The introduction of International Financial Reporting Standards

The introduction of International Financial Reporting Standards
(IFRS) in 2005 will have a significant impact on the way that
many insurance companies report their financial statements. On
introduction, the consolidated accounts of almost all listed
insurance (and non-insurance) groups will have to be prepared in
compliance with IFRS, including the recently published IFRS 4 –
Insurance Contracts. The IASB intends to progress as quickly as
practicable towards phase 2 although this is not expected to be
before 2007 at the earliest. The IASB has indicated a conceptual
preference for fair value accounting at phase 2 although the target
accounting model has yet to be finalised.
Fitch welcomes the progress made by the IASB towards standards
that will be more transparent and comparable across regions. The
agency recognises the significant limitations of phase 1 but
believes that the enhanced disclosure and greater consistency at
phase 1 of the insurance accounting project (set out in IFRS 4) will
aid in the analysis of insurers and is a useful stepping stone to the
more valuable phase 2.
The agency notes that there is still much to do in defining the
accounting for phase 2, and finding a balance between
sophistication, consistency and practicality will be highly
challenging. Nevertheless, Fitch supports the conceptual shift to
fair values although cautions that this must be in partnership with
detailed disclosure allowing an assessment of important items such
as methodology, assumptions and risk.
Although concern has been raised by some about the effect of the
expected additional volatility stemming from IFRS, Fitch is only
critical of reported volatility that does not reflect the underlying
economic reality and therefore lacks informational content (i.e.
‘accounting volatility’). Some accounting volatility may be
induced at phase 1 (e.g. due to bond price movements stemming
from changing interest rates where assets and liabilities are
matched), but the agency regards this volatility as being a small
price to pay for showing an up to date picture of the balance sheet
position. At phase 2, Fitch expects reported volatility to be more
closely related to the underlying economic reality. The agency
welcomes the transparency provided by this reported economic
volatility and in particular, the information provided on the
mismatch between assets and liabilities and therefore, overall risk.
The agency notes that it does not expect any rating actions as a
direct result of the move to IFRS. However, Fitch cannot rule out
the possibility that the additional disclosure and information
contained in the accounts could lead to rating changes due to an
improved perception of risk based on the enhanced information
available. In addition, the new accounting regime could have a
medium term rating impact for some companies depending on the
response of management and investment markets to the new
standards or if the basis of taxation were to be affected.
Special Report Mind the GAAP: Fitch’s View
on Insurance IFRS
Insurance
Mind the GAAP: Fitch’s View on Insurance IFRS: May 2004
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􀂄 Introduction
International Accounting Standards began to be
developed in 1973 when the professional
accountancy bodies of Australia, Canada, France,
Germany, Japan, Mexico, the Netherlands, the UK,
Ireland and the USA founded the International
Accounting Standards Committee (‘IASC’). In 2000,
the committee underwent a major restructuring
process and in 2001, the newly restructured and
renamed International Accounting Standards Board
(IASB) held its first meeting.
The newly formed IASB adopted all of the standards
that had been prepared by the IASC and new
accounting standards produced by the board will be
known as International Financial Reporting
Standards (IFRS). The term IFRS is understood in
this report to refer to both these new standards that
will emerge over time and those set by the IASB’s
predecessor organization.
IFRS will become particularly important as from
2005, essentially all EU companies that are listed on
European exchanges will be required to produce
their consolidated accounts in accordance with
IFRS 1 . This is expected to affect around 7,000
entities, including many of the largest insurance
companies in Europe. In addition, IFRS is likely to
also be adopted by companies in many other
jurisdictions, including Hong Kong and Australia,
and many EU countries will permit non-listed
companies to file accounts under IFRS. Over time,
the use of these standards is expected to become
increasingly prevalent, particularly for those
companies wishing to access the capital markets.
Currently, there is no IFRS that deals with the
accounting treatment of insurance contracts.
Companies that already use IFRS to prepare their
accounts typically use US GAAP to “fill in the gaps”
in the published guidance. The current project to
develop standards for insurance contracts aims to
remedy this situation and improve the transparency
of reporting.
This paper sets out the key issues surrounding IFRS
for insurance contracts (both phases 1 and 2) and the
likely impact of these issues on insurance companies.
The paper focuses on general insurance issues and
does not deal with issues specific to life insurers.
1 Individual member states have the option of requiring all
companies to comply with IFRS from 2005 onwards. It should
also be noted that some kinds of listed company, at the option of
individual member states, may not have to comply with IFRS
until 2007. This delayed implementation may affect companies
with debt securities only (not shares) listed on a regulated market
of a member state. In addition, companies with a listing outside
the EU and already using internationally accepted standards (e.g.
US GAAP) may also avoid IFRS implementation until 2007.
However, many of the points made for general
insurance are also applicable to life insurance.
Although many uncertainties surround phase 2, Fitch
believes that phase 12 can only be understood and
assessed in the context of the fair value accounting
that the IASB aims to achieve.
This paper does include some comments in respect
of IAS 39 (‘Financial Instruments’) which will have
an important impact on insurers but it should be
noted that the paper is deliberately limited in scope.
The paper does not set out to outline all of the
consequences of IAS 39 3 implementation or the
likely impact from the implementation of other
IFRSs (e.g. ‘Employee benefit costs’ (IAS 19) or
‘Related party disclosures’ (IAS 24)). Where
material, such issues are likely to be addressed by
subsequent Fitch reports.
This paper is divided into the following sections:
• Overview of Insurance IFRS.
• Main features of Insurance IFRS – phases 1 and
2.
• Key issues arising from the planned Insurance
IFRS.
• Business implications of fair value reporting.
• Impact of Insurance IFRS on analysis
methodology.
• Impact of Insurance IFRS on ratings.
• Conclusion.
The report also includes a number of appendices:
• Appendix A – Principal benefits and costs of
the new Insurance IFRS reporting.
• Appendix B – Additional Insurance IFRS issues
• Appendix C – Example of possible insurance
accounting treatment.
􀂄 Overview of Insurance IFRS
The IASB has tentatively concluded that the overall
goal of new insurance standards should be to move
towards fair value accounting (i.e. recording both
assets and liabilities at the “amount for which an
asset could be exchanged, or a liability settled,
between knowledgeable, willing parties in an arm’s
length transaction.”4) More specifically, this can be
2 ‘Phase 1’ and ‘IFRS 4’ are considered to be equivalent and so
these terms are largely used interchangeably in this report.
Phases 1 and 2 are considered to be two stages in the same
process and so are collectively referred to as ‘Insurance IFRS’.
3 IAS 39 and IAS 32, which relate to accounting for, and
disclosures of, financial instruments are yet to be endorsed by the
European Union in order to require their use from 2005. A
failure to endorse these standards would leave EU companies as
being non-IFRS compliant and could negate many of the
proposed benefits for a common reported standard (including
acceptance by the SEC). Fitch expects resolution of this situation
in the near term.
4 Appendix A of IFRS 4 Insurance Contracts
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seen as a combination of two distinct processes.
Firstly, a move away from the current (P&L focused)
deferral and matching approach and towards a (more
balance sheet focused) asset-and-liability approach.
Secondly, as a move away from the current situation
of differing levels of reserving prudence and towards
a more standardised approach focused on the best
estimate. These concepts are defined further below.
After the start of the insurance project in 1997, it was
hoped that a fair value standard could be agreed by
2003 for implementation in 2005. However, in May
2002, due to the complexity of the task and the
relatively slow progress made, it became necessary
to split the project into two parts. Phase 1 will be
introduced in 2005 and has recently been published
in the form of IFRS 4 Insurance Contracts. This
standard will require significantly increased
disclosure and certain other changes to the way that
insurance contracts are accounted for (set out in the
next section). Also very important in 2005, will be
the implementation of IAS 39 Financial Instruments
by many insurers requiring most investments to be
accounted for at fair value.
The implementation of fair values for liabilities, a
more complex task due to the lack of a liquid market,
has been postponed to phase 2. The IASB is
committed to completing phase 2 as soon as possible
but this will take some time to complete. The IASB
included a sunset clause5 in exposure draft 5 (ED 5)
indicating that implementation could be scheduled
for 2007 but this was deleted from the final
accounting standard (IFRS 4). The deletion of this
clause means that there is currently no ‘deadline’ to
work to and in Fitch’s view, implementation for this
date seems optimistic.
Timetable of Introduction for IFRS on
Insurance Contracts
Date Comment
October 2003 End of consultation period on Exposure Draft
5 – ED 5
March 2004 FRS 4 published following comments
received on ED 5. (Phase 1)
2005 Exposure draft on Phase 2 to be published
20056 IFRS Financial statements to be published
for EU listed insurers (limited IFRS
comparatives for 2004 required.) Mandatory
Implementation of phase 1.
2007/8? Phase 2 implementation scheduled?
Source: IASB, Fitch Ratings
5 See Appendix B of this report for further details.
6 IFRS 4 is mandatory for financial periods beginning on or after 1
January 2005 although earlier adoption is encouraged. The target
phase 2 implementation date was financial periods beginning on
or after 1 January 2007. However, this now looks likely to be
postponed by at least a year.
The proposed asset-and-liability approach (where
assets and liabilities are recognised to the extent that
they meet required definitions with income and
expenses defined in terms of changes to assets and
liabilities) represents a significant departure from the
current situation, where revenues and costs are
matched and earned gradually over the period of the
contract. This matching of revenues and costs is
achieved through the deferral of some costs (deferred
acquisition costs – DAC) and revenue (unearned
premium reserve – UPR) to be earned over the
contract period.
Neither DAC nor UPR meet the IFRS framework
definition7 of an asset (a resource expected to give
future benefits) or a liability (an obligation arising
from past events expected to result in an outflow of
value from the company). The move across to fair
values for both assets and liabilities will ensure that
the balance sheet does not contain assets and
liabilities that fail to meet the respective definitions
and is also designed to increase the transparency of
reporting.
􀂄 Main Features of Insurance IFRS –
Phases 1 and 2
Phase 1
Fitch believes that phase 1 of the insurance
accounting project should not be appraised on a
stand-alone basis but as an intermediary step to
achieve the fair value accounting envisioned at phase
2. Phase 1 of the insurance accounting project will
require relatively limited accounting changes
compared to the ambitious overhaul planned under
phase 2. However, the standard introduces some
important principles, requires some (limited)
changes to accounting methodology and will require
significantly increased disclosure.
The broad plans for phase 1 (through ED 5) have
been public for some time and summaries have been
produced by all of the major accounting firms. As
such, only a brief summary of the requirements of
IFRS 4 is included below. The principal features of
IFRS 4 are:
Definition of Insurance Contracts
The IASB wants to ensure that similar transactions
are treated in a similar way and, therefore, the
accounting treatment specified will affect all
insurance contracts whether written by a registered
insurer or not. The definition of insurance contracts
given by IFSR 48 is overleaf.
7 IFRS definition included in the IASB Framework – para 49.
8 Appendix A – IFRS 4 Insurance Contracts
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“A contract under which one party (the insurer)
accepts significant insurance risk from another party
(the policyholder) by agreeing to compensate the
policyholder if a specified uncertain event (the
insured event) adversely affects the policyholder.”
This is an important change which should lead to a
focus on the substance of economic transactions
rather than the legal form and help to standardize the
treatment of insurance contracts across industries.
The definition will also mean that certain contracts
that are written by insurers will no longer be
classified as insurance contracts. Certain financial
reinsurance contracts and policies with a low degree
of risk transfer (e.g. certain finite risk contracts) will
not meet the above definition and therefore be
required to be treated as deposits.
Unbundling of Contracts and Accounting
for Embedded Derivatives
IFRS 4 will require some contracts which have
investment and insurance features to be unbundled
and accounted for separately. However, as a result of
numerous exclusions, this will not be as onerous as
originally feared and it is largely only financial
reinsurance contracts that will require unbundling in
phase 1. Examples of contracts that could be affected
in phase 1 include certain multi-year reinsurance
contracts linked to an experience account. This could
be extended further in phase 2.
Similar to the requirement to separate the investment
and insurance components of a contract is the
requirement to account for embedded derivatives at
fair value, with movements in this value being
recorded in the income statement. Embedded
derivatives that will have to be recorded at fair value
during phase 1 include life products offering a
guarantee of minimum equity returns on surrender or
maturity. However, phase 1 gives an exemption to
embedded derivatives that are themselves insurance
contracts, significantly reducing the contracts
affected. Examples of embedded derivatives that
may need to be accounted for at fair value at phase 2
if these rules are tightened include guaranteed
annuity options (GAOs) and guaranteed minimum
death benefits (GMDBs).
End to Equalisation Reserves
The IASB takes the view that claims reserves are
only permissible to the extent that they relate to
actual liabilities (i.e. a “present obligation ... arising
from past events ... which is expected to result in an
outflow … [of] resources embodying economic
benefits”9). Equalisation and catastrophe reserves do
9 IAS 37.10
not fulfil this required definition and so will no
longer be permitted once phase 1 is implemented10.
Treatment of Investments
Changes to the treatment of investments will not be a
direct result of IFRS 4 (or therefore, of phase 1) but
will result from the implementation of IAS 39.
Nevertheless, the requirements are closely connected
to the phase 1 requirements and will be one of the
most important changes of accounting for many
companies in 2005 when they adopt IFRSs for the
first time. Under IAS 39, the investment assets of
insurance companies will have to be categorized as
either held to maturity (with the investments held at
amortised historic cost), available for sale
(investments marked to market with changes
recorded in reserves), or held for trading (marked to
market with changes recorded in the income
statement)11.
Given the nature of insurance company liabilities,
most investments are liable to be categorized as
“available for sale” with the associated volatility in
shareholders’ equity. Many insurers would prefer to
classify investments as “held to maturity” in order to
avoid the volatility associated with marking to
market investment. However, for investments to be
classified as ‘held to maturity’, the insurer would
need to be able to demonstrate both positive intent
and an ability to hold the instrument to maturity.
This would imply that the insurer was willing to
forego future profit opportunities generated by these
financial instruments as well as implying a greater
degree of certainty as to the timing of cash flows
than is usually possible.
In practice, one of the main obstacles to investments
being classified as ‘held to maturity’ are the harsh
penalties set out in IAS 39 if these assets are sold
prior to maturity. These ‘tainting rules’ (subject to a
few exceptions) include a ban on using the held to
maturity classification for any financial instrument
for the year of sale and for two following financial
years.12
Insurance Accounting
Deferred acquisition costs will still be permitted for
insurance contracts during phase 1, and whichever
GAAP that companies currently use will continue to
prevail on the accounting for insurance contracts.
10 Equalisation and catastrophe reserves will not be allowed as
liabilities following implementation of IFRS 4. However, IFRS 4
does not prohibit the reporting of equalisation reserves as a
component of equity.
11 ‘Loans and receivables originated by the enterprise’ is a further
category that is carried at amortised cost but this categorisation
will principally be used by banks, much less so by insurers.
12 IAS 39.83 (r.2000)
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This will limit the potential benefit of increased
comparability between accounting regimes but does
serve to prevent companies having to change their
accounting systems twice in the space of a few years.
Other Changes
Other changes expected following the introduction
of IFRS in 2005 (not specific to insurance) include
the fact that stock options will need to be expensed
and goodwill will no longer be amortised (although
it will require an annual impairment test).13 These
changes are examples of the requirements that have
already been published in 2004 and further
developments are expected by the time that phase 1
for insurance contracts has to be implemented.
Disclosure Requirements for Phase 1
Fitch believes that increased disclosure is one of the
most important aspects of phase 1 and supports the
move to improve transparency as well as improved
consistency between insurers.
IFRS 4 requires significantly more detailed
quantitative and qualitative information on risk
exposures, and importantly the disclosure
requirements are formulated based on principles
rather than set required disclosures. The required
disclosures include the following:
1. Explanation of Reported Amounts
This disclosure category will include information on
accounting policies, the derivation of significant
assumptions and material changes to insurance
liabilities, reinsurance assets and DAC. The
disclosure will include whether margins are built into
the assumptions, whether they are derived from
actual company data and how they relate to recent
experience. The IASB also requires insurers to
disclose any gains or losses that have been made in
buying reinsurance to aid comparison between
companies.
2. Amount, timing and uncertainty of future
cash flows
This will require the disclosure of risk management
policies and terms and conditions that have a
material impact on the amount, timing and
uncertainty of the insurers’ cash flows. In addition,
companies will be required to report information on
insurance risk that helps users to assess the insurer
‘through the eyes of management’, as well as
additional information on insurance, interest rate and
credit risks.
13 These requirements are set out in the recently published IFRS 2
‘Share Based Payment’ and IFRS 3 ‘Business Combinations’.
See the Fitch report ‘Accounting for Stock Options: Should
Bondholders Care?’ (available at www.fitchratings.com) for
further details of the impact of stock options on ratings.
Disclosures on insurance risk will include
information on concentrations of insurance risk, the
sensitivity of profit or loss and equity to variables
and claims development data (principally for general
insurance). These disclosures will assist the users of
accounts in assessing the insurance risk associated
with an insurer and the accuracy of historic reserving
practices.
The above disclosures will undoubtedly aid
sophisticated users of financial statements in their
understanding of companies and the underlying
economic reality. However, Fitch would favour a
greater degree of prescription for phase 2 as an
overlay to a principles-based approach. The agency
notes that although principles-based disclosure
requirements can make compliance easier for
companies and are unlikely to become obsolete, such
a formulation does reduce the comparability between
companies.
Some insurers have claimed that increased
complexity for the financial statements could
obscure the true economic picture for some, less
sophisticated users. However, Fitch believes that
such concerns are frequently overstated and can be
largely addressed through suitable structuring of the
accounts. In the agency’s view, additional
complexity does not represent a valid reason for
maintaining the relatively low levels of disclosure
that are currently offered.
Phase 2
Further draft guidance on phase 2 is expected to be
released in 2005. The summary included below is
therefore based on the ‘Draft Statement of
Principles’ (DSOP) produced by the IASC,
indications that have emerged from the IASB and
preliminary discussion between industry participants.
Although the IASB has currently only expressed
‘tentative conclusions’ regarding phase 2, this paper
works on the assumption that phase 2 will aim to
measure assets and liabilities arising from insurance
contracts at their fair value.
As previously mentioned, the move to fair values
(also known as prospective provisioning) will see an
end to the deferral of acquisition costs and the
spreading of premiums over the duration of the
contract. Both premiums and expenses will be
recognized immediately as a contract is signed, with
the accounting focused on the present value of
expected future cash flows.
For example, on writing a new policy, all present and
future expected cash flows will be recorded. The net
present value (NPV) of relevant contractual
premiums will be recorded as assets (and as
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premium income) whilst the future expected cash
flows for claims and expenses will be discounted to
their NPV and recorded as liabilities (and
claims/expenses).
This is conceptually straightforward in the case of
non-life contracts where a single premium is paid at
the start of the contract. The concept is more
complex for policies where premiums may be
received over a long period (e.g. life assurance
policies). The IASB has indicated that future
premiums will be able to be recognized if
policyholders have “non-cancellable continuation or
renewal rights that significantly constrain the
insurer’s ability to reprice the contract to rates that
would apply for new policyholders whose
characteristics are similar to those of the existing
policyholder” and that “those rights will lapse if the
policyholders stop paying premiums.”14 For example,
insurers would typically charge lower premium rates
on an existing life assurance policy compared with a
new policy for an individual of the same age.
Assuming that the definitions included above are met,
the insurer would recognize the expected cash flows
(including premium and payments) allowing for
projected lapse experience.
In addition to reserving for the best estimate of the
present value of future cash flows, it is expected that
insurers will also have to include a market value
margin (MVM) on top. This margin aims to take
total reserves to the level that would be sufficient to
encourage a third party to accept the relevant
liabilities and therefore represent a proxy for fair
value in the absence of a liquid market.
􀂄 Key Issues Arising From the
Insurance Accounting Standards
Some of the key issues arising from the
implementation of Insurance IFRS (phases 1 and 2)
are commented on below:
Phase 1 and Phase 2
ai. Increase in Volatility
Volatility associated with results is expected to
increase as a result of IFRS, particularly for those
entities that currently employ a national GAAP that
records investments at amortised historic cost (e.g.
Germany and France). The increased volatility will
largely stem from:
• Financial instruments (including equities, bonds
and derivatives) being valued at market value
rather than at amortised historic cost. The
14 IASB IFRS 4 Insurance Contracts – ‘Basis for Conclusions’ –
BC 6 (d).
classification of financial instruments as
available for sale or held for trading will lead to
volatility being recorded in equity or the income
statement respectively. (IAS 39)
• The removal of claims equalization or
catastrophe reserves which act to smooth
reported profits. (IFRS 4)
• The calculation of fair values (e.g. for embedded
derivatives and claims reserves) will be
dependant on a number of assumptions and
external variables that can move significantly.
Fair values may be sensitive to small changes in
these assumptions. (This volatility will be
caused by phase 1 in the case of some embedded
derivatives and phase 2 in the case of claims
reserves.)
• The fact that premiums and costs will no longer
be smoothed over time (through deferred
acquisition costs and an unearned premium
reserve) would be expected to increase volatility
in results. The degree of profit-smoothing over
time will depend on the calculation of MVMs
and other factors noted under Recognition of
Income below. (phase 2)
• Removal of prudential margins which have
historically been used by many insurers to
reduce profit in the good years and enhance
profit in the bad years. (phase 2)
Volatility in results will be a particular factor
following phase 1, and whilst assets and liabilities
are subject to different treatment (assets at fair value,
liabilities at historic cost.) On implementation of
phase 2, the overall reported volatility could be
moderated due to the impact of also recording
liabilities at fair value.
For example, following the introduction of fair
values and the subsequent discounting on reserves,
changes in the value of assets due to interest rate
movements will be counterbalanced by changes to
the valuation of reserves (e.g. an increase in interest
rates will lead to a fall in the value of bond assets but
also a fall in the discounted value of reserve
liabilities.)
It is important to note that the above example
assumes that volatility caused by interest rates for
both assets and liabilities is recorded similarly in the
financial statements (i.e. both in shareholders’ equity
or both in the income statement). If there is an
asymmetry of treatment then income statement
volatility is liable to increase.
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aii. Impact of Increased Volatility
It has been suggested by some (including the ABI,
the insurance association in the UK) that the
increased volatility from the proposed new insurance
standard would lead to a higher cost of capital due to
investors demanding a higher risk premium
associated with an investment. The ‘headline profit’,
it is argued, will be significantly affected by various
external factors and the impact of this will be
significantly greater on the results of insurers than
would be the case for a typical corporate entity.
Fitch believes that an impact on the cost of capital
does remain a possibility but there is little evidence
that the cost of capital would change to levels
inconsistent with the actual risk associated with
insurers. As the IASB has noted, many of the
insurers with access to the capital markets already
report assets at market value with the volatility to
profit or shareholders’ equity that this entails. In
addition, to the extent that transparency is improved
and risk reduced by the proposed new reporting and
this is rewarded by the markets, there could be some
offsetting benefit to the cost of capital.
The agency believes that in considering volatility, it
is important to make the distinction between that
resulting from economic mismatch (‘economic
volatility’) and that stemming from accounting
mismatch (‘accounting volatility’). Economic
volatility reflects the underlying economic reality of
the business and does have informational content.
This is very different to accounting volatility which
stems solely from asymmetrical accounting
treatment (e.g. the use of a different accounting basis
for assets and liabilities.)
Fitch welcomes the transparency provided by
reported volatility to the extent that it reflects the
true economic mismatch between assets and
liabilities (i.e. is economic volatility). Assessing this
mismatch is important information for the users of
financial statements, allowing analysts to better
determine a company’s risk and profitability.
Fitch’s concerns therefore relate not to volatility per
se, but to accounting volatility that does not reflect
the underlying economic reality and lacks
informational content. The agency believes that
accounting requirements should be structured to
minimise the level of accounting mismatch.
Although phase 1 does result in some accounting
volatility (e.g. due to assets being largely at fair
value whilst liabilities are not) this sub-optimal result
is still considered to be vastly preferable to a stability
in reported results that is misleading.
Phase 2 Only
b. Use of Discounting
The discount rate used in phase 2 is likely to be the
return on a risk-free asset, although there is still
some discussion about whether the credit quality of
the enterprise in question should impact the liability
recorded. This aspect is further commented on below.
In the past, Fitch has argued against the use of
discounting for most insurance reserves due to the
uncertainty that is associated with both the level and
the timing of the payments. Fitch believes that in
many cases, after adjusting the discount rate for a
risk premium to allow for uncertainty (the risk
premium is deducted from the discount rate in the
case of a liability), the appropriate discount rate is
low and close to zero.
However, the agency recognizes that the market
value margin is designed specifically to address the
issue of uncertainty. Under these circumstances,
Fitch may consider an allowance for the time value
of money through discounting to be appropriate,
depending on the definition, formulation and
sophistication of the calculated MVM. The agency
notes that the effect of the discount on reserves may
be partially or completely cancelled out by the
imposition of the MVM15.
c. Market Value Margin (MVM)
A market value margin is likely to be calculated at
phase 2 reflecting uncertainty and aiming to take
total reserves towards a level that would be sufficient
to encourage a third party to take the liability on. The
rationale is that due to risk (which is not necessarily
readily diversifiable), and perhaps due to transaction
costs or asymmetric information between the trading
parties, investors would require a premium above the
best estimate to take on the liability16.
An allowance for risk could be achieved either by
risk-adjusting the discount rate applied to expected
cash flows or by adjusting the cash flows directly to
take risk into account and then using a risk-free
discount rate. MVM’s take the latter approach and
can therefore be viewed as a method of adjusting
15 This is particularly likely for short tail business (as the effect of
the discount is relatively low) and, potentially, for longer term
exposures with a high degree of uncertainty (e.g. asbestos).
16 Conceptually, the allowance for risk in respect of insurance
liabilities is similar in nature to the allowance for risk that is
achieved on the assets side of the balance sheet. Fixed income
investments, for example, are represented by the net present
value of future cash flows discounted by a risk adjusted discount
rate. For cash flows with a higher degree of risk (e.g. a ‘BB’
rated bond) a higher discount rate and therefore lower value is
appropriate as compared with an investment having more certain
cash flows (e.g. a ‘AAA’ rated bond).
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expected cash flows to allow for the uncertainty
surrounding the best estimates of insurance liabilities
that have been derived.
However, market value margins do have some
theoretical and practical weaknesses and have been
criticized for:
• Inconsistency with economic theory which says
that no charge is appropriate for diversifiable
risks.
• Not being consistent with other similar
accounting standards (e.g. post retirement
benefits).
• Making accounts more opaque (e.g. some
capital may be “hidden” in the form of MVMs);
• Significant practical problems in their
introduction.
• An ability to be misused as a profit smoothing
device.
Despite the criticisms shown above, Fitch supports
the use of market value margins as being a method
of moving towards an estimated (although largely
hypothetical) market price and as a necessary buffer
to reflect the risks and uncertainties that are inherent
in insurance contracts. The agency’s support for
MVMs is derived from two main sources:
1. Theoretical
Whilst some aspects of risk are largely diversifiable
within a single portfolio (e.g. process risk – risk that
emerges from random statistical fluctuations), there
are some elements of risk that are not so easy to
diversify. For instance, model risk and parameter
risk refer to the difficulty of accurately classifying
the probability and severity of events and modelling
expected payouts (e.g. there may be uncertainty as to
whether losses will be normally distributed or
otherwise and whether the probability of an accident
is 5% or 10%). These uncertainties are much more
difficult to diversify than process risks and in Fitch’s
view represent an important justification for MVMs.
The theoretical justification for MVMs is increased
by the fact that fair values are to be defined in
respect of their current portfolio rather than the
potential value to a hypothetical third party insurer.
Given this fact, even risks that could theoretically be
diversified away (e.g. process risk) may still warrant
an adjustment for risk through the use of an MVM.
2. Practical
Based on past experience, Fitch believes that stated
‘best estimates’ of reserves deteriorate more
frequently than they develop positively. This is
especially true in liability lines and may be due to
some elements of unintentional bias that can occur as
part of the reserving process. Reasons for this bias
could include items such as actuaries basing reserves
on existing rules, regulations and known risks.
In an environment where new risks and regulations
emerge but few disappear, this may create some
degree of a negative bias to estimates. The observed
tendency for a general deterioration in reserves from
‘best estimates’ may also relate to a natural human
optimism on behalf of management, or the ‘benefit
of the doubt’ being awarded in formulating
assumptions where uncertainty exists. Fitch also
notes the possibility of insurers ‘cheating’17 as being
a potentially important factor in some cases.
The market value margins, depending on their
calculation and size, would go some way to
counteracting this observed effect on reserves. In
addition, the use of a market value margin which
effectively risk-adjusts the NPV of claim and
expense cash flows replaces the ‘buffer’ that was
previously provided by the non-discounting of
reserves.
This analysis applies to the concept of using MVMs
and does not address the significant difficulties
surrounding the formulation of the MVMs which are
the subject of much debate within the actuarial
profession. Particular difficulties will stem from
specifying the required level of sophistication whilst
at the same time promoting consistency between
companies and minimising opportunities for
manipulation.
d.) Recognition of Income
The recognition of income is a key controversy of
the proposals. Concerns have been expressed that the
move to fair values could lead to profits being
declared with no evidence of the profit having been
earned. This will be particularly important for life
insurance companies with their longer term contracts
and reliance in some cases on future investment
returns in order to generate profit.
In general, the move away from deferral and
matching to fair values will increase the level of
profitability that is declared at the start of the
contract for non-life insurers and reduce that
recognized in subsequent years. This is due to the
discounting of reserves (meaning that investment
income is effectively recognized at the start of the
contract) and the fact that premiums are not spread
over the period of the insurance contract. However,
as will be commented on further below, the pattern
17 Inaccuracies in reserving have been categorized by some in the
insurance industry as either due to ‘cheating’ or ‘being wrong’.
See the Fitch report ‘Property/Casualty Insurance Reserves at
Year-end 2002: Filling the Hole – Slowly’ for more details.
Available at www.fitchratings.com.
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Mind the GAAP: Fitch’s View on Insurance IFRS: May 2004
9
of income recognition will be heavily impacted by
the formulation of the market value margins and the
type of business that is being written.
Broadly speaking, the profit declared on acceptance
of an insurance contract would be equal to:
+ NPV of premiums
- NPV of claims and expenses
- Market value margin on reserves
- Acquisition expenses
= Profit declared on writing contract.
If all expectations in respect of a particular contract
are proved correct then the profit emerging in future
years will solely relate to any return made through
the investment return and to the release of market
value margins as the risk associated with future cash
flows reduces. Profits or losses may also emerge on
contracts after year 1 as a result of any differences to
expectation of claims or expenses.
0
5
10
15
20
25
30
1 2 3 4 Year
Profit in Units
Def & Matching
Exit Fair Values - With MVM
Exit Fair Values - No MVM
Entry Fair Value
Source: Fitch Ratings, see appendix C for contract
assumptions and more detail on the expected accounting for
this simplified contract.
Profit Signature on Example Contract
The graph above shows the emergence of profit on a
simplified non-life contract according to four
different methods of recognizing income. The
important feature to note is that although the total
profit recorded is unchanged, the timing of profit
recognition may be significantly affected by the
move to fair value accounting and the way that fair
value is defined. The possible definitions of fair
value under discussion are as follows:
1. Entry Fair Value
Entry fair values are designed to reflect the premium
that a third party would require to accept new
contracts with identical conditions and remaining
term. The implication of this is that unless an
insurer’s prices for a risk are demonstrably higher
than the market as a whole then no profit would be
recognized at the inception of the contract.
Profitability emerges over time as the risk associated
with a policy expires. As a result of the additional
conservatism at the start of the contract, profitability
will emerge more slowly for accounting under entry
values as compared with exit values. There are a
number of ways in which entry values could
potentially be formulated to allow profitability to
emerge over time. In the example shown, Fitch has
assumed that as risk expires, the entry value method
converges to that of exit values with an MVM.
The rationale for using entry values would be a
belief that: i.) entry value is more in tune with
existing revenue recognition rules and makes
allowance for the fact that the policyholder may have
a right to cancel the policy mid-term; and ii.) the
price charged in the market for a particular risk is an
observable market price that can be used to
determine fair value for unexpired risk.
This form of profit recognition appears to be
favoured currently by the IASB, although there are
some significant difficulties with this approach,
particularly when applied to life insurers. An
absence of profitability being recorded on new
business written may make the relative performance
of companies more difficult to measure. In addition,
the approach could also lead to discontinuities in
accounting (e.g. for expired and unexpired risk)
which may add to complexity and reduce
comparability over time and between companies.
In practice, if no profitability were permitted on new
business, then it is likely that the insurance industry
would employ some form of ‘embedded value’
reporting to allow companies to indicate the
profitability that they expect to emerge. Fitch
believes that supplementary reporting would add
complexity, and in the absence of defined standards,
reduce consistency between companies. Ultimately,
the agency believes that the absence of some degree
of profit on new business would be likely to reduce
transparency and the usefulness of financial
statements.
2. Exit Fair Value
This aims to set liabilities to the level required to
induce a third party to take over the contract
liabilities that exist. Importantly, this would allow
profits to be recognized at the start of the contract
with the level of profits recognized at inception
depending on the size of the market value margins.
There are two principal possibilities:
• No Use of Market Value Margins
It has already been noted that market value margins
can be criticized on theoretical as well as practical
grounds. If no market value margins were used then
100% of the expected profit would be recognized on
accepting the new insurance contract. The profit
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Mind the GAAP: Fitch’s View on Insurance IFRS: May 2004
10
recognized would equal the net present value of all
expected cash flows and if all parameters emerged as
expected (e.g. loss experience, expenses, investment
return) then no further profitability would emerge
from the contract. However, to the extent that actual
experience and updated expectations differ from that
originally planned for, gains and losses would
emerge from the contract from one year to the next.
This approach is favoured by some, including the
Financial Services Authority (FSA) in the UK,
which believes building in prudential margins can
result in problems being opaque. Although the IASB
regards the Market Value Margin as an adjustment to
simulate the market price rather than a prudential
buffer, the FSA currently favours basing all
assumptions on best estimate without these margins.
Under this reporting model, management and
regulators would ensure that sufficient capital is
available to deal with any negative shocks that may
emerge.
• Use of Market Value Margins
The use of market value margins would have the
effect of smoothing the profitability associated with
a contract. Some profitability would be likely to be
reported at the start of a contract (calculated based
on discounted expected future cash flows reduced to
the extent of the market value margin). Over time, as
further information emerges (e.g. through reported
loss experience), the market value margin would be
reduced (reflecting the reduced uncertainty) and
some further profitability would emerge.
Fitch considers that the smoothing effect provided by
MVMs does provide a practical alternative to the
difficulties associated with other methods of profit
recognition. This approach does provide information
on the degree of uncertainty, and expected
profitability associated with a portfolio which could
be lost to many users if no profit were declared on
writing a contract. In addition, Fitch does not favour
the option of recording 100% of expected profit in
year 1 for the same reasons that it supports the use of
MVMs (see previous section).
e.) Need to Distinguish Between
Distributable and Non-Distributable
Reserves.
The volatility that is associated with the proposed
fair value accounting gives rise to the issue of which
accumulated profit reserves should be distributable
and which should not. It is unlikely to be desirable
for all profits that emerge as a result of assumptions
made by management (e.g. assumptions as to the
profitability of a new long tail business line being
written) or as a result of market volatility (e.g.
unrealized gains on unhedged, long term derivative
positions) to be distributable to shareholders. This
issue will need to be considered objectively and
could be dealt with by suitably structuring the
financial statements or through the capital
requirements that will be demanded by regulators
(e.g. through the solvency 2 project.)
Although the income statement looks likely to
include profitability from a number of sources, users
of the accounts will need to become increasingly
sensitive to the ‘quality of earnings’. Earnings which
are derived from management assumptions (e.g.
assumed profitability on contracts written) will be
treated as being of lower quality than realized profits
which have been validated by experience.
f.) Should Fair Values Reflect the Credit
Standing of the Insurance Company?
From a strictly theoretical point of view, the fair
value of a liability, which is determined as the
present value of expected future outward cash flows,
should recognize that there is some possibility of
default on the obligation. Recognizing this
possibility reduces the expected value of future cash
flows and therefore the level of the liability. Looked
at another way, it would cost more for a company
with a high credit rating to induce an insurer of
similar credit standing to take over its liabilities than
it would for a weaker company to achieve the same
thing.
Therefore, theory suggests that weaker insurers
should use a higher discount rate on reserves,
resulting in a lower liability. In more general terms,
the discount rate used by companies (theoretically)
should be linked to their own credit rating and to the
risk premium that the market requires for this risk.
Although this may be a sound theoretical argument,
Fitch is extremely uncomfortable with this concept
given the implication that weaker insurers would
reserve less than stronger players for the same
liability. Also, there is significant circularity in such
arguments given that a credit downgrade could lead
to reduced liabilities and therefore stronger reported
capitalization. Finally, the agency believes that such
a suggestion has significant practical problems (for
example, how to treat unrated insurers or insurers
with multiple credit ratings) and that such a move
would reduce the comparability of financial
statements and thereby their usefulness to the users
of accounts.
As a result of the points made above, Fitch would
prefer to see liabilities calculated independently of
the credit quality of the insurer. However, if fair
values were to reflect the credit standing of a
particular insurer, the agency would look for
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Mind the GAAP: Fitch’s View on Insurance IFRS: May 2004
11
disclosures sufficient to allow for the standardization
of reserves at a particular rating level.
g.) Disclosure
No details have yet been set out on the disclosure
that will be required with phase 2 although the
requirements are likely to be in line with the broad
principles set out in phase 1. However, Fitch
believes that detailed disclosure will be critical in
enabling users of the accounts to properly interpret
fair value accounts. Disclosures are particularly
important for both assets and liabilities where they
are “marked to model” in the absence of a liquid
market. A recorded ‘fair value’ on its own can
provide relatively little information on the likely
standard deviation of returns, the sensitivity of
returns to specific events or the maximum losses. All
of these are relevant and important information for
the users of financial statements.
The disclosures required as part of phase 2 will be
developed by the IASB alongside the development
of the required accounting. However, examples of
important disclosure would include methodology,
sensitivity analysis, and an outline of significant
assumptions. Specific examples would include:
1. Disclosure of Inflation Assumptions
In the application of discounting, Fitch would
welcome disclosure of the inflation assumptions that
have been used and, in particular, the link assumed
between interest rates and inflation rates.
The risk is that higher interest rates lead to a
reduction in discounted claims reserves but inflation
expectations may not be adequately reflected in
claims reserves. For example, if an interest rate
increase is due to higher actual or anticipated
inflation, then expected nominal cash outflows are
likely to increase – a factor that should be
incorporated into reserve calculations.
The agency’s concern is that actuaries are often
better at projecting historic trends forward than at
estimating those that will emerge in the future.
Disclosure of inflation assumptions would assist
users in assessing the degree of conservatism that
has been applied and ensure that insurers do not take
additional credit for reserve discounting when the
impact is likely to be offset by greater cost inflation.
2. Disclosure of MVM
It will be important for the market value margin to
be disclosed in order that users of the accounts are
able to clearly identify the best estimate of liabilities
and the margin that has been built into the estimate.
A segmental disclosure of the MVMs would further
assist users in comparing between companies and
over time. This disclosure would be important for
analysts to establish likely future profitability and
also to identify the degree of confidence that
actuaries are able to apply to the reserves set. In
addition, this would give analysts the option of
considering MVMs either as additional capital above
a ‘best-estimate’ of reserves or as a prudential
reserve to counter any uncertainties or bias in reserve
calculations.
In highlighting the importance of disclosure, the
agency includes the issue of performance
presentation in addition to ‘footnote’ disclosures.
Fitch believes that the way the income statement
(and balance sheet) is structured and presented can
significantly enhance the usefulness of the financial
statement data.
h.) Other Areas
Other important areas where guidance will be
required clearly include the formulation and
calculation of the MVM as well as the following:
1. Diversification Credit
The MVMs are likely to be additive between the
pools or segments that they are calculated in (i.e. the
grouping of contracts used to calculate the MVM).
This means that no diversification credit will be
permitted between segments, although
diversification credit may well be available for
business calculated within segments (particularly if
stochastic modelling is utilized). The logical
consequence of this is that the size and formulation
of the pool or segment will impact the size of the
MVM required.
This could give insurers an incentive to carefully
manage the business that is classified together for the
purposes of determining an MVM or in performing
such calculations based on as few large units as
possible. The IASB will need to be wary of this
possibility and set out guidance preventing possible
abuse.
2. Discount Rates
The DSOP indicates a preference that cash flows at
each maturity should be discounted by different rates
depending on the term structure of risk-free interest
rates. This means that any shift in the term structure
of risk-free interest rates (i.e. changes to the yield
curve) will affect the valuation of liabilities and
therefore reported profitability (unless assets and
liabilities are fully matched). Guidance may be
required in how the term structure of interest rates
should be calculated, particularly where there is no
observable risk-free maturity.
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Mind the GAAP: Fitch’s View on Insurance IFRS: May 2004
12
3. Reinsurance Recoverables
The IASB has already specified that reinsurance
recoverables should be shown separately on the
balance sheet and not be netted off of liabilities.
However, it is not yet clear whether the discount rate
applied to estimated future cash flows should be risk
adjusted. Practical difficulties will exist in
determining the credit risk associated with particular
reinsurers and it is not clear how dispute risk will be
allowed for.
􀂄 Business Implications of Fair Value
Reporting
It is important to note that there will inevitably be
some business implications associated with the
implementation of the new standards. Given the
current preliminary proposals, the full business
implications of fair value reporting are not yet clear.
However, the implications could include the
following:
• Changes to product design – Some product lines
that are currently profitable may be less
profitable when assessed on a fair value basis
and will need to be modified or scrapped. In
addition, the duration of some (particularly life)
contracts could be shortened in order to reduce
the volatility that is associated with them.
• Improved matching – One of the key benefits of
fair value reporting is the fact that it highlights
cases where risks are not fully matched. It is
likely that assets and liabilities will be more
closely matched (e.g. in duration, currency) as a
result of the move to fair values.
• Changes to Investment Strategy – In order to
reduce volatility, there may be a trend towards
closer matching and some companies may move
away from equity investments and towards fixed
interest investments. Hedging strategies may
also need to be amended in order to ensure that
they are compliant with the requirements of the
published standards.
• The change in the definition of insurance
contracts may have a significant impact on
recorded premiums. Policies will need to be
unbundled into their insurance and investment
aspects which could result in a significant
reduction in reported insurance premiums for
many companies.
These business implications will have an important
impact on the cost and benefits associated with the
change to IFRS reporting. The claimed costs and
benefits of a change to IFRS are shown in Appendix
A.
􀂄 Impact of Insurance IFRS on
Analysis Methodology
Fitch’s publicly available criteria for rating insurance
companies were designed to be sufficiently flexible
to allow the agency to rate insurers reporting under a
variety of accounting standards. The agency ensures
that it understands the material differences that arise
as a result of various accounting methods so that
insurers can be compared between countries.
That said, the introduction will have a number of
specific effects on the way that Fitch considers
insurers:
• The significant additional disclosure that is
available will undoubtedly aid analysis. Fitch
supports the general principle of requiring
management to disclose more information on
the risks that they perceive “so that users can
assess the insurer’s financial position,
performance and cash flows ‘through the eyes of
management’”. Particularly welcome are the
disclosure requirements on assumptions,
concentrations of risk and sensitivity analysis as
well as the requirement to provide information
on insurance risk, interest rate risk and market
risk.
In addition, the agency welcomes information
on claims development and the requirement to
disclose risks with special characteristics. This
latter regulation will require information on
items such as asbestos and recognizes the
important risks that these exposures can
represent.
• Investments – Recording investments at market
value rather than amortised historic cost will
have little impact on the way that insurers are
viewed. Fitch already considers balance sheets
and profitability based on market values in
virtually all cases. This information is either
based on disclosure in the financial statements
or on additional information requested from the
rated insurers.
• Reserves – Phase 1 will have little impact on
how reserves are viewed given the fact that they
will continue to be calculated in the same way.
Changes to disclosure, however, could have
some impact on our view. Phase 2 is likely to
have more of an impact due to new information
that could be provided by the market value
margin and the requirement to reserve to the
best estimate.
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Mind the GAAP: Fitch’s View on Insurance IFRS: May 2004
13
• Capital – Equalisation and catastrophe reserves
are currently treated as part of an insurer’s
capital base. Therefore, the release of these
reserves will not impact capital sufficiency
unless they are either taxed (which appears
unlikely in the near term) or paid out as
dividends. Similarly, the ‘Fund for Future
Appropriations’ in life companies are typically
also treated as part of the capital base and this is
not expected to change under IFRS. The
financial flexibility of insurers (i.e. their ability
to source additional funds relative to needs) is
unlikely to be materially affected by IFRS but
this will continue to be assessed on a case by
case basis.
Although Fitch’s view may be affected by new
information on the size, method of calculation
and definition of the MVM, the agency currently
expects to treat MVMs as part of the best
estimate of reserves and not as part of capital.
This treatment, which differs from the 100%
equity credit awarded to existing equalization
and catastrophe reserves, is a result of several
factors:
1. The perceived bias in best estimate
reserves to deteriorate rather than
improve (as discussed earlier). In recent
years, this deterioration has been
despite reserves not having been
discounted for the time value of money
which should have provided an
additional level of comfort.
2. The discounting of reserves removes a
reserving buffer that previously existed
and exists in many other jurisdictions
(including US GAAP). Consistency
with other accounting regimes will be
increased by application of a prudential
margin to reserves above best estimate.
The inclusion of MVMs as part of
reserves will offset this effect.
• Earnings – These are likely to change
significantly at phase 2 although the effect will
depend on policies surrounding income
recognition. Fitch will continue to consider the
reported profitability although, particularly if
profit recognition is very slow, the agency will
consider the ‘embedded value’ that has been
generated. The agency will also continue to be
mindful of the quality of earnings which will
become particularly important in the move to
IFRS, whilst also ensuring that insurers are
treated fairly with those reporting under other
national GAAP.
Reinsurers that offer financial reinsurance could
see the demand for their product change as a
result of adjustments to the method of
accounting for contracts with low levels of
financial risk. Fitch believes that this is most
likely to have a negative effect on demand for
such solutions at phase 2. However, demand for
financial reinsurance may increase following
phase 1 due to the additional volatility in the
results of some insurers which they could seek
protection from.
􀂄 Impact of Insurance IFRS on
Ratings
A change in accounting standards does not impact
the underlying economic reality within the business
and, therefore, no rating changes would be expected
as a direct result of the move to the new insurance
IFRS. That said, the new standard could have
business implications (as already noted) and could
conceivably shed additional light on new issues. To
the extent that the new disclosures and financial
reporting provides a better view of the true economic
picture, rating actions could result. Further factors
that could lead to changes in insurance company
ratings would include:
Taxation
A change in the method of accounting may have a
real impact if it affects the basis of taxation. It
currently seems unlikely that the move to fair values
for listed consolidated companies will have a
significant impact on the tax that has to be paid.
In many countries within Europe (e.g. Germany and
France), tax is calculated based on individual
company, unconsolidated accounts. These accounts
will continue to be prepared under local GAAP
based on current plans leaving the tax liability
unchanged. In other cases (e.g. the UK), tax law
generally prevails over statutory reporting and is
therefore also unlikely to be affected by the change
to insurance IFRS in the near term. However, over
the medium to long term, it is possible that the use of
IFRS will be expanded to include individual
company accounts and, as a result, the basis of
taxation could change.
IFRS could have a particular impact if the release of
equalization reserves on the consolidated accounts
were to lead to the taxation of these reserves. In this
case, claims could no longer be met by equalization
reserves (held pre-tax) and would need to be met
through shareholder equity (post-tax). Although this
only relates to a timing difference in when tax is due,
it would still result in a significant loss of effective
capital to the insurance industry and a corresponding
benefit to state coffers.
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Mind the GAAP: Fitch’s View on Insurance IFRS: May 2004
14
Product Demand
It has already been noted that demand for some lines
of business (e.g. some low risk transfer products
such as financial reinsurance) could be impacted by
the proposed insurance IFRS. Any shift in product
demand could have an effect on Fitch’s credit view
relating to particular companies. However, rating
changes solely based on this factor are expected to
be rare.
Business Reaction
As noted above, the change to fair values may have
real effects, because they may cause management to
change the way in which they run the business. For
example, changes to product design, improved
matching and changed investment strategies could
all have some impact on the ratings assigned. Fitch
does not expect business reaction to have a
significant credit impact in the majority of cases.
Investment Market Reaction
If changes to accounting standards were to affect the
perception of risk associated with the insurance
industry then this could affect financial flexibility
and therefore ratings within the industry. For
example, if the cost of capital were to increase for
insurance companies due to the accounting change
then this could negatively affect the credit quality of
the industry by reducing access to new funds.
In practice, Fitch believes that the chances of a
significant impact on credit quality from changes to
the cost of capital are low. This is a result of a low
expected change in cost of capital, the ability of the
insurance industry to pass on a higher cost of capital
to policyholders in the form of pricing, and a
possible offsetting effect if market participants
perceive the new accounting information as being of
a higher quality.
􀂄 Conclusion
Fitch is very supportive of the efforts being made by
the IASB to bring greater comparability and
increased disclosure to the insurance industry. The
agency also views the move towards fair values as
being an important and valuable aim which, when
fully implemented, should lead to increased
transparency and will assist users of accounts in
better determining the underlying economic reality
within an insurance company.
However, Fitch notes that significant challenges
remain before fair values can be introduced. There
are a number of important issues that still need to be
resolved and companies will need time in order to
implement the necessary system changes and collect
the required data to produce fair value accounts. The
original deadline of 2007 for implementation seems
very optimistic given the issues that still need to be
resolved and the slow pace of progress in recent
years.
The agency does not anticipate many rating changes
to occur solely as a result of the change to insurance
IFRS, and the current rating methodology is
sufficiently flexible that changes to analytical
methodology will be limited. Companies that are
most likely to be impacted are those where the basis
of taxation may be affected by IFRS (this is not
anticipated in the short to medium term) or that see
reductions in product demand as a result of the
change.
Fitch welcomes the additional disclosure required at
phase 1 and notes that disclosure at phase 2 will be
extremely important in interpreting financial
statements. Experience with US accounting
standards (e.g. FAS 133) has shown that fair value
disclosure by itself is not sufficient. It is also
essential that disclosures allow users to assess the
level of risk associated with the fair values shown,
e.g. through disclosure of significant assumptions
and areas of judgment, as well as through sensitivity
analysis. The agency would prefer to see a greater
degree of ‘prescribed’ disclosure at phase 2 to ensure
that certain important disclosures are presented in a
consistent and comparable form.
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Mind the GAAP: Fitch’s View on Insurance IFRS: May 2004
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􀂄 Appendix A – Principal Benefits of
New Insurance IFRS reporting
The principal benefits claimed for the move towards
the new standards are as follows:
• Transparency – Fair values and improved
disclosure offer greater transparency and insight
into the financial position of the company.
Showing assets (and liabilities at phase 2) at fair
value gives a better view of the financial
position of the company at a point in time. In
addition, showing both assets and liabilities at
fair value has the added advantage of avoiding
the mismatch that occurs if these categories are
treated differently.
One of the important features of the move to fair
values is that embedded derivatives and options
will be shown at market value. This may be
particularly important in the cases of certain
embedded derivatives such as Guaranteed
Annuity Options (which caused significant
difficulties at Equitable Life) and other products
with associated guarantees. At phase 2, the fair
value of these options and guarantees are likely
to be included in the financial statements; at
present, these options often go unrecorded.
The improved transparency and disclosure may
result in improved decisions by management
and better targeting of capital by investors. In
particular, phase 2 is likely to encourage
management to more closely monitor and
control their risks (e.g. matching of asset and
liability duration to reduce interest rate risks).
• Consistency – The standardization of accounting
standards will be an important achievement in
itself. This will promote greater comparability
between companies and may improve the ability
of some insurers to access global capital markets.
The existence of a common European standard
will also make it easier to promote a
convergence of global accounting standards.
Both FASB and the IASB have indicated that
they are keen to achieve this convergence.
• Reduce accounting arbitrage – Applying
insurance accounting to insurance contracts
rather than only to registered insurers will
reduce the opportunity for arbitrage between
different accounting methods. Currently, there
may be benefits or costs to performing a
particular transaction either inside or outside an
insurance entity based on the different
accounting treatment.
• Improved management – The greater
sophistication of tools that will be required to
improve fair values will encourage companies to
improve their capital management, risk
management and asset/liability matching. This
greater sophistication may also give
management and analysts greater insight into
those products that are most efficient at
producing value.
Against this, there are a number of concerns that
have been cited by industry observers and in
particular, by insurance companies themselves:
• Cost of Capital – Insurers are concerned that
there will be an increase in the cost of capital as
a result of the increased volatility that is
expected from the new reporting standards and
investors interpreting this as an increase in risk.
• Reliability – The reliability of fair value
reporting, particularly for insurance liabilities, is
often questioned. The production of these values
is said to require a level of sophistication (e.g. in
stochastic modelling techniques) that may be
beyond many insurers and the results of these
models may not be reliable. In addition, the use
of such techniques will inevitably require some
assumptions to be made and these assumptions
may be susceptible to manipulation by
management
• Practicality – The practical aspects of
implementation will inevitably be difficult due
to the tight deadlines that have been set, the lack
of trained personnel (particularly actuaries) and
the need for firms to gather new types of
information and to educate analysts and other
users of the accounts.
• Investment Strategy – Some insurers have
suggested that volatility may adversely affect
the investment strategies that are used. Some
insurers may choose to switch investments from
equities to more stable investments such as
bonds in order to reduce potential volatility. It is
argued that the resulting investment strategy
could be over-cautious and not justifiable for
either policyholders or shareholders on a long
term view. Other stakeholders would see this
improvement in matching to be a positive
development.
• Achieving consensus – There are difficulties
still to be resolved in agreeing the standards. A
number of contentious issues still exist over the
details of implementation, including the method
of calculating the market value margin, which
forms of profit should be distributable to
shareholders, and when to recognize
profitability.
Insurance
Mind the GAAP: Fitch’s View on Insurance IFRS: May 2004
16
􀂄 Appendix B – Additional Issues
This appendix includes a number of additional issues
that are also noteworthy in considering IFRS.
Firstly, it is worth noting a number of issues that
have proved controversial but now appear to have
been resolved:
Phase 1 – Sunset Clause
A feature of exposure draft (ED) 5 that came under
some criticism is the existence of a “sunset clause”
which set a time limit on the progress towards the
implementation of Phase 2. The draft exempted
insurance companies from applying IAS 8
(‘Accounting policies, changing in accounting
estimates and errors’) until 2007. In the absence of
this exemption, insurers would have been required to
account for liabilities in accordance with IAS 37
(provisions, contingent liabilities and contingent
assets). This standard would require the use of a
discounted best estimate (using a risk-adjusted
discount rate) of non-life liabilities and potentially
the use of US GAAP for life liabilities18, each of
which would represent a significant change for many
companies. Therefore, in the absence of amendments
to the proposed standard or a subsequent override,
any delay in phase 2 (fair values) would have
resulted in a second ‘interim solution’.
IFRS 4 still refers to the IAS 8 exemption as
temporary but no time limitation has been included
in this standard.
Phase 2 – Entity Specific Values
Although the objective of the insurance accounting
standard would ideally be to reach the fair value of
insurance liabilities, this is hampered by the lack of a
liquid market. This determination of value is also
hindered by the fact that fair value cannot be
determined as the sum of that associated with
individual risks. The value of a portfolio varies
according to the portfolio which individual risks are
held in and the efficiency of the administration.
Such factors will often vary by buyer.
In order to address this difficulty in finding a true
fair value that a third party would be prepared to pay,
the DSOP (Draft Statement of Principles) originally
defined an ‘entity specific’ value. This allowed the
use of assumptions based on the insurer’s own
experience and expectations in the valuation
calculation. For instance, a true fair value (based on
a third party arms length transaction) could require
an assessment of industry expense levels, or ideally,
an assessment of the expense levels associated with
possible buyers. Given the difficulties associated
18 Source: Tillinghast-Towers-Perrin – 4/2003.
with each of these options, the entity specific fair
value of the portfolio allowed the company to use its
own expense experience in order to calculate policy
fair values and is considered to be a reasonable
proxy.
The IASB still expects insurers to use entity specific
parameters (e.g. for expenses) but has defined ‘fair
values’ in such a way as to be consistent with the use
of this entity specific information.
Secondly, there are a few other areas of IFRS that
are not considered to be central to this report but are
worth noting:
Comparison with US GAAP
As insurers increasingly switch to IFRS, accounting
standards will move increasingly to a situation where
there are two dominant sets of accounting standards,
IFRS and US GAAP. Over time, it is expected that
these two sets of standards will converge but in the
meantime there will be some important differences
that are of particular relevance to insurers. For
example:
• IFRS currently requires that impairments that
have been recorded on assets are subsequently
reversed (no further than the amortised historic
cost) where the valuation recovers. This is an
important difference from US GAAP, which
forbids such a reversal. This may benefit
insurers currently reporting under IFRS
compared with those reporting under US GAAP,
particularly under current market conditions
where the stock market is showing signs of
recovery after heavy falls and high impairment
charges. It should be noted that this will change
in 2005 with the revised version of IAS 39 (as
noted below).
• Phase 2 will require discounting of liabilities,
which is generally not permitted under US
GAAP. Some US insurers have expressed
concerns that this may give European insurers
an advantage, particularly in reporting profits on
long-tailed lines of business. In reality, the true
impact is currently very difficult to assess given
the uncertainty surrounding the way that the
market value margin will be calculated. Rating
agencies and other users of the accounts would
also be expected to standardize reporting as far
as possible between different reporting standards
to ensure that companies are compared on a
common basis.
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17
Recent Changes to IAS 39.
Although this paper does not intend to review IAS
39 (Financial Instruments) in detail, there are a few
important points to note. In December 2003, the
IASB released a revised version of IAS 39 and IAS
32 which is not required to be used until 2005
although companies do have the option of early
adoption.
The IAS 39 revised standard has some important
differences to that currently in use by companies
reporting under International Accounting Standards.
Some of the main differences include:
Selected Differences Between IAS 39
(Rev. 2000) and IAS 39 (Rev. 2003)
IAS 39 (Rev. 2000) IAS 39 (Rev. 2003)
i.) Impairment of an Available-for-Sale Equity
investment…
due to a significant (20%)
and prolonged (6 months)
decline in the fair value below
its cost.
due to a significant (20%) or
prolonged (6 months)
decline in its cost (IAS39.61)
ii.) Impairment Losses of an Available-for-Sale Equity
Instrument…
recognized in profit or loss
shall be reversed through
profit or loss.
recognized in profit or loss
shall not be reversed
through profit or loss.
(IAS39.69)
Source: IAS 39, Munich Re
For instance, the revised (2003) IAS 39 has a stricter
impairment test than that implied by the previous
standard as well as increased consistency with US
GAAP and between companies in the treatment of
revaluations following impairments. For those
insurers that have made use of the option to apply
the revised standards early, this has led to
impairments that would otherwise have been taken in
2003 being taken in 2002 in a restatement of the
prior year.
The revised standards have a greater comparability
with US GAAP which forbids the reversal of
impairment losses. It is also noteworthy that the new
IAS 39 standard includes an option to allow insurers
to designate any asset (on initial recognition) as ‘at
fair value through profit and loss’19. This should help
companies to limit the degree of accounting
volatility contained within their financial statements
by enabling them to more closely match the
treatment of assets and liabilities.
Interaction of Insurance Reporting with
IAS 39
IAS 39 specifies the way that investments,
derivatives and options should be accounted for. It is
likely that contracts issued by insurance companies
that fail to meet the definition of an insurance
contract will be accounted for as financial
instruments under this standard.
It is important to note that the difference between an
insurance contract and a financial instrument can be
small. For example, a premium paid to gain
protection against a credit rating downgrade of a
particular entity would be accounted for as a
derivative under IAS39. This compares with the
similar situation where a premium is paid to gain
protection against the failure of a debtor to pay when
due. This counts as a financial guarantee contract
that is outside of the scope of IAS 39 and would be
accounted for as insurance.
The adoption of Insurance IFRS, particularly at
Phase 2, will require a detailed portfolio review of
insurers’ portfolios to identify areas that are covered
by IAS39 (e.g. contracts that fail to meet the
definition of an insurance contract and embedded
derivatives such as index-linked bonds and
guaranteed annuity options). This process will be
complicated by the fact that the classification of a
particular contract may differ during its life. The
current proposals state that the contract is
categorized at the start of its life and then will not be
recategorised, although this could potentially be
subject to abuse.
19 In response to concern from regulators that this proposal could
be open to abuse (e.g. by recognising profitability on financial
instruments whose valuation is subject to subjectivity), the IASB
has recently released an exposure draft that would somewhat
limit this option although still aims to meet the original objective.
Insurance
Mind the GAAP: Fitch’s View on Insurance IFRS: May 2004
18
􀂄 Appendix C – Example of Possible
Accounting Treatment.
The following very simplified example is designed
to show the different way that income emerges under
the current deferral and matching approach and
under the fair value approach. The example also
shows the importance of the definition of ‘fair
values’ and the substantial impact that this may have
on the pattern of income recognition.
It is important to note that these examples are
illustrative only. The examples have been
constructed to demonstrate the general principles
inherent in the discussion of phase 2 and should not
be taken as necessarily representing the way that
accounting will work under phase 2, as the
formulation of some concepts (e.g. entry values) is
still under discussion. In particular, these examples
have been presented in a simplified manner and do
not represent the exact presentation that is envisaged
at phase 2.
The simplifying assumptions made for the examples
below include the following:
• A single policy is written for 100 of premium,
60 of claims are expected to be paid (and are
paid) in year 4.
• Acquisition costs are 20, incurred at the time of
writing the policy.
• The policy incepts half way through year 1 and
lasts for one year.
• Premiums received and acquisition costs are
paid at start of the policy. All other cash flows
occur at year ends.
• Discount rate is 3% (risk free) with the yield
curve assumed to be flat.
• Actual Investment Return = 4%.
• The Provision for Risk and Uncertainty (Market
Value Margin) is assumed to be calculated as 12
(pre-discount) where exit fair values are used
and the risk is assumed to decline by one-third
in year 2 and by a further 50% in year 3 prior to
settlement in year 4.
• Under Entry Fair Values, the MVM is set up
such that no profit is made in year 1 (i.e. insurer
is unable to show that it is charging more than
the market average for the risk). As the
insurance contract expires, accounting has been
assumed to converge with that of exit values
using an MVM.
Deferral and Matching
Year 1 Year 2 Year 3 Year 4 Total
INCOME STATEMENT
Net Premiums Written 100 - - - 100
Net Premiums Earned 50 50 - - 100
Net Claims Expense (30) (30) - - (60)
Acquisition Costs (10) (10) - - (20)
Underwriting Profit 10 10 - - 20
Investment Return 1.6 3.3 3.4 3.5 11.8
Profit 11.6 13.3 3.4 3.5 31.8
BALANCE SHEET
Cash and Investments 81.6 84.9 88.3 31.8
Deferred Acquisition Costs 10 - - -
ASSETS 91.6 84.9 88.3 31.8
Unearned Premiums 50 - - -
Claims Reserves 30 60 60 -
Retained Earnings 11.6 24.9 28.3 31.8
LIABILITIES 91.6 84.9 88.3 31.8
CASHFLOW
Premiums 100 - - - 100
Expenses (20) - - - (20)
Claims - - - (60) (60)
Investment Income 1.6 3.3 3.4 3.5 11.8
Total 81.6 3.3 3.4 (56.5) 31.8
Source: Fitch estimates
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19
Possible Accounting Treatment Using Exit Fair Value (With MVM)
Year 1 Year 2 Year 3 Year 4 Total
INCOME STATEMENT
Net Premiums (NPV) 100 - - - 100
Net Claims Expense (54.1) (54.1)
Provision for Risk and Uncertainty* (10.8) 3.8 3.9 4.0 0.8
Acquisition Costs (20) - - - (20)
Profit – Insurance Business 15.1 3.8 3.9 4.0 26.7
Investment Return 1.6 3.3 3.4 3.5 11.8
Unwind of Discount – Claim Reserve (0.8) (1.6) (1.7) (1.7) (5.9)
Unwind of Discount – MVM (0.2) (0.3) (0.2) (0.1) (0.8)
Profit 15.7 5.1 5.4 5.7 31.8
BALANCE SHEET
Cash and Investments 81.6 84.9 88.3 31.8
ASSETS 81.6 84.9 88.3 31.8
Claims Reserves 54.9 56.6 58.3 -
Provision for Risk and Uncertainty 11.0 7.5 3.9 -
Retained Earnings 15.7 20.8 26.1 31.8
LIABILITIES 81.6 84.9 88.3 31.8
CASHFLOW
Premiums 100 - - - 100
Expenses (20) - - - (20)
Claims - - - (60) (60)
Investment Income 1.6 3.3 3.4 3.5 11.8
Total 81.6 3.3 3.4 (56.5) 31.8
* Also known as the Market Value Margin or MVM.
Source: Fitch estimates
Insurance
Mind the GAAP: Fitch’s View on Insurance IFRS: May 2004
20
Possible Accounting Treatment using Exit Fair Value (NO MVM)
Year 1 Year 2 Year 3 Year 4 Total
INCOME STATEMENT
Net Premiums (NPV) 100 - - - 100
Net Claims Expense (54.1) - - - (54.1)
Provision for Risk and
Uncertainty
- - - - -
Acquisition Costs (20) - - - (20)
Profit – Insurance Business 25.9 0 0 0 25.9
Investment Return 1.6 3.3 3.4 3.5 11.8
Unwinding of Discount (0.8) (1.6) (1.7) (1.7) (5.9)
Profit 26.7 1.6 1.7 1.8 31.8
BALANCE SHEET
Cash and Investments 81.6 84.9 88.3 31.8
ASSETS 81.6 84.9 88.3 31.8
Claims Reserves 54.9 56.6 58.3 -
Provision for Risk and
Uncertainty
- - - -
Retained Earnings 26.7 28.3 30 31.8
LIABILITIES 81.6 84.9 88.3 31.8
CASHFLOW
Premiums 100 - - - 100
Expenses (20) - - - (20)
Claims - - - (60) (60)
Investment Income 1.6 3.3 3.4 3.5 11.8
Total 81.6 3.3 3.4 (56.5) 31.8
Source: Fitch estimates
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Mind the GAAP: Fitch’s View on Insurance IFRS: May 2004
21
Possible Accounting Treatment using Entry Fair Value
Year 1 Year 2 Year 3 Year 4 Total
INCOME STATEMENT
Net Premiums (NPV) 100 - - - 100
Net Claims Expense (54.1) - - - (54.1)
Provision for Risk and
Uncertainty
(18.4) 11.7 3.9 4 1.2
Acquisition Costs (20) - - - (20)
Profit – Insurance Business 7.5 11.7 3.9 4 27.1
Investment Return 1.6 3.3 3.4 3.5 11.8
Unwind of Discount–Claim
Reserves
(0.8) (1.6) (1.7) (1.7) (5.9)
Unwind of Discount-MVM (0.3) (0.6) (0.2) (0.1) (1.2)
Profit 8.1 12.7 5.4 5.7 31.8
BALANCE SHEET
Cash and Investments 81.6 84.9 88.3 31.8
ASSETS 81.6 84.9 88.3 31.8
Claims Reserves 54.9 56.6 58.3 -
Provision for Risk and
Uncertainty*
18.6 7.5 3.9 0
Retained Earnings 8.1 20.8 26.1 31.8
LIABILITIES 81.6 84.9 88.3 31.8
CASHFLOW
Premiums 100 - - - 100
Expenses (20) - - - (20)
Claims - - - (60) (60)
Investment Income 1.6 3.3 3.4 3.5 11.8
Total 81.6 3.3 3.4 (56.5) 31.8
* It has been assumed that as risk expires, the entry value method converges to an exit value method. Under this formulation, the 50% of risk that
is expired at the end of year 1 is accounted for on an ‘exit value’ basis (i.e. profit is taken on this business in a similar way to the ‘exit value with
MVM’ scenario) whilst no profit is taken on the 50% of risk that is unexpired. This is one of a number of possible formulations for entry value
accounting although details of the proposed required accounting treatment will become clearer as the phase 2 project progresses.
Source: Fitch estimates
Insurance
Mind the GAAP: Fitch’s View on Insurance IFRS: May 2004
22
􀂄 Bibliography
• ‘The Implication of Fair Value Accounting for General Insurance Companies’ – P. K. Clark, P. H.
Hinton, E. J. Nicholson, L. Storey, G. G. Wells, M. G. White.
• ‘Fair Value Accounting’ – Julian Leigh. Development of principles set out in paper to 2003 GIRO
convention.
• Draft Statement of Principles (DSOP) – 2001 – Chapters 1-6, 8-12. Published by IASB.*
• ED 5 Insurance Contracts – IASB
• IFRS 4 Insurance Contracts - IASB
• Financial Services and General Insurance Update – Tillinghast Towers Perrin – September 2003. (“IASB
publishes ED5 insurance contracts”)
• ‘Setting the Standard III’ – Peter Wright and Douglas C. Doll – In ‘Emphasis’ Tillinghast-Towers-Perrin
2003/4.
• ’IAS and their Tax Implications’ – PriceWaterhouseCoopers
• ‘Insurance Contracts Phase 1 – A Bridge to an uncertain future’ – PriceWaterhouseCoopers
• ED 5, Insurance Contracts: Detailed Summary – Deloitte Touche Tohmatsu
* Neither the IASB nor the Insurance Steering Committee is responsible for this publication. This publication has not been reviewed or
approved by the IASB or the Insurance Steering Committee.
Copyright © 2004 by Fitch, Inc., Fitch Ratings Ltd. and its subsidiaries. One State Street Plaza, NY, NY 10004.
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