Hitesh Patel outlines the proposed reforms of accounting methods for re/insurers.

The international insurance industry is currently facing a crisis of unprecedented proportions from the tragic World Trade Center losses and plunging stock markets. Such events have added to calls for radical changes to the regulation of insurance companies, measurement of solvency and how insurance business is accounted for. There is growing acceptance within some regulatory authorities that the reform of accounting methods could lead to changes in the measurement of solvency requirements for insurers. In addition, the need for transparency in insurance company financial statements has never been greater.

The International Accounting Standards Board (IASB) has re-confirmed its intention to produce an accounting standard for insurance contracts. It is the only international body that currently has a project to radically reform insurance accounting. The IASB has an important responsibility to sort out the significant shortcomings in accounting for insurance business and improve the consistency of financial reporting internationally. It appears to have risen to this challenge and has made a standard for insurance contracts a priority project, in spite of a good deal of reluctance from some board members who feel that sectoral rules should not be a high priority. In this vein they have gone one step further and made insurance a leadership project, where the IASB will lead the way in global thinking on this subject. National standard setters and regulatory authorities are monitoring the project with great interest.

The requirements for all EU listed companies to produce accounts based on International Accounting Standards (IAS) by 2005 has created a gap that the IASB needs to fill. Currently, there are no accounting standards that set out the requirements for recognising and measuring insurance liabilities. Some listed insurers, which currently adopt International Accounting Standards IAS, use US GAAP as a proxy to account for assets and liabilities arising from insurance contracts, but none of the IAS address specific insurance issues and certain of them (for example IAS 32, 37 and 39) contain specific scope exclusions with respect to insurance liabilities.

There are several good reasons for prioritising the setting of an insurance standard. To begin with, there is a need for the standard to be in place for 2005, when all listed EU insurers need to comply with IAS. Meeting this timetable will be a real challenge. There is currently great diversity in accounting practices for insurers. Insurance industry accounting practices in a number of countries differ significantly from accounting practices used by other enterprises in the same country.

An International Financial Reporting Standard on insurance contracts is required for a number of reasons. Traditionally, insurance accounting is very conservative, particularly in Europe, as accounting is driven by prudent regulatory requirements. An example is life insurance accounting in the UK, which uses the modified statutory solvency basis for financial reporting purposes. This is widely discredited for not showing the true performance for the period. In response to this, all listed life insurers include with their annual reports, as supplementary information, results on the achieved profits method.

At the same time, there is currently no consistency in financial reporting in Europe - the Insurance Accounts Directive (IAD) contains so many options that comparability between insurers located in different member states is difficult, if not impossible. Also influencing the need for an international financial reporting standard is the significant subjectivity in the valuation of liabilities. This results in a large range of possible outcomes and reduces the comparability of financial statements.

The insurance industry is undoubtedly the least well understood by investors, stakeholders and the general public. One of the factors contributing to this is the opaque method of insurance accounting, particularly for life insurance, and the lack of disclosures of risks and sensitivities.

In view of recent events, the case for change to meet the needs of the users of financial statements internationally has never been stronger.

IASB's achievements
In November 1999, the International Accounting Standards Committee (IASC) steering committee on insurance published a very lengthy issues paper that put forward a number of radical proposals. The main focus of this paper is accounting for insurance contracts by all enterprises. This means it covers not only the accounting treatment by the insurer but also by a corporate policyholder.

One of the recommendations of the issues paper was to dispense with the deferral and matching model, currently in use in most jurisdictions, and move to the asset/liability model. Two versions of the asset/liability model have been put forward, one involves measuring the liabilities at fair value and the other at an `entity specific value' is based on the company's own assumptions.

Briefly, the asset/liability model includes in the balance sheet only those items that meet the definitions of `asset', `liability' and `equity' in the IASB framework. The profit or loss disclosed in the income statement is the net movement in the period in the values of the assets and liabilities recognised. The proposed model recognises changes in the profit and loss as and when they arise.

The use of the asset/liability model results in a proper recognition of all prospective cashflows predicted for each contract, with allowances made for any which may potentially arise from the implementation of guarantees or from the exercise of options. There is no artificial deferral of revenues and costs.

Under the steering committee's proposals, the valuation of liabilities would be based on discounted current best estimates of future cashflows with an explicit adjustment for risk and uncertainty. Assumptions are updated at the reporting date rather than `locking in' those used at the inception of the contract. Accordingly, estimates of liabilities are likely to change significantly each year to reflect developments in the market. For example, the discount rate would be adjusted each year to reflect changes in market interest rates. The proposals of the IASC for establishing provisions for risk and uncertainty will be key to the success of the standard. Insurance business involves accepting risk. The way in which risk is recognised in the financial statements will be fundamental.

Consistency and transparency of accounting will be improved by ensuring that there is an accepted method of calculating the risk and uncertainty provision, and also disclosing this amount so that there is comparability between companies.

A significant benefit of the asset/liability model is that it may provide a better indication of the value of the new business written. The true overall profitability of each contract written will be more apparent at the outset of the contract and not several years later. A proper valuation of all future estimated cashflows would be undertaken and the liabilities recorded at the best estimate. The estimate would be increased by a provision for risk and uncertainty, which may result in the recognition of a profit at the inception of the contract.

An international insurance standard based on the asset/liability model would overcome many of the problems of current accounting for insurance contracts by producing financial statements that are more transparent. Combined with additional disclosures, this would provide existing and potential shareholders, and other users of the accounts, with a more reliable view of current results and longer term profitability. The benefits from the greater transparency and consistency resulting from the use of the asset/liability model provides a compelling case for change. However, there are already some signs that the board may not accept a pure asset/liability model, which has been proposed by the (IASC) steering committee. In particular, the recognition of gain on sale and how profit is recognised over the duration of the insurance contract will be further debated.

Fair value model
A fundamental issue the IASB has to face when developing the insurance standard for insurance contracts is whether liabilities should be measured at fair value. This would be the preference of the Joint Working Group (JWG) on financial instruments, which would like to see all financial instruments (including insurance contracts) measured at fair value with changes reported in current earnings.

The adoption of the full fair value model has attracted much criticism from both the banking and insurance industries. It is not clear at this stage whether the IASB will proceed with full fair value accounting for insurers. In particular, the IASB may wish to consider the wider measurement concept (including value in use) and whether the fair value `exit value' notion sits comfortably with revenue recognition principles. It appears unlikely that a full fair value standard for financial instruments will come into force by 2005, since the IASB has not listed it as a priority project. Insurers will therefore have to contend with the `interim' standard IAS 39 (Financial Instruments: Recognition and Measurement), which will be subject to a `repairs and maintenance' project before 2005. While IAS 39 will apply to investments held by insurers, liabilities arising from insurance contracts are not covered by the standard. Insurance contracts, which principally transfer financial risks, would also be accounted under IAS 39.

Opposition arguments
There has, however, been considerable opposition to the proposals put forward by the steering committee. Some of the key arguments made by opponents are:

  • the use of the asset/liability model, which leads to the possibility of companies recognising a gain on the sale of a contract, conflicts with IAS 18, the revenue recognition standard. It is also not consistent with the profit measurement concepts adopted by all other industries;

  • significant volatility will be introduced if changes in fair values of assets and liabilities are taken through the income statement. The current proposals have not adequately addressed the issue of performance reporting as the IASB has a separate project.

  • the adoption of the fair value model introduces more subjectivity leading to less reliable financial statements and;

  • insurance is seen to be a long-term business and therefore changes in short-term assumptions should not be relevant in measuring long-term performance.

    Next steps
    Under the IASB's new structure, the steering committee will be replaced by an advisory committee. The steering committee last met in June 2001 to finalise the Draft Statement of Principles (DSOP), which will be discussed by the new board. The board has started reviewing certain sections of the DSOP, and some of the sections of have been published on the IASB's website.

    In the meantime, it is anticipated that a programme of field visits and field tests will be undertaken over the next six to nine months to assess the practical issues that may arise in implementing the standard.

    The results from such work should provide the IASB with the evidence and comfort to publish an exposure draft possibly by the end of this year, with the publication of a final standard in late 2003 or early 2004. The timetable for implementation by EU listed companies appears quite tight, particularly if major systems changes will be required. If the IASB is unable to produce a standard for adoption by 2005, the European Commission and the insurance industry may have to come to some agreement on the basis of accounting for insurance liabilities which is consistent with other IAS principles.

    By Hitesh Patel
    Hitesh Patel is a partner at KPMG and a member of the IASB's advisory committee on insurance contracts. The views in this article are the views of the author only and are not necessarily those of KPMG.

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