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Reserving judgment: the advent of the International Financial Reporting Standard finds European insurers in a gray area when it comes to accounting for insurance contracts.

Key Points

* As the international accounting standard goes into effect in the EU Jan. 1, one crucial issue for the insurance industry remains unresolved and will occupy the IASB for the next few years--how to account for liabilities related to insurance contracts.

* Insurance contracts will continue to be accounted for under previous GAAP methods, but the new standard does attempt to clarify the definition of such contracts, putting particular emphasis on the amount of risk being transferred.

* Analysts say there is concern that financial reporting may become less transparent for insurers under the international standard, given the lack of an agreed-upon solution for treating insurance contracts.

Publicly traded companies in the European Union are bracing for the implementation of the International Financial Reporting Standard--set to replace the various country-based accounting standards among the EU member states on Jan. 1, 2005. As time runs out, a kind of leap-of-faith outlook that had insurance companies on edge earlier this year has given way to a wait-and-see attitude from standard-setters, who earlier this year decided to put changes in accounting for insurance contracts on hold for a few more years.

The shift to the international standard--known by the shorthand IFRS--is a huge project, with an estimated 7,000 companies based in the 25 EU member states, including the United Kingdom, having to make the change, said Francesco Nagari, a senior manager with PricewaterhouseCoopers' global corporate reporting group. "Companies have already spent huge amounts of money preparing for the new reporting standard," he said.

As companies begin to state earnings in IFRS for the first quarter and First half of 2005, they also will have to restate results from 2004 to give investors an idea of how the 2005 IFRS results compare with the previous year, said Nagari.

A Compromised Launch

With such a huge overhaul of financial-reporting methods in the works, controversies surrounding specific aspects of the proposed methods were inevitable. One of the most hotly debated controversies involves the methods to be used in accounting for insurance contracts. Debate between the London-based International Accounting Standards Board and insurance trade groups, and between both and the European Commission--the EU's executive body--heated up last year to the point where, early this year, the IASB decided to put off bringing insurance contracts into the fold until it has time to explore more fully the implications of IFRS for insurers.

The result of the decision is that IFRS 4--the latest version of the standard as it relates to insurance contracts, unveiled in March 2004 by the IASB, will be implemented in two phases, giving the board time to work out some unresolved issues related to insurance contracts.

The standard set to take effect in January is a "Phase I" version, designed to ease companies through the transition while unresolved issues are worked out, said Peter Clark, senior project manager with the IASB. Phase II, which is expected to establish more detailed rules related to insurance contracts, doesn't have an implementation date, said Clark. "A lot of what we are trying to do right now is maintain the status quo on accounting for insurance contracts," he said.

Insurance contracts proved to be a "difficult and complex area," as well as controversial, "much too complex to be completed by 2005," said Clark.

Work on Phase II, detailing the accounting for insurance contracts, had become "dormant" over the past year after the IASB ran into opposition from the insurance industry, said Clark. In September 2004, the board established a working group on insurance contracts to revisit the issue. "What the board has said is that, because it was such a controversial area, we're going to go back to the basics and restart work on Phase II," he said. "The board had been looking at fair-value accounting on insurance contracts, but that proved controversial, so we're going to take a fresh look at it."

Clark said there is no deadline for the completion of work on Phase II, which is expected to take several years. The Phase II working group consists mainly of chief financial officers from large insurers in Europe, the United States, Japan and Australia.

IFRS 4 was the result of a compromise between the IASB and the insurance industry in Europe, which had several problems with the way the proposed standard would treat insurance contracts. Insurers were concerned particularly with the fair-value method of accounting advocated by the IASB's proposed standard for treating financial instruments--a set of rules known as IAS 39. Under fair-value reporting, companies have to "mark to market" their assets and liabilities, or report the current market value of such items as invested assets and liabilities.

In a speech before the European Parliament's Committee on Economic and Monetary Affairs in September 2004, IASB Chairman Sir David Tweedie outlined the complexities that led the board to adopt a revised IAS 39, which he called a "complex" and "carefully crafted" approach to bridging fair-value accounting with traditional, cost-based accrual methods. In the speech, Tweedie acknowledged the version of IAS 39 that takes effect in 2005 falls short of the principles-based approach the board had hoped to implement fully.

"In this mixed-attribute model, IAS 39 allows similar financial instruments to be accounted for differently, depending on management's designation or its stated or intended use of the instruments," said Tweedie in his speech. "Its use of alternative accounting methods necessitates detailed rules to limit the extent to which management can defer losses and manage earnings by the selective recognition of gains and losses, and compromises our primary objective of providing principle-based accounting standards."

Tweedie said the IASB resisted calls from business segments to postpone implementing the international standard until unresolved problems could be addressed. "I believe that finding such a replacement will not be easy and will probably take a long time--a luxury that we did not have in preparation for adoption of the international standard in the European Union," he said. "In the absence of an alternative that would provide sufficient transparency, IAS 39--already tested in the marketplace--remained the best option."

Hung Up on Insurance Liabilities

Insurers argue that invested surplus. needed to cover insurance contract obligations, has a long-range aspect that makes current valuation meaningless. They also are concerned with the way the fair-value method would look at items such as catastrophe reserves. These are invested assets, but at the same time they cover potential liabilities. To what extent can the short-term vagaries of unrealized investment gains and losses be reconciled with the more stable long-term projections of potential liabilities?

Stephen P. Lowe, managing director for the property/casualty practice of the Tillinghast unit of consultancy Towers Perrin, said "the most significant threshold issue" for property/casualty insurers is that standard-setting bodies such as the IASB presented accounting principles but "articulated no real, industry-specific guidance" as to how fair-value calculations should be measured for property/casualty claims reserves. "Those reserves are the most significant items on the insurer's balance sheet, and they're not treated, so there are no market values to be observed," he said.

That knowledge gap left property/casualty executives "scratching their heads," as they grasped the proposed principles but had no guidance as to how the principles could be put into practice, said Lowe.

Tillinghast developed what it thought would be a reasonable method to measure insurance liabilities based on the fair-value approach, and ran tests across various property/casualty balance sheets, finding results that "varied widely," depending on business mix, lines of business and other elements that distinguish one insurer from another.

"We think our findings raised some serious questions about whether the goal of achieving greater transparency was going to be achieved," said Lowe. "To achieve transparency, you have to have reasonable comparability from one company to another."

In effect, the inconsistent nature that Tillinghast found in fair-value results for insurance liabilities would "overlay" inherent differences from insurer to insurer caused by differences in reserving approaches, creating yet more uncertainty as to whether anyone comparing one insurer with another is comparing apples to apples, said Lowe. "I don't see how the fair-value approach is going to make those comparisons more transparent," he said.

For life insurers, issues such as "smoothing techniques," designed to reduce the long-term volatility of invested assets and surplus, would have to be examined as Phase II progresses, said Doug Doll, consulting life insurance actuary with Tillinghast. Doll said U.S. life insurers have to work on the assumption that U.S. generally accepted accounting principles eventually are to be harmonized with IFRS. In August 2004, Tillinghast published results of a survey of North American life insurance company chief financial officers, which found that 81% of respondents expected the United States and Canada to join the EU on a single accounting standard within the next 10 years.

"There's a lot of uncertainty about how insurance liability is going to be defined," said Doll. "There is always some uncertainty in life insurance mortality assumptions, so one question is whether there should be a margin built into liability assumptions."

Life insurers are concerned that fair-value accounting for their liabilities will distort the value of products designed to accumulate value over time--such as annuities. Such products are priced on the assumption that they will earn a higher return than the "risk-free rate"--the rate on government bonds--but under a fair-value accounting method, they would likely be marked to market at the risk-free rate, lower than their assumed value, said Doll.

"How some of these asset-accumulation products will look under a fairvalue method is an area of concern," he said.

The uncertainty in measuring insurance liabilities is more acute for property/casualty insurers than for life insurers, since life insurers have stronger predictive abilities about their future obligations. "In property/casualty, you never know when that next big catastrophe is coming, or where asbestos is going," said Lowe.

Searching for a Solution

Such uncertainty convinced the IASB to delay implementing specific rules for insurance contracts, hence IFRS 4, which essentially puts off decisions about insurance contracts for a few more years as the board studies the issue further. As a result, some flexibility was written into IAS 39 to allow for the eventual transition.

"The improved version of IAS 39 contains a fair-value option, which allows reporting entities to designate from day one whether they want to measure under fair value their financial assets or liabilities," said Nagari.

Such a "carve-out" or modified version of IAS 39 may introduce some uncertainty in financial reporting over the next few years, as various companies essentially adopt slightly different standards, based on the reporting options they choose, said Nagari. Adding to the uncertainty is the European Commission, which hasn't indicated what it would like to see EU companies adopt.

"It is not clear to me that the European Commission will adopt a homogeneous approach to IAS 39, or whether they will endorse different versions for different regions," said Nagari. "It is not clear to what extent each member state will have discretion to adopt all or part of the standard."

If the European Commission gives member states the option of either adopting the full version of IAS 39 or the carve-out version, indications coming from individual states suggest there will not be unanimity as to which approach to take, said Nagari.

Marie Braverman, a partner in PwC's Assurance Services practice, said there is still a "lingering debate" around where fair-value accounting is going, at least when it comes to insurance-contract liabilities. "IFRS 4 is sort of a bridge to those final conditions," she said.

Essentially, IFRS 4 allows insurance contracts to continue to be accounted for under local GAAP methods,"as long as they can be identified as insurance contracts," said Nagari, whose London-based group is developing a "global interpretation" of IFRS, along with PwC's position on the implications of IFRS 4 for insurance contracts.

For the next few years, the question of how to define an insurance contract will be crucial to what a final international standard will look like. "Contracts that do not transfer significant insurance risk will not be allowed to be measured under their local GAAP standards," said Nagari. "They will have to find another standard--more likely than not IAS 39."

One product not likely to meet the definition of an insurance contract is the unit-linked life policy, which pays a very small death benefit in addition to accumulated funds, said Nagari. "A company with a large proportion of its business in unit-linked products will likely have to more fully adopt IAS 39," he said.

Insurers need to know whether sizable portions of their business portfolios are subject to fair-value measurement, since if that is the case, they must match liabilities subject to fair-value accounting with assets that move in the same way, said Nagari.

Clark added that, outside of insurance contracts, a lot of the accounting for financial instruments under IFRS is similar to U.S. GAAP. Those insurance products that may be reclassified because they don't fit the requirements of substantial risk transfer that characterize insurance contracts would then fall into other categories of financial instruments, with U.S. GAAP-like treatment. "That will probably create some changes for some people," he said.

For Tillinghast's Lowe, the split-treatment approach of Phase I may actually be worse than any uniform approach on both sides of the balance sheet. "I question the part-way implementation," he said. "It doesn't do the industry any good to say, 'you can't figure out how to mark your liabilities to market, so why don't you just mark your assets to market and leave your liabilities the way they are.' That's not a solution. I think it actually makes matters worse."

One response by insurers to the asset-liability mismatch may be to seek more ways to securitize their liabilities, along the lines of the catastrophe bonds property insurers sometimes use in regions at high risk from natural disasters, said Lowe. "If they can't securitize their liabilities and they just have to hold them, I suspect what they'll be looking for are products that will hedge the market risks to their assets. If their liabilities are to be fixed, they would want their assets to be fixed."

That would be an "accounting-driven" as opposed to an economics-driven strategy, in which insurers actually have to spend money to hedge the increased volatility--and hence higher risks--to their assets. "The big risk for the property/casualty insurers is if there's another downdraft in the stock market or a significant rise in interest rates," said Lowe. Either event would result in a "huge paper loss" for marked-to-market investment portfolios, he said.

Lowe said the industry itself could make it easier to fashion a transparent accounting standard for insurance contracts--perhaps even with a fair-value approach, if it could develop a single actuarial standard for reserving. "If the industry, through trade groups and working groups, can come up with a single approach, the variations across companies wouldn't be so much of an issue," he said. "But if each company decides to do this on its own, there will be huge variations. It's just another source of murkiness."

Follow the Leader

As many as 90 countries are set to follow the EU's lead in adopting IFRS in some form by 2005, said Clark. Switzerland is one. The Australian Prudential Regulation Authority, which regulates financial services and insurance in that country, said earlier this year it is working with industry to implement IFRS in 2005.

"Many emerging-market countries are looking to adopt the international standard because they don't have a structure in place to switch from," said Clark. "Other economies are going to tweak their existing standards to line them up with the international standard. Hong Kong, for example, will need to make relatively few changes."

Standard-setters in two of the most important economies outside Europe--the United States and Japan--have committed to a working relationship with the IASB on harmonization of standards but haven't set a timetable for convergence. The IASB and the Financial Accounting Standards Board in the United States announced the "Norwalk Agreement" in October 2002, in which they declared a shared goal to achieve harmonization of standards. The Accounting Standards Board of Japan announced in October 2004 it would start talks with the IASB on convergence.

While the IASB isn't working closely with standard-setters in Japan, convergence there will be "a bit more complex," as Japan's accounting board has been formally set up only within the past four years, and the country has taken "a more independent path" in outlining its accounting standards, said Clark.

The IASB is working closely with the FASB on harmonization of U.S. GAAP with IFRS, but so far the issue of insurance contracts has been on the back burner, as the FASB hasn't made it a priority, said Clark.

The differences among current accounting methods in countries that are moving toward convergence with the EU may actually serve as a starting point for the Phase II working group's project on insurance contracts, according to Clark. "What we are probably going to do with the re-launch of Phase II is start by looking at the existing models, and see where the similarities and differences, strengths and weaknesses are, and move forward from there," he said.

The IASB and predecessor committees and boards have been working on the idea of a single, international accounting standard since at least 1966. The Jan. 1 launch of the standard in the European Union is a culmination of sorts for all those years of work, but it is still only a partial solution to the problem; the standard is still a work in progress.

As Tweedie said in his September speech, the board has a number of issues to resolve beyond even the thorny problem of accounting for insurance contracts--there are a number of unresolved problems presented by banking, for instance.

"The IASB wants to find a better accounting solution for financial instruments that will produce meaningful results without undue complexity and dependence on detailed rules, but experience shows that an ideal solution will take several years to develop," Tweedie said in his speech.

Tweedie acknowledged the board isn't there yet, and the envisioned simplicity of an international standard has been elusive as industry-specific problems emerged. But he stoutly defended the decision to move ahead with a partial solution, because, he said, "it is essential to provide credibility to financial statements prepared under international financial reporting standards and to the development of a common European capital market."

International Financial Reporting Standard Timeline


Professional accounting standards bodies in the United States, Canada and United Kingdom agree to create Accountants International Study Group to study and compare accounting practices in the three countries.


International Accounting Standards Committee formed as a result of AISG's work.


After several years spent forging closer links with financial reporting groups such as the United Nations, the U.S. Securities and Exchange Commission, stock exchanges and various trade groups, IASC publishes its first volume of proposed international accounting standards.


IASC restructures and adopts new constitution; European Commission announces plan to adopt international accounting standard no later than 2005. Sir David Tweedie, chairman of the U.K. Accounting Standards Board, named first chairman of restructured IASC board.


International Accounting Standards Board, with a new 14-member board, established in London by IASC to develop international financial reporting standard.

Oct. 31, 2003:

IASB releases Exposure Draft 5--Insurance Contracts, which intensifies debate about the use of fair-value accounting for insurance contracts.

Dec. 17, 2003:

IAS 39, issued by the IASB, codifies the board's views on the fair-value accounting method for financial instruments.

March 31, 2004:

IAS 39 amended to allow optional use of fair-value accounting for insurance contracts, giving rise to IFRS 4--the Phase I standard for insurance contracts to go into effect in 2005.

July 29, 2004:

Australia's financial services regulator outlines plan to harmonize Australian standards with IFRS in 2005.

Sept. 21, 2004:

IASB announces working group to analyze accounting issues related to insurance contracts.

Oct. 12, 2004:

IASB begins talks with the Accounting Standards Board of Japan about a joint project to minimize differences between IFRS and Japanese accounting standards.

Jan. 1, 2005:

IFRS to take effect for about 7,000 publicly traded companies in the 25 European Union member states.


IASB continues work on Phase II implementation of IFRS for insurance contracts. Work expected to take at least two years.

RELATED ARTICLE: Accounting for the insurance contract.

The International Accounting Standards Board got an earful from the insurance industry when, in October 2003, it published its "Exposure Draft 5--Insurance Contracts" proposal for handling insurance liabilities under the International Financial Reporting Standard. Insurers were concerned particularly with what they perceived as a looming asset-liability mismatch under IFRS, caused by marking to market the various instruments used by insurers to invest their reserves.

The mark-to-market, or "fair value" method of accounting for assets on an insurer's balance sheet is not seen as problematic, since a company can adjust its mix of assets to adapt to fluctuating market conditions. But the same approach is questionable for an insurer's liabilities--specifically for the reserves maintained against those liabilities, which by statute and rating-agency tests must be held at a certain level and in certain forms over longer periods of time. An insurer can't easily shift the investments in its reserves to bob and weave with fluctuating market conditions--hence the sense that a fair-value approach to accounting lot insurance liabilities would leave an insurer unduly vulnerable to conditions outside its control.

On March 31, 2004, the IASB unveiled "IFRS 4--Insurance Contracts," which splits the insurance industry's entry into IFRS into two phases and gives insurers several options as to how to account for their liabilities. On Jan. 1, 2005, Phase I will require EU-listed insurers to adopt IFRS and the reporting requirements for financial instruments outlined in IAS 39 for all their reporting. But this excludes those related to insurance contracts, including insurance liabilities carried on their balance sheets.

Phase II, to be implemented at an undetermined date in the next few years, would establish an as-yet incomplete plan to account for insurance contracts.

While insurers will have several options as to how to account for insurance contracts under IFRS 4, they will need to meet more stringent disclosure requirements for such accounting, said Peter Clark, project manager with the International Accounting Standards Board. "What IFRS 4 does first of all is introduce disclosure requirements for insurance contracts, since there were none before," said Clark. "There will be more disclosure involving insurance contracts than there had been."

A second, important aspect of IFRS 4 is that "in most respects, it tries to keep the accounting unchanged with respect to insurance contracts," he said. "What the board didn't want to do was put through changes at this time that might have to be reversed in a few years' time when we've done more work on insurance contracts."

IFRS 4 essentially gives insurers some relief from reporting standards related to financial instruments as outlined in two previous IASB publications, known as IAS 32 and IAS 39. IFRS 4 includes a new definition of an insurance contract, which removes some of those contracts from the scope of IAS 39, according to IASB documents.

But IFRS 4 doesn't change the treatment of financial assets held by insurers to back insurance contracts--such assets are still treated as financial instruments under IAS 39.

Among the biggest headaches that insurers anticipate when the international standard takes effect is the so-called asset-liability mismatch. Such a mismatch arises because financial assets will be accounted for at fair value--they will be marked to market value for every reporting period--as outlined in IAS 32. But IFRS 4 will permit insurance liabilities to be accounted for at interest-rate levels when the liability originated, as had been done under the older standards.

The result is that the measurement of an insurer's assets can lead to some volatility from one reporting period to another. To ease the burden of asset-liability mismatches, IFRS 4 was designed to give insurers options concerning how to handle their reporting of liabilities. Insurers can opt to continue accounting for liabilities as they had been, or they can mark to market liability valuations using current interest rates--a fair-value approach. Insurers can also continue to use "shadow accounting" techniques, which allow unrealized gains and losses on assets to be measured against liabilities in the same way as realized gains and losses.

To some extent, the asset-liability mismatch that would arise under a fair-value approach on the liability side already exists in U.S. GAAP accounting, according to IASB analyses. As the Financial Accounting Standards Board in the United States and the IASB work together toward a harmonization project, U.S. GAAP treatment of insurance contracts will likely change to reflect concerns raised by insurers in Europe.

Peter Clark

RELATED ARTICLE: Multiple requirements to meet.

From the regulatory view, the accounting complexities for insurers also come from their position in the market. Lloyd's, for instance, is planning to shift to using the U.K. GAAP standard in 2005. As a private entity, Lloyd's isn't required to use the International Financial Reporting Standard. But a number of Lloyd's underwriters are publicly traded companies and as such are required to adopt IFRS. Companies such as Amlin plc and Hiscox plc will have to adopt IFRS, but at the same time, they will have to state earnings in the standard used by Lloyd's as well, to satisfy, U.K. regulatory requirements specific to Lloyd's.

"The burden on European insurers could increase, to the extent that you would have to report your public results on a different basis than what you would use to report to regulatory bodies or market bodies like Lloyd's," said Francesco Nagari, a senior manager with PricewaterhouseCoopers' global corporate reporting group.

Marie Braverman, a partner in PwC's Assurance Services practice, said clients in France and other EU member countries continue to prepare results in local GAAP for several reasons. "Either they want to compare results under the former standard with IFRS, or there are local regulatory requirements, or their management reporting simply hasn't caught up with IFRS requirements," she said.

EU-based companies also listed on stock exchanges in the United States, usually as foreign private issuers, must file a Form 20-F with the U.S. Securities and Exchange Commission, which requires such companies to show a reconciliation between their results under home-country GAAP rules and results as they would have been under U.S. GAAE, said Braverman. "For many of these companies beginning next year, that will be a reconciliation between IFRS and U.S. GAAP," she said.

Braverman sees a positive impact on U.S. securities regulators from the use of IFRS. "From the SEC's perspective, this is the first time they will see consistent differences in reconciliation statements to U.S. GAAP," she said. "Previously, they have seen reconciliations from all types of local GAAPs that they've had to decipher and interpret. Now they are going to see one standard reconciled to U.S. GAAP."

Theoretically, IFRS itself will be "a lot closer to U.S. GAAP" than some of the local European standards formerly in use, Braverman said.

Nagari added that some European companies, notably German insurer Allianz A.G., already have used IFRS to prepare reconciliations with U.S. GAAP. Other German insurers and reinsurers, notably Munich Re Group, have been using IFRS to state earnings already. Insurers based in Switzerland also got a jump on IFRS reporting--even though Switzerland is not an EU country.

"German and Swiss insurers have been ahead of the game, largely because they have had in place local legislation that allowed them to prepare public financial statements under IFRS, and those reporting changes were accepted by the local exchange regulators," said Nagari. German exchange regulators allowed companies to choose either IFRS or German GAAP methods to state their earnings, and industry leaders such as Munich Re and Allianz went with IFRS, he said.

Peter Clark, senior project manager with the International Accounting Standards Board, said that some German and Swiss insurers have been using IFRS for "several years," but when it comes to accounting for insurance contracts within their statements, they "tended to rely on U.S. GAAP" measurements to "fill in the gaps" created by the uncertainty surrounding such contracts.

The "worst of all possible worlds" may be inhabited by multinational companies that market securities on both European and U.S. exchanges, such as those that sell stock in one market and debt in another, said Stephen P. Lowe, managing director for the property/casualty practice of the Tillinghast unit of consultancy Towers Perrin. "Those companies will be required to prepare financial statements under both international GAAP and U.S. GAAP," he said.

Marie Braverman Stephen P. Lowe
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Author:Pilla, David
Publication:Best's Review
Geographic Code:4E
Date:Dec 1, 2004
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