Alan Punter summarises the multifarious changes to regulation and compliance faced by the re/insurance industry
Between 2000 and 2002, the global insurance industry had to sail through conditions which have been famously described as a 'perfect storm', with significant challenges on both the underwriting and investment sides of the business. This storm abated somewhat during 2003, with relatively benign catastrophe loss experience and the beginnings of a stock market recovery.
However, the industry is now entering a new period of challenging conditions, perhaps best referred to as a 'reform storm'. Over the next three years or so, a number of major accounting and regulatory/compliance changes will come into force, including IAS, IFRS, CP190, CP195, CP04/7, EU Solvency I and EU Solvency II. Whilst each initiative on its own may present manageable change, the combination of the number of such changes, some of which are interlinked, occurring at more or less the same time and often with tight timescales, could all whip up yet more turbulent conditions for the insurance industry to navigate once again.
These various changes in accounting and regulation, the details of many of which are yet to be finalised, will take effect on local, regional, international and global bases. As an illustration of the growing scale of the challenges ahead, the Comite Europeen des Assurances (CEA) has tracked the number of EU insurance-related initiatives between 1990 and 2003 (see Table 1, page 14).
IASB - International Accounting Standards Board
The IASB issues International Financial Reporting Standards (IFRS), and has adopted the body of International Accounting Standards (IAS) issued by its predecessor, the Board of the International Accounting Standards Committee.
Standards of particular interest include:
- IAS 32 Financial Instruments: Disclosure and Presentation;
- IAS 37 Provisions, Contingent Liabilities, and Contingent Assets;
- IAS 38 Intangible Assets; and
- IAS 39 Financial Instruments: Recognition and Measurement.
The IASB defines an insurance contract as follows:
"An insurance contract is a contract under which an insurer accepts significant insurance risk from another party by agreeing to compensate the policyholder if the insured event adversely affects the policyholder. 'Significant' means at least one scenario in which the insured event would result in payment of significant additional benefits."
IFRS - International Financial Reporting Standards
The first International Financial Reporting Standard was issued by the IASB in June 2003. Standards issued by the Board of the International Accounting Standards Committee before the IASB's inception in February 2001 are known as International Accounting Standards (IAS). Because the IASB adopted the International Accounting Standards already issued, the International Financial Reporting Standards include International Accounting Standards.
Listed companies in the European Union are due to adopt IFRS by 2005.
The hope is that the Financial Accounting Standards Board in the US will also adopt more or less the same standards.
Work on specific standards for insurance companies has been underway since 1997, but much remains to be agreed. Most of the problems revolve around the key IFRS concept of moving from cost accounting to the 'fair value' measurement of assets and liabilities. Fair value is best expressed as the 'mark-to-market' price of any asset or liability. However, the adoption of fair value accounting is currently meeting many challenges and some resistance from the insurance industry because there are no liquid market prices for insurance liabilities and the particular long-term nature of many insurance contracts makes profit recognition difficult in the early years. The insurance industry view is that fair value accounting will significantly add to the volatility of insurance companies' reported performance.
At present, implementation for European insurance companies is proposed in two phases:
- Phase 1 (2004-2007) transition period. International Financial Reporting Standard IFRS 4 (Insurance Contracts) was published in March 2004 and should be effective from 1 January 2005 for all insurance (and reinsurance) entities reporting under IFRSs, including all EU publicly listed insurance companies.
Insurers should account for their portfolio of insurance contracts using existing accounting (i.e. local GAAP), subject to some constraints. Of these, the two most significant are the elimination of catastrophe or equalisation provisions and the requirement for enhanced transparency of insurance contract liabilities (i.e. the timing and amount of future cash flows, and their uncertainty). Insurance liabilities should be shown on the balance sheet until they are discharged or expire and shown gross, i.e. not be offset against reinsurance assets.
Non-insurance contracts should be accounted for as investment contracts under IAS 39 or otherwise.
- Phase 2 (2007 onwards). Full reporting of insurance contracts under IFRS will become mandatory.
Regulation and compliance
CP190 (UK FSA Consultation Paper 190) 'Enhanced capital requirements and individual capital assessments for non-life insurers'
The Financial Services Authority (FSA) is the UK's single statutory financial services regulator. In July 2003 it published a consultation paper on proposals for the regulation of the capital adequacy of non-life insurance companies. The new regulations are due to come into effect in 2005 for UK insurance companies. The Society of Lloyd's and managing agents will be subject to their own specific set of prudential rules under CP04/7, following similar principles to CP190.
The principles within CP190 will create a new risk-based minimum capital requirement, enhanced capital requirement (ECR). This ECR will raise the explicit minimum regulatory capital requirement currently required for non-life insurers in EU member states (also known as Solvency I). This will be based on capital charges applied to asset and insurance risks.
CP190 also includes detailed proposals for assessing individual capital adequacy standards (ICAS) for non-life insurers. Under ICAS, non-life insurers will be required to carry out, and submit to the FSA, regular assessments of the amount and quality of their capital. The FSA will use these calculations and ECR to form a view of the amount of capital an insurance company should hold, the individual capital guidance (ICG).
A separate consultation, CP136, sets out a broader regime for assessing ICAS for financial institutions. CP195 is the FSA consultation paper on 'Enhanced capital requirements and individual capital assessments for life insurers'. It introduces a 'twin peak' approach for assessing the financial resources to support with-profits business and gives detail on how ICAS will apply to life insurers.
EU Solvency I and II
The EU's Solvency I Directives (life and non-life) were adopted in March 2002 and applied from 1 January 2004 in the UK. EU member states may allow a transitional period of five years for insurers to meet the requirements of the directives, a period which ends on 20 March 2007. The Solvency I directives increase the minimum guarantee fund and the solvency thresholds based on premiums and claims. The thresholds will increase in line with the European index of consumer prices.
Solvency II will adopt a three pillar structure (similar to the Basel regulations for banks) but adapted for insurance supervision. The three pillars are:
1. quantitative capital - minimum capital to operate with a quantified low probability of failure;
2. supervisory requirements - principles of internal control; and
3. market discipline - with emphasis on transparency and disclosure.
Solvency II will require the adoption of IFRS. There is no exact timetable published for Solvency II, and because of the growing uncertainty of the contents of IFRS Phase II with respect to insurance contracts, adoption is unlikely to be any earlier than 2007, with full implementation several years after that.
The International Association of Insurance Supervisors (IAIS) was established in 1994 and represents the insurance supervisory authorities of some 100 jurisdictions. It was formed to:
- promote cooperation among insurance supervisory authorities;
- set international standards for insurance supervision and regulation by issuing global insurance principles, standards and guidance papers;
- provide training to members; and
- coordinate work with regulators in other financial sectors and international financial institutions, to promote financial stability.
The IAIS has agreed a standard on the supervision of reinsurance companies, requiring insurance supervisors around the world to regulate reinsurance in their jurisdictions. In the UK, the FSA has regulated reinsurers, but in many other countries there is no regulation of reinsurance. In April 2004, the EU issued a proposal for a reinsurance directive which will apply regulatory requirements broadly similar to those for insurance companies and introduce Solvency I requirements to reinsurance regulation.
All these accounting and regulatory changes are broadly targeted to achieve greater international harmonisation of standards for insurance companies and convergence of standards across different types of financial institutions.
Once all this change has been finalised and implemented, it may be easier for re/insurance companies to prepare and file account and reports for stock market and regulatory purposes. Additionally, there should be greater consistency between externally published reports and internal systems for performance measurement and risk management needs. However, there is great uncertainty over the timing and particularly the details of many of these changes.
Thus the one certainty over the next few years is that insurance and reinsurance companies will need to devote considerable time and resources to adapting to and complying with all these new standards, generating plenty of work for their accounting, actuarial, legal and information technology departments - and plenty of business opportunities for the management consultants, accountants, actuaries, lawyers and information systems providers to sell their products and services.