Michael Butler warns that new regulations in the pipeline could hit the re/insurance industry hard.

The most successful insurers and reinsurers have always liked to be known for innovative products which owe their success to advanced analytical and actuarial techniques, allied to a certain flair for the unexpected. The less sophisticated - but not necessarily less successful - end of the market, meanwhile, likes to take its chances in a constantly renewing encounter with contingency writ large. Both ends of the market have managed to co-exist on a more-or-less equal footing until now, because each has had to satisfy different financial and regulatory requirements, both in terms of industry sector and geographical location. But change is coming.

Regulators are establishing common standards for all financial services markets, including the insurance industry. This will hit some sectors of the insurance industry harder than others, and it will hit some in particular - for example the until-now mainly unregulated European reinsurance industry - very hard indeed.

In the UK, the Financial Services Authority (FSA) has recently published its proposed framework for individual capital adequacy standards (ICAS) which sets out a self-assessment process requiring firms to consider capital add-ons to minimum solvency requirements to address business, systems and control risks.

Solvency requirements

For insurance firms, this will be a major new development as the current EU directive on solvency requirements for the insurance industry is not specifically risk-based. Firms will need to document how risks have been addressed and to develop internal capital models. The capital add-ons are designed to reflect exposure arising from operational risk and systems and control weaknesses. The FSA considers the adequacy of systems and controls to be fundamental to the capital adequacy assessment process. The ICAS framework will be introduced some time in 2004.

Those companies which need to prepare for the new requirements can ill-afford to lose any time. This development emphasises the insurance industry's need to embrace a centralised approach to risk management which has the ability to analyse data in a flexible way, to search for trends and patterns, to analyse productivity and to help business planning and forecasting.

For insurers and reinsurers in Europe, meanwhile, there is another regulatory issue that won't go away. In common with many other industries, insurance probably knows less than it should about the workings of the International Accounting Standards Board (IASB). But it is about to get a crash course.

The EU has elected to adopt international accounting standards covering financial reporting for publicly traded companies, as a result of which International Accounting Standards (IAS) will be introduced in the EU with effect from 2005. For the insurance industry, the introduction of IAS is likely to be doubly complex as it is planned to coincide with a new IAS on accounting for insurance contracts which has been gestating since 1997, and on which an issues paper was issued by the IASB in 1999.

Right at the heart of the IAS agenda is an issue which has fundamental implications for the insurance industry, and even more so for the reinsurance sector. In simple terms, this relates to the very definition of an insurance contract.

To date, the definitions have been flexible at best and vague at worst. Most importantly, they have failed to address the grey area of timing risks, whereby claims payments are effectively made from returns realised on investment of premiums.

A look at the IAS draft definition of an insurance contract is revealing. It says such a contract is one "under which one party (the insurer) accepts an insurance risk by agreeing with another party (the policyholder) to make payment if a specified uncertain future event occurs, other than an event that is only a change in a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, a credit rating or credit index or similar variable".

The IAS draft recognises that uncertainty - or risk - is the essence of an insurance contract. And it is quite clear that there is a fundamental difference between insurance risk and the risk that is present in a derivative financial instrument, which the draft defines as a `price risk'.

The IAS draft accepts that the amount to be paid under an insurance contract can be affected by changes in price, or a similar variable, such as an index. But it says a contract does not meet the definition of an insurance contract if the only event that triggers payment is a change in a specified interest rate or similar variable. Such a contract, it says, is a derivative financial instrument.

Reinsurers, in particular, will need to follow developments in this regard very closely. The exclusion of `financial risk' from the definition of insurance contracts in the IAS draft means that some existing products will need to be re-examined, not least alternative risk transfer (ART) agreements.

Under an ART agreement, there is no uncertainty about the question of paying out, and quite often not much uncertainty about how much is to be paid out; it is only a question of when the pay-out will take place. It has been suggested that there will no longer be an ART industry if its products fail to meet the definition of an IAS insurance contract. This is only speculation at present, but it is nevertheless inevitable that issues raised by the IAS draft will result in some serious rethinking of both new and existing multi-year contracts in this specialist market.

There are major issues involving the method of accounts presentation and tax obligations. If an ART product cannot be described as an insurance contract, the ART product may have to be redesigned in order to meet the criteria, or else tax-deductibility may be threatened. So it is not so much a question of `It's an insurance contract, but is it ART?' but, `It's ART, but is it a reinsurance contract?'

Fair value accounting

Another key debate involving the IAS draft has centred on the merits of two different bases of accounting - a deferral and matching approach based on recognition of income and costs, and fair value accounting of assets and liabilities. The latter is the more favoured option and, if adopted, could involve major changes for some non-life insurers. Indeed, it has been argued that, without fair value accounting, it will be very difficult - if not impossible - to produce a suitable accounting regime for the insurance industry. In any event, a move to a fair value basis will have serious implications for the insurance and reinsurance industries, which have traditionally operated on the basis of the deferral and matching system.

Fair value accounting is all about valuing balance sheet assets and liabilities that have devolved from entering into a contract of insurance or reinsurance. It presupposes that, at the time of entering into the contract, the parties recognise the asset and liability consequences of their undertaking. This includes upfront recognition of potential - as well as actual - liabilities.

Under fair value accounting, the parties to a contract are expected to take a view of what their respective assets and liabilities might be. In essence, one might say that insurers could reasonably ask themselves how much they would have to pay somebody to buy the risk from them.

The draft IAS envisages all prospective cashflow, including estimates of claims, being recorded and recognised at the time a contract is written. This represents a fundamental change for non-life insurers, involving a move away from the traditional accident-year basis of accounting to an underwriting-year basis, with recognition of underwriting results from the year of contract inception. This is likely to lead to earlier recognition of profit or loss and more volatility in income statements, especially for long-tail liability business.

It will also mean that there will be no unearned premium reserves or deferred acquisition costs, and deferred or fund bases of accounting will not be permitted.

But it is the proposed imposition of new market value margins (MVMs) to reflect risk and uncertainty which may be the biggest source of potential problems for the insurance and reinsurance sectors. Simply described, the MVM is a buffer against uncertainties in cashflow which may be attributed to a variety of causes, including claims fluctuations and inaccurate liability forecasts.

One of the main problems envisaged in connection with the imposition of MVMs is the lack of any firm guidelines from the IASB on how the MVMs are to be calculated. It is fair to say that finding the right basis for MVMs will vary in accordance with the individual characteristics of different classes of insurance business. Among the factors which insurers will have to take into account are the volatility of reserves, the length of any liability tail, the status of the business, i.e., current or run-off, and the ratio of earned to unearned cashflow. For more complex classes of business, for example reinsurance, more sophisticated methods of claims forecasting are likely to be required.

The MVM will be subjective, and will allow for new factors and considerations which may come into play to affect the insurance contract. In order to get at the MVM, much will depend on the quality and detail of data available, on how up-to-date that data is, and on the ability of the parties to analyse it. Those with the best data, and the best systems with which to analyse it, will have a distinct advantage over their competitors in the marketplace.

Today, there is no excuse for the insurance industry not to have at its fingertips the very latest data relating to their business and their markets, together with the ability to analyse it in any number of relevant ways. The days when critics of the insurance industry used to argue that underwriters' idea of loss prevention was to increase the deductibles are long gone. Sophisticated risk analysis programmes, using data warehousing and other advanced techniques to forecast and effectively manage risk, are now a constituent part of a credible insurance industry.

Underwriting in the dark can no longer be deemed an option, if it ever was. There has never been any doubt that the insurance industry could benefit greatly from the application of technology to its business models. While investment in such sophisticated services has remained largely a matter of choice, the introduction of IAS will serve to underline the serious financial consequences for the insurance industry of getting its sums wrong, and the wisdom of investing in services which can help get the projections right.

The introduction of IAS in 2005 will have a number of consequences for the insurance and reinsurance industries. Chief among these will be the need to develop a much sharper focus on actuarial processes and claims run-off projections in order to minimise capital requirements.

The adoption of fair value accounting principles for asset valuation purposes, and the harmonisation of tax accounting with accounting standards, will mean that the introduction of IAS will lead to the advancement of recognition of profit for tax purposes.

There are a number of imponderables involved in getting ready for IAS, and a number of ways of tackling the issues. But it is clear that ignoring those issues will neither make them go away, nor resolve them. What is also clear is that the insurance industry will need still greater recourse to technology and to sophisticated accounting and actuarial techniques if it is to position itself advantageously within the terms of the new standard requirements.

It has been said that a less-than-perfect standard of accounting for the insurance industry is better than no standard at all. That may or may not be true. What is true is that Europe is moving towards a unified approach to regulation and capital adequacy, and insurers and reinsurers which fail to hear the starting gun will be left at the post.

By Michael Butler

Michael Butler is a partner in the insurance division of law firm Moore Stephens in London.