Fitch Insurance

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5 May 2004

www.fitchratings.com

Analysts

Andrew Murray ACA+44 20 7417 [email protected]

Harish Gohil FIA+44 20 7417 [email protected]

Keith Buckley CFA+1 312 368 [email protected]

Julie Burke CPA, CFA+1 312 368 3158

[email protected]

SummaryThe introduction of International Financial Reporting Standards(IFRS) in 2005 will have a significant impact on the way thatmany insurance companies report their financial statements. Onintroduction, the consolidated accounts of almost all listedinsurance (and non-insurance) groups will have to be prepared incompliance with IFRS, including the recently published IFRS 4 Insurance Contracts. The IASB intends to progress as quickly aspracticable towards phase 2 although this is not expected to bebefore 2007 at the earliest. The IASB has indicated a conceptualpreference for fair value accounting at phase 2 although the target

accounting model has yet to be finalised.

Fitch welcomes the progress made by the IASB towards standardsthat will be more transparent and comparable across regions. Theagency recognises the significant limitations of phase 1 butbelieves that the enhanced disclosure and greater consistency atphase 1 of the insurance accounting project (set out in IFRS 4) willaid in the analysis of insurers and is a useful stepping stone to themore valuable phase 2.

The agency notes that there is still much to do in defining theaccounting for phase 2, and finding a balance betweensophistication, consistency and practicality will be highlychallenging. Nevertheless, Fitch supports the conceptual shift tofair values although cautions that this must be in partnership withdetailed disclosure allowing an assessment of important items suchas methodology, assumptions and risk.

Although concern has been raised by some about the effect of theexpected additional volatility stemming from IFRS, Fitch is onlycritical of reported volatility that does not reflect the underlyingeconomic reality and therefore lacks informational content (i.e.accounting volatility). Some accounting volatility may beinduced at phase 1 (e.g. due to bond price movements stemmingfrom changing interest rates where assets and liabilities arematched), but the agency regards this volatility as being a smallprice to pay for showing an up to date picture of the balance sheetposition. At phase 2, Fitch expects reported volatility to be moreclosely related to the underlying economic reality. The agencywelcomes the transparency provided by this reported economicvolatility and in particular, the information provided on themismatch between assets and liabilities and therefore, overall risk.

The agency notes that it does not expect any rating actions as adirect result of the move to IFRS. However, Fitch cannot rule outthe possibility that the additional disclosure and informationcontained in the accounts could lead to rating changes due to animproved perception of risk based on the enhanced informationavailable. In addition, the new accounting regime could have amedium term rating impact for some companies depending on theresponse of management and investment markets to the newstandards or if the basis of taxation were to be affected.

Special Report Mind t he GAAP: Fi t c h s View

on Insuranc e IFRS


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Mind the GAAP: Fitchs View on Insurance IFRS: May 2004

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In t roduct ionInternational Accounting Standards began to bedeveloped in 1973 when the professionalaccountancy bodies of Australia, Canada, France,

Germany, Japan, Mexico, the Netherlands, the UK,Ireland and the USA founded the InternationalAccounting Standards Committee (IASC). In 2000,the committee underwent a major restructuringprocess and in 2001, the newly restructured andrenamed International Accounting Standards Board(IASB) held its first meeting.

The newly formed IASB adopted all of the standardsthat had been prepared by the IASC and newaccounting standards produced by the board will beknown as International Financial ReportingStandards (IFRS). The term IFRS is understood in

this report to refer to both these new standards thatwill emerge over time and those set by the IASBspredecessor organization.

IFRS will become particularly important as from2005, essentially all EU companies that are listed onEuropean exchanges will be required to producetheir consolidated accounts in accordance withIFRS 1 . This is expected to affect around 7,000entities, including many of the largest insurancecompanies in Europe. In addition, IFRS is likely toalso be adopted by companies in many other

jurisdictions, including Hong Kong and Australia,and many EU countries will permit non-listedcompanies to file accounts under IFRS. Over time,the use of these standards is expected to becomeincreasingly prevalent, particularly for thosecompanies wishing to access the capital markets.

Currently, there is no IFRS that deals with theaccounting treatment of insurance contracts.Companies that already use IFRS to prepare theiraccounts typically use US GAAP to fill in the gapsin the published guidance. The current project todevelop standards for insurance contracts aims toremedy this situation and improve the transparencyof reporting.

This paper sets out the key issues surrounding IFRSfor insurance contracts (both phases 1 and 2) and thelikely impact of these issues on insurance companies.The paper focuses on general insurance issues anddoes not deal with issues specific to life insurers.

1 Individual member states have the option of requiring allcompanies to comply with IFRS from 2005 onwards. It shouldalso be noted that some kinds of listed company, at the option ofindividual member states, may not have to comply with IFRSuntil 2007. This delayed implementation may affect companieswith debt securities only (not shares) listed on a regulated marketof a member state. In addition, companies with a listing outsidethe EU and already using internationally accepted standards (e.g.US GAAP) may also avoid IFRS implementation until 2007.

However, many of the points made for generalinsurance are also applicable to life insurance.Although many uncertainties surround phase 2, Fitchbelieves that phase 1 2 can only be understood and

assessed in the context of the fair value accountingthat the IASB aims to achieve.

This paper does include some comments in respectof IAS 39 (Financial Instruments) which will havean important impact on insurers but it should benoted that the paper is deliberately limited in scope.The paper does not set out to outline all of theconsequences of IAS 39 3 implementation or thelikely impact from the implementation of otherIFRSs (e.g. Employee benefit costs (IAS 19) orRelated party disclosures (IAS 24)). Wherematerial, such issues are likely to be addressed bysubsequent Fitch reports.

This paper is divided into the following sections:

Overview of Insurance IFRS.

Main features of Insurance IFRS phases 1 and2.

Key issues arising from the planned InsuranceIFRS.

Business implications of fair value reporting.

Impact of Insurance IFRS on analysismethodology.

Impact of Insurance IFRS on ratings.

Conclusion.

The report also includes a number of appendices:

Appendix A Principal benefits and costs ofthe new Insurance IFRS reporting.

Appendix B Additional Insurance IFRS issues

Appendix C Example of possible insuranceaccounting treatment.

Overview of Insuranc e IFRS

The IASB has tentatively concluded that the overallgoal of new insurance standards should be to movetowards fair value accounting (i.e. recording bothassets and liabilities at the amount for which an

asset could be exchanged, or a liability settled,between knowledgeable, willing parties in an armslength transaction.4) More specifically, this can be

2 Phase 1 and IFRS 4 are considered to be equivalent and sothese terms are largely used interchangeably in this report.Phases 1 and 2 are considered to be two stages in the sameprocess and so are collectively referred to as Insurance IFRS.

3 IAS 39 and IAS 32, which relate to accounting for, anddisclosures of, financial instruments are yet to be endorsed by theEuropean Union in order to require their use from 2005. Afailure to endorse these standards would leave EU companies asbeing non-IFRS compliant and could negate many of theproposed benefits for a common reported standard (includingacceptance by the SEC). Fitch expects resolution of this situation

in the near term.4 Appendix A of IFRS 4 Insurance Contracts


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seen as a combination of two distinct processes.Firstly, a move away from the current (P&L focused)deferral and matching approach and towards a (morebalance sheet focused) asset-and-liability approach.

Secondly, as a move away from the current situationof differing levels of reserving prudence and towardsa more standardised approach focused on the bestestimate. These concepts are defined further below.

After the start of the insurance project in 1997, it washoped that a fair value standard could be agreed by2003 for implementation in 2005. However, in May2002, due to the complexity of the task and therelatively slow progress made, it became necessaryto split the project into two parts. Phase 1 will beintroduced in 2005 and has recently been publishedin the form of IFRS 4 Insurance Contracts. Thisstandard will require significantly increaseddisclosure and certain other changes to the way thatinsurance contracts are accounted for (set out in thenext section). Also very important in 2005, will bethe implementation of IAS 39 Financial Instrumentsby many insurers requiring most investments to beaccounted for at fair value.

The implementation of fair values for liabilities, amore complex task due to the lack of a liquid market,has been postponed to phase 2. The IASB iscommitted to completing phase 2 as soon as possiblebut this will take some time to complete. The IASBincluded a sunset clause5 in exposure draft 5 (ED 5)

indicating that implementation could be scheduledfor 2007 but this was deleted from the finalaccounting standard (IFRS 4). The deletion of thisclause means that there is currently no deadline towork to and in Fitchs view, implementation for thisdate seems optimistic.

Timet able of In troduct ion for IFRS on

Insurance Contracts

Date Comment

October 2003 End of consultation period on Exposure Draft5 ED 5

March 2004 FRS 4 published following commentsreceived on ED 5. (Phase 1)

2005 Exposure draft on Phase 2 to be published20056 IFRS Financial statements to be published

for EU listed insurers (limited IFRScomparatives for 2004 required.) MandatoryImplementation of phase 1.

2007/8? Phase 2 implementation scheduled?

Source: IASB, Fitch Ratings

5 See Appendix B of this report for further details.

6 IFRS 4 is mandatory for financial periods beginning on or after 1January 2005 although earlier adoption is encouraged. The targetphase 2 implementation date was financial periods beginning onor after 1 January 2007. However, this now looks likely to bepostponed by at least a year.

The proposed asset-and-liability approach (whereassets and liabilities are recognised to the extent thatthey meet required definitions with income andexpenses defined in terms of changes to assets and

liabilities) represents a significant departure from thecurrent situation, where revenues and costs arematched and earned gradually over the period of thecontract. This matching of revenues and costs isachieved through the deferral of some costs (deferredacquisition costs DAC) and revenue (unearnedpremium reserve UPR) to be earned over thecontract period.

Neither DAC nor UPR meet the IFRS frameworkdefinition7 of an asset (a resource expected to givefuture benefits) or a liability (an obligation arisingfrom past events expected to result in an outflow of

value from the company). The move across to fairvalues for both assets and liabilities will ensure thatthe balance sheet does not contain assets andliabilities that fail to meet the respective definitionsand is also designed to increase the transparency ofreporting.

Main Features of Ins uranc e IFRS

Phases 1 and 2

Phase 1

Fitch believes that phase 1 of the insuranceaccounting project should not be appraised on a

stand-alone basis but as an intermediary step toachieve the fair value accounting envisioned at phase2. Phase 1 of the insurance accounting project willrequire relatively limited accounting changescompared to the ambitious overhaul planned underphase 2. However, the standard introduces someimportant principles, requires some (limited)changes to accounting methodology and will requiresignificantly increased disclosure.

The broad plans for phase 1 (through ED 5) havebeen public for some time and summaries have beenproduced by all of the major accounting firms. As

such, only a brief summary of the requirements ofIFRS 4 is included below. The principal features ofIFRS 4 are:

Def in it ion o f Insurance Cont ract s

The IASB wants to ensure that similar transactionsare treated in a similar way and, therefore, theaccounting treatment specified will affect allinsurance contracts whether written by a registeredinsurer or not. The definition of insurance contractsgiven by IFSR 48 is overleaf.

7

IFRS definition included in the IASB Framework para 49.8 Appendix A IFRS 4 Insurance Contracts


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A contract under which one party (the insurer)accepts significant insurance risk from another party(the policyholder) by agreeing to compensate thepolicyholder if a specified uncertain event (the

insured event) adversely affects the policyholder.

This is an important change which should lead to afocus on the substance of economic transactionsrather than the legal form and help to standardize thetreatment of insurance contracts across industries.The definition will also mean that certain contractsthat are written by insurers will no longer beclassified as insurance contracts. Certain financialreinsurance contracts and policies with a low degreeof risk transfer (e.g. certain finite risk contracts) willnot meet the above definition and therefore berequired to be treated as deposits.

Unbundl ing o f Cont ract s and Account ing

for Embedded Der iva t ives

IFRS 4 will require some contracts which haveinvestment and insurance features to be unbundledand accounted for separately. However, as a result ofnumerous exclusions, this will not be as onerous asoriginally feared and it is largely only financialreinsurance contracts that will require unbundling inphase 1. Examples of contracts that could be affectedin phase 1 include certain multi-year reinsurancecontracts linked to an experience account. This couldbe extended further in phase 2.

Similar to the requirement to separate the investmentand insurance components of a contract is therequirement to account for embedded derivatives atfair value, with movements in this value beingrecorded in the income statement. Embeddedderivatives that will have to be recorded at fair valueduring phase 1 include life products offering aguarantee of minimum equity returns on surrender ormaturity. However, phase 1 gives an exemption toembedded derivatives that are themselves insurancecontracts, significantly reducing the contractsaffected. Examples of embedded derivatives that

may need to be accounted for at fair value at phase 2if these rules are tightened include guaranteedannuity options (GAOs) and guaranteed minimumdeath benefits (GMDBs).

End to Equal isat ion Reserves

The IASB takes the view that claims reserves areonly permissible to the extent that they relate toactual liabilities (i.e. a present obligation ... arisingfrom past events ... which is expected to result in anoutflow [of] resources embodying economicbenefits9). Equalisation and catastrophe reserves do

9 IAS 37.10

not fulfil this required definition and so will nolonger be permitted once phase 1 is implemented10.

Treatmen t o f I nvestmen ts

Changes to the treatment of investments will not be adirect result of IFRS 4 (or therefore, of phase 1) butwill result from the implementation of IAS 39.Nevertheless, the requirements are closely connectedto the phase 1 requirements and will be one of themost important changes of accounting for manycompanies in 2005 when they adopt IFRSs for thefirst time. Under IAS 39, the investment assets ofinsurance companies will have to be categorized aseither held to maturity (with the investments held atamortised historic cost), available for sale(investments marked to market with changesrecorded in reserves), or held for trading (marked to

market with changes recorded in the incomestatement)11.

Given the nature of insurance company liabilities,most investments are liable to be categorized asavailable for sale with the associated volatility inshareholders equity. Many insurers would prefer toclassify investments as held to maturity in order toavoid the volatility associated with marking tomarket investment. However, for investments to beclassified as held to maturity, the insurer wouldneed to be able to demonstrate both positive intentand an ability to hold the instrument to maturity.

This would imply that the insurer was willing toforego future profit opportunities generated by thesefinancial instruments as well as implying a greaterdegree of certainty as to the timing of cash flowsthan is usually possible.

In practice, one of the main obstacles to investmentsbeing classified as held to maturity are the harshpenalties set out in IAS 39 if these assets are soldprior to maturity. These tainting rules (subject to afew exceptions) include a ban on using the held tomaturity classification for any financial instrumentfor the year of sale and for two following financial

years.

12

Insurance Account ing

Deferred acquisition costs will still be permitted forinsurance contracts during phase 1, and whicheverGAAP that companies currently use will continue toprevail on the accounting for insurance contracts.

10 Equalisation and catastrophe reserves will not be allowed asliabilities following implementation of IFRS 4. However, IFRS 4does not prohibit the reporting of equalisation reserves as acomponent of equity.

11 Loans and receivables originated by the enterprise is a furthercategory that is carried at amortised cost but this categorisation

will principally be used by banks, much less so by insurers.12 IAS 39.83 (r.2000)


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This will limit the potential benefit of increasedcomparability between accounting regimes but doesserve to prevent companies having to change theiraccounting systems twice in the space of a few years.

Other Changes

Other changes expected following the introductionof IFRS in 2005 (not specific to insurance) includethe fact that stock options will need to be expensedand goodwill will no longer be amortised (althoughit will require an annual impairment test). 13 Thesechanges are examples of the requirements that havealready been published in 2004 and furtherdevelopments are expected by the time that phase 1for insurance contracts has to be implemented.

Disclosure Requirements for Phase 1Fitch believes that increased disclosure is one of themost important aspects of phase 1 and supports themove to improve transparency as well as improvedconsistency between insurers.

IFRS 4 requires significantly more detailedquantitative and qualitative information on riskexposures, and importantly the disclosurerequirements are formulated based on principlesrather than set required disclosures. The requireddisclosures include the following:

1. Explanation of Reported AmountsThis disclosure category will include information onaccounting policies, the derivation of significantassumptions and material changes to insuranceliabilities, reinsurance assets and DAC. Thedisclosure will include whether margins are built intothe assumptions, whether they are derived fromactual company data and how they relate to recentexperience. The IASB also requires insurers todisclose any gains or losses that have been made inbuying reinsurance to aid comparison betweencompanies.

2. Amount, timing and uncertainty of futurecash flows

This will require the disclosure of risk managementpolicies and terms and conditions that have amaterial impact on the amount, timing anduncertainty of the insurers cash flows. In addition,companies will be required to report information oninsurance risk that helps users to assess the insurerthrough the eyes of management, as well asadditional information on insurance, interest rate andcredit risks.

13 These requirements are set out in the recently published IFRS 2Share Based Payment and IFRS 3 Business Combinations.See the Fitch report Accounting for Stock Options: ShouldBondholders Care? (available at www.fitchratings.com) forfurther details of the impact of stock options on ratings.

Disclosures on insurance risk will includeinformation on concentrations of insurance risk, thesensitivity of profit or loss and equity to variablesand claims development data (principally for general

insurance). These disclosures will assist the users ofaccounts in assessing the insurance risk associatedwith an insurer and the accuracy of historic reservingpractices.

The above disclosures will undoubtedly aidsophisticated users of financial statements in theirunderstanding of companies and the underlyingeconomic reality. However, Fitch would favour agreater degree of prescription for phase 2 as anoverlay to a principles-based approach. The agencynotes that although principles-based disclosurerequirements can make compliance easier for

companies and are unlikely to become obsolete, sucha formulation does reduce the comparability betweencompanies.

Some insurers have claimed that increasedcomplexity for the financial statements couldobscure the true economic picture for some, lesssophisticated users. However, Fitch believes thatsuch concerns are frequently overstated and can belargely addressed through suitable structuring of theaccounts. In the agencys view, additionalcomplexity does not represent a valid reason formaintaining the relatively low levels of disclosurethat are currently offered.

Phase 2

Further draft guidance on phase 2 is expected to bereleased in 2005. The summary included below istherefore based on the Draft Statement ofPrinciples (DSOP) produced by the IASC,indications that have emerged from the IASB andpreliminary discussion between industry participants.Although the IASB has currently only expressedtentative conclusions regarding phase 2, this paperworks on the assumption that phase 2 will aim tomeasure assets and liabilities arising from insurance

contracts at their fair value.

As previously mentioned, the move to fair values(also known as prospective provisioning) will see anend to the deferral of acquisition costs and thespreading of premiums over the duration of thecontract. Both premiums and expenses will berecognized immediately as a contract is signed, withthe accounting focused on the present value ofexpected future cash flows.

For example, on writing a new policy, all present andfuture expected cash flows will be recorded. The netpresent value (NPV) of relevant contractualpremiums will be recorded as assets (and as


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premium income) whilst the future expected cashflows for claims and expenses will be discounted totheir NPV and recorded as liabilities (andclaims/expenses).

This is conceptually straightforward in the case ofnon-life contracts where a single premium is paid atthe start of the contract. The concept is morecomplex for policies where premiums may bereceived over a long period (e.g. life assurancepolicies). The IASB has indicated that futurepremiums will be able to be recognized ifpolicyholders have non-cancellable continuation orrenewal rights that significantly constrain theinsurers ability to reprice the contract to rates thatwould apply for new policyholders whosecharacteristics are similar to those of the existing

policyholder and that those rights will lapse if thepolicyholders stop paying premiums.14 For example,insurers would typically charge lower premium rateson an existing life assurance policy compared with anew policy for an individual of the same age.Assuming that the definitions included above are met,the insurer would recognize the expected cash flows(including premium and payments) allowing forprojected lapse experience.

In addition to reserving for the best estimate of thepresent value of future cash flows, it is expected thatinsurers will also have to include a market valuemargin (MVM) on top. This margin aims to taketotal reserves to the level that would be sufficient toencourage a third party to accept the relevantliabilities and therefore represent a proxy for fairvalue in the absence of a liquid market.

Key Issues Ar is ing From t he

Insurance Account ing Standards

Some of the key issues arising from theimplementation of Insurance IFRS (phases 1 and 2)are commented on below:

Phase 1 and Phase 2

ai . Increase in Vo la t i l i t y

Volatility associated with results is expected toincrease as a result of IFRS, particularly for thoseentities that currently employ a national GAAP thatrecords investments at amortised historic cost (e.g.Germany and France). The increased volatility willlargely stem from:

Financial instruments (including equities, bondsand derivatives) being valued at market valuerather than at amortised historic cost. The

14 IASB IFRS 4 Insurance Contracts Basis for Conclusions BC 6 (d).

classification of financial instruments asavailable for sale or held for trading will lead tovolatility being recorded in equity or the incomestatement respectively. (IAS 39)

The removal of claims equalization orcatastrophe reserves which act to smoothreported profits. (IFRS 4)

The calculation of fair values (e.g. for embeddedderivatives and claims reserves) will bedependant on a number of assumptions andexternal variables that can move significantly.Fair values may be sensitive to small changes inthese assumptions. (This volatility will becaused by phase 1 in the case of some embeddedderivatives and phase 2 in the case of claims

reserves.)

The fact that premiums and costs will no longerbe smoothed over time (through deferredacquisition costs and an unearned premiumreserve) would be expected to increase volatilityin results. The degree of profit-smoothing overtime will depend on the calculation of MVMsand other factors noted under Recognition ofIncome below. (phase 2)

Removal of prudential margins which havehistorically been used by many insurers toreduce profit in the good years and enhanceprofit in the bad years. (phase 2)

Volatility in results will be a particular factorfollowing phase 1, and whilst assets and liabilitiesare subject to different treatment (assets at fair value,liabilities at historic cost.) On implementation ofphase 2, the overall reported volatility could bemoderated due to the impact of also recordingliabilities at fair value.

For example, following the introduction of fairvalues and the subsequent discounting on reserves,changes in the value of assets due to interest rate

movements will be counterbalanced by changes tothe valuation of reserves (e.g. an increase in interestrates will lead to a fall in the value of bond assets butalso a fall in the discounted value of reserveliabilities.)

It is important to note that the above exampleassumes that volatility caused by interest rates forboth assets and liabilities is recorded similarly in thefinancial statements (i.e. both in shareholders equityor both in the income statement). If there is anasymmetry of treatment then income statementvolatility is liable to increase.


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ai i. Impac t o f Increased Vo la t i l i t y

It has been suggested by some (including the ABI,the insurance association in the UK) that theincreased volatility from the proposed new insurance

standard would lead to a higher cost of capital due toinvestors demanding a higher risk premiumassociated with an investment. The headline profit,it is argued, will be significantly affected by variousexternal factors and the impact of this will besignificantly greater on the results of insurers thanwould be the case for a typical corporate entity.

Fitch believes that an impact on the cost of capitaldoes remain a possibility but there is little evidencethat the cost of capital would change to levelsinconsistent with the actual risk associated withinsurers. As the IASB has noted, many of the

insurers with access to the capital markets alreadyreport assets at market value with the volatility toprofit or shareholders equity that this entails. Inaddition, to the extent that transparency is improvedand risk reduced by the proposed new reporting andthis is rewarded by the markets, there could be someoffsetting benefit to the cost of capital.

The agency believes that in considering volatility, itis important to make the distinction between thatresulting from economic mismatch (economicvolatility) and that stemming from accountingmismatch (accounting volatility). Economic

volatility reflects the underlying economic reality ofthe business and does have informational content.This is very different to accounting volatility whichstems solely from asymmetrical accountingtreatment (e.g. the use of a different accounting basisfor assets and liabilities.)

Fitch welcomes the transparency provided byreported volatility to the extent that it reflects thetrue economic mismatch between assets andliabilities (i.e. is economic volatility). Assessing thismismatch is important information for the users offinancial statements, allowing analysts to better

determine a companys risk and profitability.

Fitchs concerns therefore relate not to volatility perse, but to accounting volatility that does not reflectthe underlying economic reality and lacksinformational content. The agency believes thataccounting requirements should be structured tominimise the level of accounting mismatch.Although phase 1 does result in some accountingvolatility (e.g. due to assets being largely at fairvalue whilst liabilities are not) this sub-optimal resultis still considered to be vastly preferable to a stabilityin reported results that is misleading.

Phase 2 Only

b. Use o f Discount ing

The discount rate used in phase 2 is likely to be the

return on a risk-free asset, although there is stillsome discussion about whether the credit quality ofthe enterprise in question should impact the liabilityrecorded. This aspect is further commented on below.

In the past, Fitch has argued against the use ofdiscounting for most insurance reserves due to theuncertainty that is associated with both the level andthe timing of the payments. Fitch believes that inmany cases, after adjusting the discount rate for arisk premium to allow for uncertainty (the riskpremium is deducted from the discount rate in thecase of a liability), the appropriate discount rate is

low and close to zero.

However, the agency recognizes that the marketvalue margin is designed specifically to address theissue of uncertainty. Under these circumstances,Fitch may consider an allowance for the time valueof money through discounting to be appropriate,depending on the definition, formulation andsophistication of the calculated MVM. The agencynotes that the effect of the discount on reserves maybe partially or completely cancelled out by theimposition of the MVM15.

c. Market Va lue Marg in (MVM)A market value margin is likely to be calculated atphase 2 reflecting uncertainty and aiming to taketotal reserves towards a level that would be sufficientto encourage a third party to take the liability on. Therationale is that due to risk (which is not necessarilyreadily diversifiable), and perhaps due to transactioncosts or asymmetric information between the tradingparties, investors would require a premium above thebest estimate to take on the liability16.

An allowance for risk could be achieved either byrisk-adjusting the discount rate applied to expected

cash flows or by adjusting the cash flows directly totake risk into account and then using a risk-freediscount rate. MVMs take the latter approach andcan therefore be viewed as a method of adjusting

15 This is particularly likely for short tail business (as the effect ofthe discount is relatively low) and, potentially, for longer termexposures with a high degree of uncertainty (e.g. asbestos).

16 Conceptually, the allowance for risk in respect of insuranceliabilities is similar in nature to the allowance for risk that isachieved on the assets side of the balance sheet. Fixed incomeinvestments, for example, are represented by the net presentvalue of future cash flows discounted by a risk adjusted discountrate. For cash flows with a higher degree of risk (e.g. a BBrated bond) a higher discount rate and therefore lower value isappropriate as compared with an investment having more certaincash flows (e.g. a AAA rated bond).


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expected cash flows to allow for the uncertaintysurrounding the best estimates of insurance liabilitiesthat have been derived.

However, market value margins do have sometheoretical and practical weaknesses and have beencriticized for:

Inconsistency with economic theory which saysthat no charge is appropriate for diversifiablerisks.

Not being consistent with other similaraccounting standards (e.g. post retirementbenefits).

Making accounts more opaque (e.g. somecapital may be hidden in the form of MVMs);

Significant practical problems in theirintroduction.

An ability to be misused as a profit smoothingdevice.

Despite the criticisms shown above, Fitch supportsthe use of market value margins as being a methodof moving towards an estimated (although largelyhypothetical) market price and as a necessary bufferto reflect the risks and uncertainties that are inherentin insurance contracts. The agencys support forMVMs is derived from two main sources:

1. TheoreticalWhilst some aspects of risk are largely diversifiable

within a single portfolio (e.g. process risk risk thatemerges from random statistical fluctuations), thereare some elements of risk that are not so easy todiversify. For instance, model risk and parameterrisk refer to the difficulty of accurately classifyingthe probability and severity of events and modellingexpected payouts (e.g. there may be uncertainty as towhether losses will be normally distributed orotherwise and whether the probability of an accidentis 5% or 10%). These uncertainties are much moredifficult to diversify than process risks and in Fitchsview represent an important justification for MVMs.

The theoretical justification for MVMs is increasedby the fact that fair values are to be defined inrespect of their current portfolio rather than thepotential value to a hypothetical third party insurer.Given this fact, even risks that could theoretically bediversified away (e.g. process risk) may still warrantan adjustment for risk through the use of an MVM.

2. PracticalBased on past experience, Fitch believes that statedbest estimates of reserves deteriorate morefrequently than they develop positively. This isespecially true in liability lines and may be due to

some elements of unintentional bias that can occur aspart of the reserving process. Reasons for this bias

could include items such as actuaries basing reserveson existing rules, regulations and known risks.

In an environment where new risks and regulationsemerge but few disappear, this may create somedegree of a negative bias to estimates. The observedtendency for a general deterioration in reserves frombest estimates may also relate to a natural humanoptimism on behalf of management, or the benefitof the doubt being awarded in formulatingassumptions where uncertainty exists. Fitch alsonotes the possibility of insurers cheating17 as beinga potentially important factor in some cases.

The market value margins, depending on theircalculation and size, would go some way tocounteracting this observed effect on reserves. Inaddition, the use of a market value margin whicheffectively risk-adjusts the NPV of claim andexpense cash flows replaces the buffer that waspreviously provided by the non-discounting ofreserves.

This analysis applies to the concept of using MVMsand does not address the significant difficultiessurrounding the formulation of the MVMs which arethe subject of much debate within the actuarialprofession. Particular difficulties will stem fromspecifying the required level of sophistication whilstat the same time promoting consistency betweencompanies and minimising opportunities formanipulation.

d. ) Recogni t ion o f Incom e

The recognition of income is a key controversy ofthe proposals. Concerns have been expressed that themove to fair values could lead to profits beingdeclared with no evidence of the profit having beenearned. This will be particularly important for lifeinsurance companies with their longer term contractsand reliance in some cases on future investmentreturns in order to generate profit.

In general, the move away from deferral and

matching to fair values will increase the level ofprofitability that is declared at the start of thecontract for non-life insurers and reduce thatrecognized in subsequent years. This is due to thediscounting of reserves (meaning that investmentincome is effectively recognized at the start of thecontract) and the fact that premiums are not spreadover the period of the insurance contract. However,as will be commented on further below, the pattern

17 Inaccuracies in reserving have been categorized by some in theinsurance industry as either due to cheating or being wrong.See the Fitch report Property/Casualty Insurance Reserves atYear-end 2002: Filling the Hole Slowly for more details.Available at www.fitchratings.com.


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of income recognition will be heavily impacted bythe formulation of the market value margins and thetype of business that is being written.

Broadly speaking, the profit declared on acceptanceof an insurance contract would be equal to:

+ NPV of premiums- NPV of claims and expenses- Market value margin on reserves- Acquisition expenses= Profit declared on writing contract.

If all expectations in respect of a particular contractare proved correct then the profit emerging in futureyears will solely relate to any return made throughthe investment return and to the release of marketvalue margins as the risk associated with future cashflows reduces. Profits or losses may also emerge oncontracts after year 1 as a result of any differences toexpectation of claims or expenses.

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5

10

15

20

25

30

1 2 3 4Year

Profitin

Units

Def & Matching

Exit Fair Values - With MVM

Exit Fair Values - No MVM

Entry Fair Value

Source: Fitch Ratings, see appendix C for contract

assumptions and more detail on the expected accounting for

this simplified contract.

Profit Signature on Example Contract

The graph above shows the emergence of profit on asimplified non-life contract according to fourdifferent methods of recognizing income. Theimportant feature to note is that although the total

profit recorded is unchanged, the timing of profitrecognition may be significantly affected by themove to fair value accounting and the way that fairvalue is defined. The possible definitions of fairvalue under discussion are as follows:

1. Entry Fair ValueEntry fair values are designed to reflect the premiumthat a third party would require to accept newcontracts with identical conditions and remainingterm. The implication of this is that unless aninsurers prices for a risk are demonstrably higherthan the market as a whole then no profit would be

recognized at the inception of the contract.Profitability emerges over time as the risk associated

with a policy expires. As a result of the additionalconservatism at the start of the contract, profitabilitywill emerge more slowly for accounting under entryvalues as compared with exit values. There are a

number of ways in which entry values couldpotentially be formulated to allow profitability toemerge over time. In the example shown, Fitch hasassumed that as risk expires, the entry value methodconverges to that of exit values with an MVM.

The rationale for using entry values would be abelief that: i.) entry value is more in tune withexisting revenue recognition rules and makesallowance for the fact that the policyholder may havea right to cancel the policy mid-term; and ii.) theprice charged in the market for a particular risk is anobservable market price that can be used to

determine fair value for unexpired risk.

This form of profit recognition appears to befavoured currently by the IASB, although there aresome significant difficulties with this approach,particularly when applied to life insurers. Anabsence of profitability being recorded on newbusiness written may make the relative performanceof companies more difficult to measure. In addition,the approach could also lead to discontinuities inaccounting (e.g. for expired and unexpired risk)which may add to complexity and reducecomparability over time and between companies.

In practice, if no profitability were permitted on newbusiness, then it is likely that the insurance industrywould employ some form of embedded valuereporting to allow companies to indicate theprofitability that they expect to emerge. Fitchbelieves that supplementary reporting would addcomplexity, and in the absence of defined standards,reduce consistency between companies. Ultimately,the agency believes that the absence of some degreeof profit on new business would be likely to reducetransparency and the usefulness of financialstatements.

2. Exit Fair ValueThis aims to set liabilities to the level required toinduce a third party to take over the contractliabilities that exist. Importantly, this would allowprofits to be recognized at the start of the contractwith the level of profits recognized at inceptiondepending on the size of the market value margins.There are two principal possibilities:

No Use of Market Value MarginsIt has already been noted that market value marginscan be criticized on theoretical as well as practicalgrounds. If no market value margins were used then

100% of the expected profit would be recognized onaccepting the new insurance contract. The profit


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recognized would equal the net present value of allexpected cash flows and if all parameters emerged asexpected (e.g. loss experience, expenses, investmentreturn) then no further profitability would emerge

from the contract. However, to the extent that actualexperience and updated expectations differ from thatoriginally planned for, gains and losses wouldemerge from the contract from one year to the next.

This approach is favoured by some, including theFinancial Services Authority (FSA) in the UK,which believes building in prudential margins canresult in problems being opaque. Although the IASBregards the Market Value Margin as an adjustment tosimulate the market price rather than a prudentialbuffer, the FSA currently favours basing allassumptions on best estimate without these margins.

Under this reporting model, management andregulators would ensure that sufficient capital isavailable to deal with any negative shocks that mayemerge.

Use of Market Value MarginsThe use of market value margins would have theeffect of smoothing the profitability associated witha contract. Some profitability would be likely to bereported at the start of a contract (calculated basedon discounted expected future cash flows reduced tothe extent of the market value margin). Over time, asfurther information emerges (e.g. through reported

loss experience), the market value margin would bereduced (reflecting the reduced uncertainty) andsome further profitability would emerge.

Fitch considers that the smoothing effect provided byMVMs does provide a practical alternative to thedifficulties associated with other methods of profitrecognition. This approach does provide informationon the degree of uncertainty, and expectedprofitability associated with a portfolio which couldbe lost to many users if no profit were declared onwriting a contract. In addition, Fitch does not favourthe option of recording 100% of expected profit inyear 1 for the same reasons that it supports the use ofMVMs (see previous section).

e. ) Need to Dis t ingu ish Betw een

Dis t r ibu tab le and Non-Dis t r ibu tab le

Reserves.

The volatility that is associated with the proposedfair value accounting gives rise to the issue of whichaccumulated profit reserves should be distributableand which should not. It is unlikely to be desirablefor all profits that emerge as a result of assumptionsmade by management (e.g. assumptions as to theprofitability of a new long tail business line being

written) or as a result of market volatility (e.g.unrealized gains on unhedged, long term derivative

positions) to be distributable to shareholders. Thisissue will need to be considered objectively andcould be dealt with by suitably structuring thefinancial statements or through the capital

requirements that will be demanded by regulators(e.g. through the solvency 2 project.)

Although the income statement looks likely toinclude profitability from a number of sources, usersof the accounts will need to become increasinglysensitive to the quality of earnings. Earnings whichare derived from management assumptions (e.g.assumed profitability on contracts written) will betreated as being of lower quality than realized profitswhich have been validated by experience.

f . ) Should Fair Values Ref lect the Credi t

S tand ing o f the Insurance Company?From a strictly theoretical point of view, the fairvalue of a liability, which is determined as thepresent value of expected future outward cash flows,should recognize that there is some possibility ofdefault on the obligation. Recognizing thispossibility reduces the expected value of future cashflows and therefore the level of the liability. Lookedat another way, it would cost more for a companywith a high credit rating to induce an insurer ofsimilar credit standing to take over its liabilities thanit would for a weaker company to achieve the samething.

Therefore, theory suggests that weaker insurersshould use a higher discount rate on reserves,resulting in a lower liability. In more general terms,the discount rate used by companies (theoretically)should be linked to their own credit rating and to therisk premium that the market requires for this risk.

Although this may be a sound theoretical argument,Fitch is extremely uncomfortable with this conceptgiven the implication that weaker insurers wouldreserve less than stronger players for the sameliability. Also, there is significant circularity in sucharguments given that a credit downgrade could leadto reduced liabilities and therefore stronger reportedcapitalization. Finally, the agency believes that sucha suggestion has significant practical problems (forexample, how to treat unrated insurers or insurerswith multiple credit ratings) and that such a movewould reduce the comparability of financialstatements and thereby their usefulness to the usersof accounts.

As a result of the points made above, Fitch wouldprefer to see liabilities calculated independently ofthe credit quality of the insurer. However, if fairvalues were to reflect the credit standing of aparticular insurer, the agency would look for


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disclosures sufficient to allow for the standardizationof reserves at a particular rating level.

g.) Disc losure

No details have yet been set out on the disclosurethat will be required with phase 2 although therequirements are likely to be in line with the broadprinciples set out in phase 1. However, Fitchbelieves that detailed disclosure will be critical inenabling users of the accounts to properly interpretfair value accounts. Disclosures are particularlyimportant for both assets and liabilities where theyare marked to model in the absence of a liquidmarket. A recorded fair value on its own canprovide relatively little information on the likelystandard deviation of returns, the sensitivity ofreturns to specific events or the maximum losses. All

of these are relevant and important information forthe users of financial statements.

The disclosures required as part of phase 2 will bedeveloped by the IASB alongside the developmentof the required accounting. However, examples ofimportant disclosure would include methodology,sensitivity analysis, and an outline of significantassumptions. Specific examples would include:

1. Disclosure of Inflation AssumptionsIn the application of discounting, Fitch wouldwelcome disclosure of the inflation assumptions thathave been used and, in particular, the link assumedbetween interest rates and inflation rates.

The risk is that higher interest rates lead to areduction in discounted claims reserves but inflationexpectations may not be adequately reflected inclaims reserves. For example, if an interest rateincrease is due to higher actual or anticipatedinflation, then expected nominal cash outflows arelikely to increase a factor that should beincorporated into reserve calculations.

The agencys concern is that actuaries are oftenbetter at projecting historic trends forward than atestimating those that will emerge in the future.Disclosure of inflation assumptions would assistusers in assessing the degree of conservatism thathas been applied and ensure that insurers do not takeadditional credit for reserve discounting when theimpact is likely to be offset by greater cost inflation.

2. Disclosure of MVMIt will be important for the market value margin tobe disclosed in order that users of the accounts areable to clearly identify the best estimate of liabilitiesand the margin that has been built into the estimate.A segmental disclosure of the MVMs would furtherassist users in comparing between companies and

over time. This disclosure would be important foranalysts to establish likely future profitability andalso to identify the degree of confidence thatactuaries are able to apply to the reserves set. In

addition, this would give analysts the option ofconsidering MVMs either as additional capital abovea best-estimate of reserves or as a prudentialreserve to counter any uncertainties or bias in reservecalculations.

In highlighting the importance of disclosure, theagency includes the issue of performancepresentation in addition to footnote disclosures.Fitch believes that the way the income statement(and balance sheet) is structured and presented cansignificantly enhance the usefulness of the financialstatement data.

h.) Other Areas

Other important areas where guidance will berequired clearly include the formulation andcalculation of the MVM as well as the following:

1. Diversification CreditThe MVMs are likely to be additive between thepools or segments that they are calculated in (i.e. thegrouping of contracts used to calculate the MVM).This means that no diversification credit will bepermitted between segments, althoughdiversification credit may well be available forbusiness calculated within segments (particularly ifstochastic modelling is utilized). The logicalconsequence of this is that the size and formulationof the pool or segment will impact the size of theMVM required.

This could give insurers an incentive to carefullymanage the business that is classified together for thepurposes of determining an MVM or in performingsuch calculations based on as few large units aspossible. The IASB will need to be wary of thispossibility and set out guidance preventing possibleabuse.

2. Discount RatesThe DSOP indicates a preference that cash flows ateach maturity should be discounted by different ratesdepending on the term structure of risk-free interestrates. This means that any shift in the term structureof risk-free interest rates (i.e. changes to the yieldcurve) will affect the valuation of liabilities andtherefore reported profitability (unless assets andliabilities are fully matched). Guidance may berequired in how the term structure of interest ratesshould be calculated, particularly where there is noobservable risk-free maturity.


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3. Reinsurance RecoverablesThe IASB has already specified that reinsurancerecoverables should be shown separately on thebalance sheet and not be netted off of liabilities.

However, it is not yet clear whether the discount rateapplied to estimated future cash flows should be riskadjusted. Practical difficulties will exist indetermining the credit risk associated with particularreinsurers and it is not clear how dispute risk will beallowed for.

Business Impl ic at ions of Fair Value

Repor t ingIt is important to note that there will inevitably besome business implications associated with theimplementation of the new standards. Given thecurrent preliminary proposals, the full business

implications of fair value reporting are not yet clear.However, the implications could include thefollowing:

Changes to product design Some product linesthat are currently profitable may be lessprofitable when assessed on a fair value basisand will need to be modified or scrapped. Inaddition, the duration of some (particularly life)contracts could be shortened in order to reducethe volatility that is associated with them.

Improved matching One of the key benefits of

fair value reporting is the fact that it highlightscases where risks are not fully matched. It islikely that assets and liabilities will be moreclosely matched (e.g. in duration, currency) as aresult of the move to fair values.

Changes to Investment Strategy In order toreduce volatility, there may be a trend towardscloser matching and some companies may moveaway from equity investments and towards fixedinterest investments. Hedging strategies mayalso need to be amended in order to ensure thatthey are compliant with the requirements of the

published standards.

The change in the definition of insurancecontracts may have a significant impact onrecorded premiums. Policies will need to beunbundled into their insurance and investmentaspects which could result in a significantreduction in reported insurance premiums formany companies.

These business implications will have an importantimpact on the cost and benefits associated with thechange to IFRS reporting. The claimed costs and

benefits of a change to IFRS are shown in AppendixA.

Impac t of I nsurance IFRS on

Analysis MethodologyFitchs publicly available criteria for rating insurancecompanies were designed to be sufficiently flexible

to allow the agency to rate insurers reporting under avariety of accounting standards. The agency ensuresthat it understands the material differences that ariseas a result of various accounting methods so thatinsurers can be compared between countries.

That said, the introduction will have a number ofspecific effects on the way that Fitch considersinsurers:

The significant additional disclosure that isavailable will undoubtedly aid analysis. Fitchsupports the general principle of requiring

management to disclose more information onthe risks that they perceive so that users canassess the insurers financial position,performance and cash flows through the eyes ofmanagement. Particularly welcome are thedisclosure requirements on assumptions,concentrations of risk and sensitivity analysis aswell as the requirement to provide informationon insurance risk, interest rate risk and marketrisk.

In addition, the agency welcomes informationon claims development and the requirement to

disclose risks with special characteristics. Thislatter regulation will require information onitems such as asbestos and recognizes theimportant risks that these exposures canrepresent.

Investments Recording investments at marketvalue rather than amortised historic cost willhave little impact on the way that insurers areviewed. Fitch already considers balance sheetsand profitability based on market values invirtually all cases. This information is eitherbased on disclosure in the financial statements

or on additional information requested from therated insurers.

Reserves Phase 1 will have little impact onhow reserves are viewed given the fact that theywill continue to be calculated in the same way.Changes to disclosure, however, could havesome impact on our view. Phase 2 is likely tohave more of an impact due to new informationthat could be provided by the market valuemargin and the requirement to reserve to thebest estimate.


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Capital Equalisation and catastrophe reservesare currently treated as part of an insurerscapital base. Therefore, the release of thesereserves will not impact capital sufficiency

unless they are either taxed (which appearsunlikely in the near term) or paid out asdividends. Similarly, the Fund for FutureAppropriations in life companies are typicallyalso treated as part of the capital base and this isnot expected to change under IFRS. Thefinancial flexibility of insurers (i.e. their abilityto source additional funds relative to needs) isunlikely to be materially affected by IFRS butthis will continue to be assessed on a case bycase basis.

Although Fitchs view may be affected by new

information on the size, method of calculationand definition of the MVM, the agency currentlyexpects to treat MVMs as part of the bestestimate of reserves and not as part of capital.This treatment, which differs from the 100%equity credit awarded to existing equalizationand catastrophe reserves, is a result of severalfactors:

1. The perceived bias in best estimatereserves to deteriorate rather thanimprove (as discussed earlier). In recentyears, this deterioration has been

despite reserves not having beendiscounted for the time value of moneywhich should have provided anadditional level of comfort.

2. The discounting of reserves removes areserving buffer that previously existedand exists in many other jurisdictions(including US GAAP). Consistencywith other accounting regimes will beincreased by application of a prudentialmargin to reserves above best estimate.The inclusion of MVMs as part ofreserves will offset this effect.

Earnings These are likely to changesignificantly at phase 2 although the effect willdepend on policies surrounding incomerecognition. Fitch will continue to consider thereported profitability although, particularly ifprofit recognition is very slow, the agency willconsider the embedded value that has beengenerated. The agency will also continue to bemindful of the quality of earnings which willbecome particularly important in the move toIFRS, whilst also ensuring that insurers aretreated fairly with those reporting under othernational GAAP.

Reinsurers that offer financial reinsurance couldsee the demand for their product change as aresult of adjustments to the method ofaccounting for contracts with low levels of

financial risk. Fitch believes that this is mostlikely to have a negative effect on demand forsuch solutions at phase 2. However, demand forfinancial reinsurance may increase followingphase 1 due to the additional volatility in theresults of some insurers which they could seekprotection from.

Impac t of I nsurance IFRS on

Rat ings

A change in accounting standards does not impactthe underlying economic reality within the businessand, therefore, no rating changes would be expected

as a direct result of the move to the new insuranceIFRS. That said, the new standard could havebusiness implications (as already noted) and couldconceivably shed additional light on new issues. Tothe extent that the new disclosures and financialreporting provides a better view of the true economicpicture, rating actions could result. Further factorsthat could lead to changes in insurance companyratings would include:

Taxa t ion

A change in the method of accounting may have areal impact if it affects the basis of taxation. It

currently seems unlikely that the move to fair valuesfor listed consolidated companies will have asignificant impact on the tax that has to be paid.

In many countries within Europe (e.g. Germany andFrance), tax is calculated based on individualcompany, unconsolidated accounts. These accountswill continue to be prepared under local GAAPbased on current plans leaving the tax liabilityunchanged. In other cases (e.g. the UK), tax lawgenerally prevails over statutory reporting and istherefore also unlikely to be affected by the changeto insurance IFRS in the near term. However, over

the medium to long term, it is possible that the use ofIFRS will be expanded to include individualcompany accounts and, as a result, the basis oftaxation could change.

IFRS could have a particular impact if the release ofequalization reserves on the consolidated accountswere to lead to the taxation of these reserves. In thiscase, claims could no longer be met by equalizationreserves (held pre-tax) and would need to be metthrough shareholder equity (post-tax). Although thisonly relates to a timing difference in when tax is due,it would still result in a significant loss of effective

capital to the insurance industry and a correspondingbenefit to state coffers.


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Product Demand

It has already been noted that demand for some linesof business (e.g. some low risk transfer productssuch as financial reinsurance) could be impacted by

the proposed insurance IFRS. Any shift in productdemand could have an effect on Fitchs credit viewrelating to particular companies. However, ratingchanges solely based on this factor are expected tobe rare.

Business React ion

As noted above, the change to fair values may havereal effects, because they may cause management tochange the way in which they run the business. Forexample, changes to product design, improvedmatching and changed investment strategies couldall have some impact on the ratings assigned. Fitch

does not expect business reaction to have asignificant credit impact in the majority of cases.

I nvestmen t Marke t Reac t ion

If changes to accounting standards were to affect theperception of risk associated with the insuranceindustry then this could affect financial flexibilityand therefore ratings within the industry. Forexample, if the cost of capital were to increase forinsurance companies due to the accounting changethen this could negatively affect the credit quality ofthe industry by reducing access to new funds.

In practice, Fitch believes that the chances of asignificant impact on credit quality from changes tothe cost of capital are low. This is a result of a lowexpected change in cost of capital, the ability of theinsurance industry to pass on a higher cost of capitalto policyholders in the form of pricing, and apossible offsetting effect if market participantsperceive the new accounting information as being ofa higher quality.

ConclusionFitch is very supportive of the efforts being made bythe IASB to bring greater comparability and

increased disclosure to the insurance industry. Theagency also views the move towards fair values asbeing an important and valuable aim which, whenfully implemented, should lead to increased

transparency and will assist users of accounts inbetter determining the underlying economic realitywithin an insurance company.

However, Fitch notes that significant challengesremain before fair values can be introduced. Thereare a number of important issues that still need to beresolved and companies will need time in order toimplement the necessary system changes and collectthe required data to produce fair value accounts. Theoriginal deadline of 2007 for implementation seemsvery optimistic given the issues that still need to beresolved and the slow pace of progress in recent

years.

The agency does not anticipate many rating changesto occur solely as a result of the change to insuranceIFRS, and the current rating methodology issufficiently flexible that changes to analyticalmethodology will be limited. Companies that aremost likely to be impacted are those where the basisof taxation may be affected by IFRS (this is notanticipated in the short to medium term) or that seereductions in product demand as a result of thechange.

Fitch welcomes the additional disclosure required atphase 1 and notes that disclosure at phase 2 will beextremely important in interpreting financialstatements. Experience with US accountingstandards (e.g. FAS 133) has shown that fair valuedisclosure by itself is not sufficient. It is alsoessential that disclosures allow users to assess thelevel of risk associated with the fair values shown,e.g. through disclosure of significant assumptionsand areas of judgment, as well as through sensitivityanalysis. The agency would prefer to see a greaterdegree of prescribed disclosure at phase 2 to ensurethat certain important disclosures are presented in aconsistent and comparable form.


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Appendix A Pr incipal Benef i ts of

New Insurance IFRS repor t ingThe principal benefits claimed for the move towardsthe new standards are as follows:

Transparency Fair values and improveddisclosure offer greater transparency and insightinto the financial position of the company.Showing assets (and liabilities at phase 2) at fairvalue gives a better view of the financialposition of the company at a point in time. Inaddition, showing both assets and liabilities atfair value has the added advantage of avoidingthe mismatch that occurs if these categories aretreated differently.

One of the important features of the move to fair

values is that embedded derivatives and optionswill be shown at market value. This may beparticularly important in the cases of certainembedded derivatives such as GuaranteedAnnuity Options (which caused significantdifficulties at Equitable Life) and other productswith associated guarantees. At phase 2, the fairvalue of these options and guarantees are likelyto be included in the financial statements; atpresent, these options often go unrecorded.

The improved transparency and disclosure mayresult in improved decisions by managementand better targeting of capital by investors. Inparticular, phase 2 is likely to encouragemanagement to more closely monitor andcontrol their risks (e.g. matching of asset andliability duration to reduce interest rate risks).

Consistency The standardization of accountingstandards will be an important achievement initself. This will promote greater comparabilitybetween companies and may improve the abilityof some insurers to access global capital markets.The existence of a common European standardwill also make it easier to promote aconvergence of global accounting standards.

Both FASB and the IASB have indicated thatthey are keen to achieve this convergence.

Reduce accounting arbitrage Applyinginsurance accounting to insurance contractsrather than only to registered insurers willreduce the opportunity for arbitrage betweendifferent accounting methods. Currently, theremay be benefits or costs to performing aparticular transaction either inside or outside aninsurance entity based on the differentaccounting treatment.

Improved management The greatersophistication of tools that will be required to

improve fair values will encourage companies toimprove their capital management, riskmanagement and asset/liability matching. Thisgreater sophistication may also give

management and analysts greater insight intothose products that are most efficient atproducing value.

Against this, there are a number of concerns thathave been cited by industry observers and inparticular, by insurance companies themselves:

Cost of Capital Insurers are concerned thatthere will be an increase in the cost of capital asa result of the increased volatility that isexpected from the new reporting standards andinvestors interpreting this as an increase in risk.

Reliability The reliability of fair valuereporting, particularly for insurance liabilities, isoften questioned. The production of these valuesis said to require a level of sophistication (e.g. instochastic modelling techniques) that may bebeyond many insurers and the results of thesemodels may not be reliable. In addition, the useof such techniques will inevitably require someassumptions to be made and these assumptionsmay be susceptible to manipulation bymanagement

Practicality The practical aspects of

implementation will inevitably be difficult dueto the tight deadlines that have been set, the lackof trained personnel (particularly actuaries) andthe need for firms to gather new types ofinformation and to educate analysts and otherusers of the accounts.

Investment Strategy Some insurers havesuggested that volatility may adversely affectthe investment strategies that are used. Someinsurers may choose to switch investments fromequities to more stable investments such asbonds in order to reduce potential volatility. It is

argued that the resulting investment strategycould be over-cautious and not justifiable foreither policyholders or shareholders on a longterm view. Other stakeholders would see thisimprovement in matching to be a positivedevelopment.

Achieving consensus There are difficultiesstill to be resolved in agreeing the standards. Anumber of contentious issues still exist over thedetails of implementation, including the methodof calculating the market value margin, whichforms of profit should be distributable toshareholders, and when to recognizeprofitability.


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Appendix B Addi t ional Iss uesThis appendix includes a number of additional issuesthat are also noteworthy in considering IFRS.

Firstly, it is worth noting a number of issues thathave proved controversial but now appear to havebeen resolved:

Phase 1 Sunset Clause

A feature of exposure draft (ED) 5 that came undersome criticism is the existence of a sunset clausewhich set a time limit on the progress towards theimplementation of Phase 2. The draft exemptedinsurance companies from applying IAS 8(Accounting policies, changing in accountingestimates and errors) until 2007. In the absence ofthis exemption, insurers would have been required to

account for liabilities in accordance with IAS 37(provisions, contingent liabilities and contingentassets). This standard would require the use of adiscounted best estimate (using a risk-adjusteddiscount rate) of non-life liabilities and potentiallythe use of US GAAP for life liabilities18, each ofwhich would represent a significant change for manycompanies. Therefore, in the absence of amendmentsto the proposed standard or a subsequent override,any delay in phase 2 (fair values) would haveresulted in a second interim solution.

IFRS 4 still refers to the IAS 8 exemption as

temporary but no time limitation has been includedin this standard.

Phase 2 Ent i t y Speci f ic Values

Although the objective of the insurance accountingstandard would ideally be to reach the fair value ofinsurance liabilities, this is hampered by the lack of aliquid market. This determination of value is alsohindered by the fact that fair value cannot bedetermined as the sum of that associated withindividual risks. The value of a portfolio variesaccording to the portfolio which individual risks areheld in and the efficiency of the administration.

Such factors will often vary by buyer.

In order to address this difficulty in finding a truefair value that a third party would be prepared to pay,the DSOP (Draft Statement of Principles) originallydefined an entity specific value. This allowed theuse of assumptions based on the insurers ownexperience and expectations in the valuationcalculation. For instance, a true fair value (based ona third party arms length transaction) could requirean assessment of industry expense levels, or ideally,an assessment of the expense levels associated withpossible buyers. Given the difficulties associated

18 Source: Tillinghast-Towers-Perrin 4/2003.

with each of these options, the entity specific fairvalue of the portfolio allowed the company to use itsown expense experience in order to calculate policyfair values and is considered to be a reasonable

proxy.

The IASB still expects insurers to use entity specificparameters (e.g. for expenses) but has defined fairvalues in such a way as to be consistent with the useof this entity specific information.

Secondly, there are a few other areas of IFRS thatare not considered to be central to this report but areworth noting:

Compar ison w i th US GAAP

As insurers increasingly switch to IFRS, accountingstandards will move increasingly to a situation wherethere are two dominant sets of accounting standards,IFRS and US GAAP. Over time, it is expected thatthese two sets of standards will converge but in themeantime there will be some important differencesthat are of particular relevance to insurers. Forexample:

IFRS currently requires that impairments thathave been recorded on assets are subsequentlyreversed (no further than the amortised historiccost) where the valuation recovers. This is animportant difference from US GAAP, whichforbids such a reversal. This may benefitinsurers currently reporting under IFRScompared with those reporting under US GAAP,particularly under current market conditionswhere the stock market is showing signs ofrecovery after heavy falls and high impairmentcharges. It should be noted that this will changein 2005 with the revised version of IAS 39 (asnoted below).

Phase 2 will require discounting of liabilities,which is generally not permitted under USGAAP. Some US insurers have expressedconcerns that this may give European insurersan advantage, particularly in reporting profits onlong-tailed lines of business. In reality, the trueimpact is currently very difficult to assess giventhe uncertainty surrounding the way that themarket value margin will be calculated. Ratingagencies and other users of the accounts wouldalso be expected to standardize reporting as faras possible between different reporting standardsto ensure that companies are compared on acommon basis.


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Recent Changes t o IAS 39.

Although this paper does not intend to review IAS39 (Financial Instruments) in detail, there are a fewimportant points to note. In December 2003, the

IASB released a revised version of IAS 39 and IAS32 which is not required to be used until 2005although companies do have the option of earlyadoption.

The IAS 39 revised standard has some importantdifferences to that currently in use by companiesreporting under International Accounting Standards.Some of the main differences include:

Selected Di f ferences Between IAS 39

(Rev. 2000) and IAS 39 (Rev. 2003)

IAS 39 (Rev. 2000) IAS 39 (Rev. 2003)i.) Impairment of an Available-for-Sale Equityinvestment

due to a significant (20%)and prolonged (6 months)decline in the fair value belowits cost.

due to a significant (20%) orprolonged (6 months)decline in its cost (IAS39.61)

ii.) Impairment Losses of an Available-for-Sale EquityInstrument

recognized in profit or lossshall be reversed throughprofit or loss.

recognized in profit or lossshall not be reversedthrough profit or loss.(IAS39.69)

Source: IAS 39, Munich Re

For instance, the revised (2003) IAS 39 has a stricterimpairment test than that implied by the previousstandard as well as increased consistency with USGAAP and between companies in the treatment ofrevaluations following impairments. For thoseinsurers that have made use of the option to applythe revised standards early, this has led toimpairments that would otherwise have been taken in2003 being taken in 2002 in a restatement of theprior year.

The revised standards have a greater comparability

with US GAAP which forbids the reversal of

impairment losses. It is also noteworthy that the newIAS 39 standard includes an option to allow insurersto designate any asset (on initial recognition) as atfair value through profit and loss19. This should help

companies to limit the degree of accountingvolatility contained within their financial statementsby enabling them to more closely match thetreatment of assets and liabilities.

In teract ion o f Insurance Repor t ing w i t h

IAS 39

IAS 39 specifies the way that investments,derivatives and options should be accounted for. It islikely that contracts issued by insurance companiesthat fail to meet the definition of an insurancecontract will be accounted for as financialinstruments under this standard.

It is important to note that the difference between aninsurance contract and a financial instrument can besmall. For example, a premium paid to gainprotection against a credit rating downgrade of aparticular entity would be accounted for as aderivative under IAS39. This compares with thesimilar situation where a premium is paid to gainprotection against the failure of a debtor to pay whendue. This counts as a financial guarantee contractthat is outside of the scope of IAS 39 and would beaccounted for as insurance.

The adoption of Insurance IFRS, particularly at

Phase 2, will require a detailed portfolio review ofinsurers portfolios to identify areas that are coveredby IAS39 (e.g. contracts that fail to meet thedefinition of an insurance contract and embeddedderivatives such as index-linked bonds andguaranteed annuity options). This process will becomplicated by the fact that the classification of aparticular contract may differ during its life. Thecurrent proposals state that the contract iscategorized at the start of its life and then will not berecategorised, although this could potentially besubject to abuse.

19 In response to concern from regulators that this proposal couldbe open to abuse (e.g. by recognising profitability on financialinstruments whose valuation is subject to subjectivity), the IASBhas recently released an exposure draft that would somewhatlimit this option although still aims to meet the original objective.


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Appendix C Exam ple of Possible

Acc ount ing Treatment .The following very simplified example is designedto show the different way that income emerges under

the current deferral and matching approach andunder the fair value approach. The example alsoshows the importance of the definition of fairvalues and the substantial impact that this may haveon the pattern of income recognition.

It is important to note that these examples areillustrative only. The examples have beenconstructed to demonstrate the general principlesinherent in the discussion of phase 2 and should notbe taken as necessarily representing the way thataccounting will work under phase 2, as theformulation of some concepts (e.g. entry values) is

still under discussion. In particular, these exampleshave been presented in a simplified manner and donot represent the exact presentation that is envisagedat phase 2.

The simplifying assumptions made for the examplesbelow include the following:

A single policy is written for 100 of premium,

60 of claims are expected to be paid (and arepaid) in year 4.

Acquisition costs are 20, incurred at the time ofwriting the policy.

The policy incepts half way through year 1 andlasts for one year.

Premiums received and acquisition costs arepaid at start of the policy. All other cash flowsoccur at year ends.

Discount rate is 3% (risk free) with the yieldcurve assumed to be flat.

Actual Investment Return = 4%.

The Provision for Risk and Uncertainty (MarketValue Margin) is assumed to be calculated as 12(pre-discount) where exit fair values are usedand the risk is assumed to decline by one-thirdin year 2 and by a further 50% in year 3 prior to

settlement in year 4. Under Entry Fair Values, the MVM is set up

such that no profit is made in year 1 (i.e. insureris unable to show that it is charging more thanthe market average for the risk). As theinsurance contract expires, accounting has beenassumed to converge with that of exit valuesusing an MVM.

Deferra l and Matc hing

Year 1 Year 2 Year 3 Year 4 Total

INCOME STATEMENT

Net Premiums Written 100 - - - 100Net Premiums Earned 50 50 - - 100Net Claims Expense (30) (30) - - (60)Acquisition Costs (10) (10) - - (20)

Underwriting Profit 10 10 - - 20Investment Return 1.6 3.3 3.4 3.5 11.8

Profit 11.6 13.3 3.4 3.5 31.8

BALANCE SHEETCash and Investments 81.6 84.9 88.3 31.8Deferred Acquisition Costs 10 - - -

ASSETS 91.6 84.9 88.3 31.8

Unearned Premiums 50 - - -Claims Reserves 30 60 60 -Retained Earnings 11.6 24.9 28.3 31.8

LIABILITIES 91.6 84.9 88.3 31.8

CASHFLOWPremiums 100 - - - 100Expenses (20) - - - (20)Claims - - - (60) (60)Investment Income 1.6 3.3 3.4 3.5 11.8

Total 81.6 3.3 3.4 (56.5) 31.8

Source: Fitch estimates


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19

Possib le Account ing Treatm ent Using Exi t Fair Value (With MVM)


INCOME STATEMENTNet Premiums (NPV) 100 - - - 100

Net Claims Expense (54.1) (54.1)Provision for Risk and Uncertainty* (10.8) 3.8 3.9 4.0 0.8Acquisition Costs (20) - - - (20)

Profit Insurance Business 15.1 3.8 3.9 4.0 26.7Investment Return 1.6 3.3 3.4 3.5 11.8Unwind of Discount Claim Reserve (0.8) (1.6) (1.7) (1.7) (5.9)Unwind of Discount MVM (0.2) (0.3) (0.2) (0.1) (0.8)

Profit 15.7 5.1 5.4 5.7 31.8BALANCE SHEETCash and Investments 81.6 84.9 88.3 31.8

ASSETS 81.6 84.9 88.3 31.8

Claims Reserves 54.9 56.6 58.3 -Provision for Risk and Uncertainty 11.0 7.5 3.9 -

Retained Earnings 15.7 20.8 26.1 31.8

LIABILITIES 81.6 84.9 88.3 31.8


Total 81.6 3.3 3.4 (56.5) 31.8

* Also known as the Market Value Margin or MVM.Source: Fitch estimates


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20

Possib le Account ing Treatm ent using Exi t Fair Value (NO MVM)



Net Claims Expense (54.1) - - - (54.1)Provision for Risk andUncertainty

- - - - -

Acquisition Costs (20) - - - (20)

Profit Insurance Business 25.9 0 0 0 25.9Investment Return 1.6 3.3 3.4 3.5 11.8Unwinding of Discount (0.8) (1.6) (1.7) (1.7) (5.9)


ASSETS 81.6 84.9 88.3 31.8

Claims Reserves 54.9 56.6 58.3 -Provision for Risk andUncertainty

- - - -

Retained Earnings 26.7 28.3 30 31.8

LIABILITIES 81.6 84.9 88.3 31.8


Total 81.6 3.3 3.4 (56.5) 31.8

Source: Fitch estimates


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Possib le Acc ount ing Treatm ent using Entry Fair Value



Net Claims Expense (54.1) - - - (54.1)Provision for Risk andUncertainty

(18.4) 11.7 3.9 4 1.2

Acquisition Costs (20) - - - (20)

Profit Insurance Business 7.5 11.7 3.9 4 27.1Investment Return 1.6 3.3 3.4 3.5 11.8Unwind of DiscountClaimReserves

(0.8) (1.6) (1.7) (1.7) (5.9)

Unwind of Discount-MVM (0.3) (0.6) (0.2) (0.1) (1.2)


ASSETS 81.6 84.9 88.3 31.8

Claims Reserves 54.9 56.6 58.3 -Provision for Risk andUncertainty*

18.6 7.5 3.9 0

Retained Earnings 8.1 20.8 26.1 31.8

LIABILITIES 81.6 84.9 88.3 31.8

CASHFLOWPremiums 100 - - - 100Expenses (20) - - - (20)Claims - - - (60) (60)

Investment Income 1.6 3.3 3.4 3.5 11.8Total 81.6 3.3 3.4 (56.5) 31.8

* It has been assumed that as risk expires, the entry value method converges to an exit value method. Under this formulation, the 50% of risk thatis expired at the end of year 1 is accounted for on an exit value basis (i.e. profit is taken on this business in a similar way to the exit value withMVM scenario) whilst no profit is taken on the 50% of risk that is unexpired. This is one of a number of possible formulations for entry valueaccounting although details of the proposed required accounting treatment will become clearer as the phase 2 project progresses.Source: Fitch estimates


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Bibl iography

The Implication of Fair Value Accounting for General Insurance Companies P. K. Clark, P. H.Hinton, E. J. Nicholson, L. Storey, G. G. Wells, M. G. White.

Fair Value Accounting Julian Leigh. Development of principles set out in paper to 2003 GIROconvention.

Draft Statement of Principles (DSOP) 2001 Chapters 1-6, 8-12. Published by IASB.*

ED 5 Insurance Contracts IASB

IFRS 4 Insurance Contracts - IASB

Financial Services and General Insurance Update Tillinghast Towers Perrin September 2003. (IASBpublishes ED5 insurance contracts)

Setting the Standard III Peter Wright and Douglas C. Doll In Emphasis Tillinghast-Towers-Perrin2003/4.

Fitch Insurance

Documents

Transcript of Fitch Insurance