerning the insurance industry’s position is that the altogether negative view of IFRS by the industry has considerably evolved during the past couple of years. Though sev- eral issues are still in discussion, the benefits provided by the new accounting rules are being recognized in terms of the contribution they make to corporate governance. (The planned timetable foresees a discussion paper by early 2006, an exposure draft after mid-2007, and a final standard by mid-2008.)
Notes
1 ECB, Monthly Bulletin, 2004.
2 The name is variously spelled Paciolo, Pacciolo, Paccioli by different authors.
3 Or de Vinci, depending on the author.
4 Marcel Brion, Leonar De Vinci, tome premier, Le Livre Club du Libraire, Paris [year not noted].
5 Robert N. Anthony, Management Accounting, Irwin, Homewood, IL, 1956.
6 This is suggested from evidence which exists in the archives of the state of Genoa dating from 1340, and of Venice dating from 1406–34.
7 Morton Backer (ed.), Handbook of Modern Accounting Theory, Prentice Hall, New York, 1955.
8 D.N. Chorafas, After Basel II: Assuring Compliance and Smoothing the Rough Edges, Lafferty/VRL Publishing, London, 2005.
9 D.N. Chorafas, Economic Capital Allocation with Basel II: Cost and Benefit Analysis, Butterworth–Heinemann, London and Boston, 2004.
10 D.N. Chorafas, How to Understand and Use Mathematics for Derivatives, Volume 2 – Advanced Modelling Methods, Euromoney Books, London, 1995.
11 D.N. Chorafas, Statistical Processes and Reliability Engineering, D. Van Nostrand Co., Princeton, NJ, 1960.
12 D.N. Chorafas, Economic Capital Allocation with Basel II: Cost and Benefit Analysis, Butterworth–Heinemann, London and Boston, 2004.
13 ECB, Financial Stability Review, Frankfurt, June 2005.
14 D.N. Chorafas, The Management of Equity Investments, Butterworth-Heinemann, London, 2005.
15 D.N. Chorafas, Statistical Processes and Reliability Engineering, D. Van Nostrand Co., Princeton, NJ, 1960.
16 D.N. Chorafas, Management Risk: The Bottleneck Is at the Top of the Bottle, Macmillan/Palgrave, London, 2004.
17 Basel Committee on Banking Supervision, ‘Supervisory Guidance on the Use of Fair Value Option under IFRS’, Consultative Document, BIS, July 2005, Basel.
18 Geneva Association, Insurance Economics, No. 48, 2003.
19 D.N. Chorafas, Corporate Accountability, with Case Studies in Finance, Macmillan/Palgrave, London, 2004.
20 Geneva Association, Progress, No. 41, June 2005.
3
Dynamics of International Financial Reporting
Standards
1. Introduction
Disclosures about risks associated with financial instruments are useful to all stakeholders: regulators, investors, the entities themselves, and the general pub- lic. Banks are supervised for their deposit-taking, securities deals, and portfolio positions, among other issues. With innovation in the financial industry in high gear, it has become very difficult to satisfactorily differentiate an entity active in derivative instruments (see Chapter 5) from a speculator holding a portfolio of risky assets. Uncertainty is omnipresent for a number of reasons:
● From the way liquidity and solvency are managed
● To a timely evaluation of exposure and proactive control of assumed risks.
As Chapters 1 and 2 brought to the reader’s attention, plenty of users of financial statements want to have reliable information about exposure(s) arising from dif- ferent financial instruments, including, but not limited to, credit risk, market risk, and operational risk. Investors, correspondent banks and regulators also need to know the ability of entities they are dealing with to identify, measure, monitor, and control the different risks they take.
All this enters into disclosure standards, along with the fact that clear and con- sistent requirements should apply to all entities. This way the market operates on a level playing field, and users receive comparable information about risks they incur. We can summarize under seven points what is new in corporate accounting with IFRS, and at the same time which are the new standards’ pillars.
These are (in alphabetical order):
● Derivatives: The company’s balance sheet must show the current market value of all derivative instruments which it contains; there is no more hide and seek. Derivatives can be recorded on both sides of the balance sheet (see Chapter 14).
● Fair value: This will, in all likelihood, be the most significant impact of IFRS. Fair value of assets and liabilities that have not been traded will become a culture, uncertainty over its measurement when no ready market exists for certain issues notwithstanding.
The valuing of the company’s assets at market price is part and parcel of the quan- titative evaluation and disclosure. Fair value is not just ‘any’ market price, but one agreed upon by a willing buyer and a willing seller under other than fire sales conditions. (This definition comes from the Financial Accounting Standards Board.)
● Goodwill: Companies can no longer amortize goodwill from acquisitions.
Instead, they must conduct an annual impairment review, taking a charge if the asset’s value falls.
● Intangible assets: Management must both disclose and quantify the value of assets like patents, software, customer lists, trademarks, research and development projects. These can no longer be lumped into goodwill.
● Reduction of exceptions: A number traditionally seen as exceptional, as for example restructuring costs or gains and losses on trading assets, will increasingly be regarded as part of the firm’s operating performance. The mixing of company assets and pension assets is no longer permitted.
● Pensions: Companies need to account on their profit and loss statement of the year for the full impact of pension liabilities, as well as for pension assets.
● Stock options: Management can no longer bury the cost of stock-based compensation as footnotes to financial accounts. The company must show full value of all options granted to executives and employees.
The first two bullets partly overlap, because not only will derivatives be meas- ured at fair value and included on the balance sheet, but also all dealing and most investment securities held by banks will be measured at fair value.
Moreover, banks are expected largely to consolidate special purpose vehicles (SPVs), which have been often used to hide risks. In short, financial institutions will need to:
● Review their hedging strategies and SPV policies, and
● Make changes to their current solutions for keeping exposure non-trans- parent, or definitely become transparent.
In the opinion of the European Central Bank, the new standards may also change banks’ behaviour, especially their risk management practices, because they could cause concern over risk-taking if the impact on the accounts becomes less clear.
Reserves for credit losses will be affected by the introduction of a new provi- sioning methodology, while the fund for general banking reserves will be reclas- sified as equity.1
These and other changes in financial reporting, as for example the recognition of actuarial losses on pension obligations, may result in a decrease in equity and the reclassification of certain capital instruments from equity to liabilities. The new accounting culture will clearly have profound effects on the balance sheets and P&L statements of the 7000 listed European companies which switched their
books to IFRS. How fast will the new rules sip down the investment community?
Some experts reckon that:
● It will take up to two years before analysts and investors fully come to grips with what the changes mean.
● But in the end analysts and investors will have a much better understand- ing of a firm’s financials, because IFRS forces companies to disclose more information than ever before.
IFRS rules will also unveil items that many European companies either buried as footnotes in their financial reports or simply did not reveal at all. The afore- mentioned derivative financial instruments and pension liabilities are examples.
Still the most important underpinning of IFRS’s dynamics is the switch from his- torical cost accounting to fair value accounting.