Fair-value reporting: if you are an insurance accounting executive, be careful what you wish for.

As global accounting systems continue their inexorable move toward fair-value reporting, the credit crisis has highlighted some unexpected challenges.

Now, some users are rethinking their commitment to that objective. Estimating asset values has been shown to be more difficult than anyone thought a few months ago. What if insurance liabilities, where no one pretends there is a deep and liquid market even in the best of times, were assessed in a market value framework? What would be the implications for reporting results?

Perhaps the thought of dynamically valuing insurance liabilities during periods of falling risk-free rates, or of rising capital costs, is what led some insurers to suggest recently that marking assets to market in a period of distress is not such a good thing after all. But since those suggestions have been rebuffed, how could insurance liabilities have been affected in the credit crisis, had they been based on fair values? Or how might they behave in an insurance catastrophe?

In the financial reporting world, as we have brutally seen, fair values must recognize current market conditions. For insurers' liabilities, this would mean recognizing at least two factors: first, changes in risk-free rate levels, and second, in the aftermath of a significant insurance-oriented tail event (insurer's version of the credit crisis), the additional costs associated with the need to carry more capital at a higher cost. Volatile earnings and capital may well be the outcome of a system that recognizes credit-spread changes in asset values and values' liabilities using risk-free rates plus cost-of-capital risk margins.

Is this what fair value proponents were expecting?

In the current U.S. situation, risk-free rates have been driven down during the last year. This would lead to rising liabilities (mitigated by deterioration in one's own credit standing if that is considered in the fair value model), just as many asset values were being pushed down by spreads and default estimates that overwhelmed the reduction of the risk free rates. While economically valid, I wonder if that's what insurers expect to report in such instances.

A similar outcome is obtained following an insurance tail event. Here, some suggest that liabilities should be valued using a "through the cycle" approach to capital costs. This would eliminate a source of volatility in liabilities, but could hardly be considered consistent with the current market and would create glaring inconsistencies with asset valuation methods.

In this sense, asset values would be impacted by changing risk margins--for example, spreads--but insurance liabilities would not be similarly affected. Do liability values, shielded from current cost levels, represent the "economic reality" that should be presented? Shouldn't investors be aware that the real value of the business has shrunk due to greater uncertainty, increased capital requirements and higher costs of raising capital?

Fair-value financials sound good in theory, but the devil in the details might produce unexpected results. Consideration of how a fair-value system might have worked recently suggests that the impact on insurers should be better understood--before we have to deal with getting what we've wished for.

Robert Stein, a Best's Review columnist, is global vice chairman of Global Financial Services for Ernst & Young and editor of CrossCurrents. He may be reached at [e-mail].