Gerd Häusler looks at the increasing inter-relations between the re/insurance and banking sectors.
The increasing blurring of the boundaries between insurance and other financial institutions, especially in the OTC derivatives markets, implies a heightened importance of the insurance industry for systemic financial stability and calls for a stronger supervisory focus on financial risks (as opposed to underwriting risks). More disclosure and transparency of financial risks and how they are managed is also becoming increasingly necessary. Fair value accounting, if properly implemented, could make more explicit the redistribution of risks over time that is being done by insurers almost as a by-product of their core business of risk pooling, and could improve the pricing of those risks. But as the positions in the vigorous debate on fair value accounting appear rather entrenched, there may be some scope to reach a middle ground; there may be some methods that address some of the problems associated with fair value accounting while retaining most of the benefits, particularly improved transparency and consistency of financial statements.
Systemic financial stabilityTraditionally, banks have mainly been associated with systemic financial stability due to their maturity transformation and their central role in the payment system. By contrast, financial problems in the insurance industry were viewed as unlikely to become systemic, in part because insurance companies in financial difficulties would face only `slow-moving' liquidity shocks in light of their relatively long-term liabilities. It was therefore considered unlikely that insurers under financial strain having to raise liquidity would have to resort to large-scale rapid asset sales. But as the dividing lines between banks and insurance companies have become blurred, and as insurers have intensified their financial market activities and built up considerable counterparty relationships with banks, the insurance industry has become increasingly relevant for systemic stability.From the perspective of financial stability, the activities of insurance companies can be viewed from three perspectives:
Fair value accounting While cross-sectional risk sharing is the core business of both life and non-life insurance, the risk sharing over time is often more implicit. Risk sharing over time is a result of mismatches between an insurer's assets and liabilities, and is therefore linked to one of the key concerns expressed about fair value accounting: namely the fact that reported earnings would likely become more volatile as values of assets and liabilities behave differently. To the extent that the higher earnings volatility stems from an asset and liability mismatch, it is in large part a real risk and is the result of risk sharing over time provided by the insurer.Fair value accounting will likely make this intertemporal risk sharing more explicit and apparent, and would reveal its costs more clearly. This type of risk sharing would therefore likely be priced by the market more appropriately. Overall, financial efficiency might be enhanced.Although in principle more accurate measurement of asset/liability mismatches is likely to improve transparency and market efficiency, there are still practical questions about the best measurement approach. It is probably relatively uncontroversial that market values of assets and liabilities, at any one moment, may not indicate the long-term health of a firm if they represent transitory short-term volatility or if market prices are in some way distorted. This is especially true for long-term assets whose prices may be particularly volatile.Therefore, a snapshot of market values may not, in fact, capture accurately the financial condition of an insurance company, and could, in a worst case, be misleading to outside observers. Given the increased volatility of capital markets in recent years, unnecessary noise arising from temporary fluctuations in the valuation of financial intermediaries' balance sheets could, if markets overreact, add to financial stability risks in the system. There may be scope for supplemental accounting information that would preserve an appropriate degree of transparency while softening the apparent volatility of results, prevent misleading accounting results from causing unwarranted market reactions, and avoid premature supervisory requirements to sell assets that might worsen the long-term financial condition of insurers and could adversely affect financial market conditions generally. It might thus be useful to consider ways to make valuation methods a bit more stable, or at least ways to explain the context of the fair value results so that investors and analysts can interpret the figures from a longer-term perspective.To address some of these concerns, various approaches could be considered that could smooth the more extreme effects of marking to market and could provide supplementary information (including how model-based valuation results vary with changes in underlying parameter values) so that investors reach more balanced conclusions.On the asset side, one could consider valuing financial assets that are traded on secondary markets (such as equities) based on some average of market prices over time. Averaging over relatively short periods (say, from one week to three months) would greatly reduce day-to-day noise in asset prices. Alternatively, the averaging could also be done over longer-term periods (say, up to one year) to smooth out some of the effects of the financial cycle, though under normal circumstances it might be hard to justify that up-to-date market price signals should be ignored for such extended periods of time. These averages could be provided either as supplemental, more stable, results to act as background information for the latest mark-to-market figures, or they could even be used in the main earnings calculation itself.In another approach, financial assets could be grouped into different `books', such as a trading book and a long-term investment book. While assets in the trading book would be marked to market, assets in the long-term investment book could be valued on an amortised cost basis. The investment book need not involve only assets being held to maturity, but also those being used for specified investment needs with a long horizon.On the liability side, where models will largely have to be used to value insurance obligations, supplemental explanations could describe the sensitivity of liability values to key changes in parameter values of the pricing models. This would give a clearer idea of the degree of uncertainty behind the earnings data, and their sensitivity to long-term assumptions.More generally, financial reporting based on alternative assumptions could be presented as an important part of an insurance company's explanation of factors behind its latest earnings announcement. Disclosing the sensitivities of some key asset and liability values to underlying factors, such as interest rates, would be very instructive for investors. Some type of dual reporting would be particularly important during the transition phase between 2005 and 2007 if fair value accounting would apply to the asset side but not yet to the liability side, likely causing particular volatility in earnings.There is a particular concern among some that fair value calculations could cause insurers to breach regulatory limits too easily, and force them to sell assets into falling markets. This could be safeguarded against both by using more stable valuation methods for the purpose of regulatory limits than for reporting the published accounts, and by allowing appropriately long periods for companies to adjust their holdings, perhaps after case-by-case consultation with supervisors.There is some possible scope for a middle ground. There are ways to supplement fair value reporting with information that would enable investors to take an appropriately longer-term view of the financial health of an insurance company and the insurance industry as a whole.
By Gerd HäuslerGerd Häusler is Counsellor and Director in the International Capital Markets Department of the International Monetary Fund. The views expressed are those of the author, and do not necessarily reflect the views of the IMF.