Insurers will have to report their 2004 accounts in a new way to give a more realistic view of their business, but experts believe the change could cause them to withdraw from some sectors. Michael Faulkner reports.
In 2004, insurance companies will need to implement a new and controversial accounting standard that will have a significant impact on their business.
Experts argue that the International Financial Reporting Standard (IFRS) could cause some insurers to withdraw from lines of business. But they also say that it may help to smooth the insurance cycle.
IFRS is the product of EU legislation seeking to make accounts more consistent and transparent between countries. The idea is that it should allow for a better comparison of the accounts of companies in different states, and a greater understanding of the accounts themselves, enabling investors to gain a better understanding of the returns they are getting.
All companies listed on any EU stock exchange will need to implement the standards.
The International Accounting Standards Board (IASB) is developing the standard for insurance contracts. Its aim is to provide a more realistic way of accounting for assets and liabilities.
The standard will be implemented in two phases, and insurers will need to begin the first phase this year. This will require insurers to make some significant changes to their traditional accounting practices. It covers areas such as how insurance contracts are defined and how reserves are treated.
Deloitte partner Mark Rhys says that the requirements of phase one should not be underestimated.
"General insurers may have looked at phase one and thought there was not a lot to it, but looking at the details there are some issues. Insurers should not underestimate the hassle of getting to phase one."
Insurers will need to produce their first set of figures for phase one this year. Although the phase will only come into effect for 2005 accounts, comparative statements for the 2004 period will also be needed.
But the difficulties of phase one will be minor compared to those of phase two. It is this second phase that poses the most significant challenges to the insurance industry, and where the impact on insurers' businesses will be the greatest.
Phase two requires assets and liabilities to be accounted for using 'fair values'. This will completely change the way that insurance contracts are accounted for.
The standard has yet to be finalised, and key questions remain as to the method of calculating the fair value. But whatever is finally decided, conducting these assessments will not be simple for the industry.
Experts predict that the move to fair value accounting will cause insurers to reassess which lines of business they wish to write and how they rate them.
Morgan Consulting managing director Ed Morgan argues that a fair valuation of assets and - more importantly - liabilities, will require insurers to look at their capital allocation on a more realistic basis. On a fair value basis, certain classes of business will become less profitable or require more capital to support them, he says.
Of course the opposite is also true: other lines of business may become more profitable on a fair value basis, or require less capital support.
"Insurers may withdraw from some lines of business, or re-adjust their premiums to reflect changing capital requirements or profitability," says Morgan.
Morgan also says that IFRS will encourage greater specialisation among insurers. "Insurers who are in certain lines of business for only historical reasons will be under greater pressure to justify why they are in those classes."
Deloitte partner Andrew Downes says that in the longer term fair valuation could act to smooth the insurance cycle, reducing the impact of hard and soft markets.
He argues that as companies gain a more realistic understanding of the financial performance of each line of business, they will become disciplined in their underwriting and pricing, and more able to make early adjustments to maintain profitability. This, he says, will act to temper the fluctuations in the insurance market.
In addition, increased transparency will put further pressure on insurers from investors and analysts to underwrite sensibly. It will also enable insurers to keep an eye on the pricing strategies of their competitors.
The combined effect if these developments, argues Downes, could be more measured underwriting and pricing, and a less extreme underwriting cycle.
The two phases of the new standard
The new financial reporting standard for insurance contracts will come into effect in two phases.
Phase one will require insurers to make some significant changes to their traditional accounting practices. There are three main changes that general insurers will have to make.
First, insurers will no longer be able to 'smooth' their results through the practice of holding catastrophe or equalisation reserves.
In the past insurers have held back profit from good years, placing it in their reserves, in order to bolster profits in bad years.
Second, onerous disclosure requirements will be imposed, which could increase the size insurers' annual reports by up to 50%. Companies will be required to describe their businesses and the risks they face in considerable detail.
Last, insurers will also need to redefine their definition of an insurance contract. A distinction will need to be drawn between financial risk and insurance risk. As a result, financial reinsurance will need to be split into its finance and reinsurance components.
This phase will come into effect only for 2005 accounts, but comparative statements for the 2004 period will be needed.
Phase two requires assets and liabilities to be accounted for using a 'fair value' approach. This part has yet to be finalised. The phase was originally due to come into effect on 1 January 1007, but it seems likely that it will be delayed by a year.
The IASB has postponed publication of the final standard because of technical concerns. But others suggest that heavy lobbying by the insurance industry has been instrumental in delaying the work. As a result, it now seems unlikely that the standard will be produced before 2006, for implementation in 2008. If so, insurers will be required to produce comparative figures in their 2007 accounts.
Are new accounting rules a good thing?
The insurance industry has been lobbying hard against the International Financial Reporting Standrad (IFRS). Its objections have been based around earnings volatility, subjectivity and cost of implementation.
Standard & Poor's analyst Rob Jones is dismissive of many of these objections, arguing that accounting practices should not be used to obscure business performance. But he does have some concerns, which relate to the practical aspects - particularly the cost - of applying IFRS.
"The resources required to implement IFRS will be considerable. It will require huge actuarial resources which are already scarce. Investment in new systems will be needed, and accountants and auditors will need to be trained in a very short time frame. Costs will increase in an industry where margins are already under acute pressure."
The implementation costs are estimated to be in the region of seven-figure sums - if not greater - for each insurer, according to Ed Morgan, managing director of actuary Morgan Consulting.
Yet despite the resource issues, experts see the introduction of IFRS as a positive step for the insurance industry.
Jones says: "The objectives are laudable. Many insurers statements are inconsistent, opaque and provide inadequate disclosures.
Although insurance markets are global, the methods of financial reporting are not.
"IFRS will result in much greater consistency, enabling better comparison between insurers. Transparency will also be substantially enhanced."
Deloitte partner Mark Rhys says that the increased transparency will help insurers to raise capital, as investors will be better able to see what returns they are getting.
The introduction of the standard may also help to prevent the collapse of insurance companies. Morgan argues: "There will be growing pains, but with more realistic accounting standards, businesses will be better managed. There will be less risk of insolvency and better allocation of capital. Failures such as the collapse of Independent Insurance might have been avoided if IFRS was in place."
Insurers may also see benefits in terms of their regulatory reporting and solvency requirements. Jones says that the FSA might move to rely on the IFRS accounts rather than extensive regulatory filings. This would reduce the regulatory burden on insurers.
Deloitte partner Andrew Downes says that the FSA is unlikely to begin fair value models for at least three years. "In 2007/2008 the FSA will probably begin to ask general insurers for this information. If an insurer is able to demonstrate a good fair value model then the FSA will probably regard it in a better light."
What is fair value accounting?
Phase two of the new financial reporting standard requires assets and liabilities to be accounted for using a fair value approach - essentially a market value assessment.
Deloitte partner Andrew Downes says that a fair value model differs from the traditional method of calculating future liability in that it requires insurers to take into account a range of uncertain events in the calculation. This includes factors such as the timing of claims, the state of the economy and legislative changes - all of which will affect the ultimate payment pattern of claims. In contrast, the traditional method involves the forecast of an ultimate loss ratio - a more simplistic method.
The standard has yet to be finalised, but it will not be a simple task for the industry to implement.
Ed Morgan, managing director of actuary Morgan Consulting, says: "Much depends on how 'fair' the fair valuation needs to be. It's difficult to put market values on liabilities - there are no right answers where there are uncertain assumptions to be made."
Downes says that one of the problems is that there are no generally accepted models for the calculation of fair value.
"Different people might calculate it using different methodologies. If so, it will be difficult to compare calculations. It will take a lot of work to come up with an acceptable model. The banking industry has managed to do this, so it is a hurdle that can be overcome, but it cannot be done overnight."