Insurance accounting rules and the impact on small insurers

The International Accounting Standards Board has finally issued a draft standard for the valuation of insurance liabilities, being the second phase of International Financial Reporting Standards 4, following a consultation period, which ended in November.

This controversial draft standard aims to match the valuation approach for assets with that of liabilities, in other words, move towards a common approach of using a market valuation or, as an approximation, some form of discounted present value of future cashflows, plus a risk adjustment and residual margin adjustment to determine the value of liabilities on the balance sheet of insurers.

Valuation method
The IASB considers this valuation method will show a more realistic and appropriate balance sheet position for insurers than is offered using the current mix of historical cost and other valuation methods.

The proposals have already drawn criticism from certain quarters, such as the German insurance market, because, while appearing sensible in theory, they have been challenged on the grounds they will make the valuation of insurance companies as a whole more difficult, which could detrimentally impact the ability of insurers to raise capital, at a time when Solvency II may require them to do just that.

"The IASB considers this valuation method will show a more realistic and appropriate balance sheet position."

Struggle for risk managers
Actually, it is more than just capital providers that will have difficulty - risk managers will struggle to determine what the actuarial estimates contained in the valuations really mean, and, therefore, what the actual financial position of their insurance carrier is, and risk managers with captives will struggle with the fact that their captive may have to disclose lots more information about its liabilities, just because it is an insurer, for no apparent practical benefit.

While most assets of an insurer are able to be valued on a market value basis, being either cash on deposit, or traded securities and bonds for which a ready market exists, the same cannot be said for the liabilities.

Not traded
Many insurance liabilities, being the unpaid present and future claims that will arise on written policies are not ‘traded' and there is no ready market value. Furthermore, the determination of a discounted present value of future cashflows requires an estimate of the likely value and timing of the cashflows together with an estimate of the discount factor - which may be different to the interest rate applicable on the asset side of the balance sheet - plus an estimate of the likely risk adjustment applicable to the liabilities (being a ‘cost' for the assumption of such liabilities by another carrier). There are lots of ‘estimates' and, therefore, more uncertainty and subjectivity.

While this estimation may be a little more accurate if the insurer is a large multi-national, multi-line carrier with a good track record and a stable portfolio of risks. It becomes a lot more subjective for smaller start-up companies that have a growing portfolio of risks in one or two lines of business only.

"It becomes a lot more subjective for smaller start-up companies."

Unnecessary disclosures
The UK Accounting Standards Board has recognised certain smaller companies may be required to produce too much unnecessary accounting disclosures, where they are small or medium-sized, or where there is no public accountability - such as is the case for captives.

Unfortunately the exposure draft relating to the simplifications from full IFRS disclosures for insurers (known as the Financial Reporting Standards for Medium-Sized Entities) are limited due to the fact that most insurers will be publicly accountable, and will not meet the Companies Act definition of small because it applies only to companies with a turnover of less than £6.5m; net assets of less than £3.2m and less than 50 employees.

Small advantages
At the moment, only small publicly accountable, and prudentially regulated companies will be able to take advantage of the simplifications, as well as some qualifying subsidiaries of publicly accountable parent companies.

Even if an insurer were small enough to avail itself of the FRSME, there is no insurance accounting standard equivalent of IFRS 4 within the FRSME, so insurers could be stuck with this standard anyway, by it being the nearest equivalent standard applicable.

"Only small publicly accountable, and prudentially regulated companies will be able to take advantage of the simplifications."

Guernsey, as Europe's largest captive domicile, is putting pressure on the IASB to treat captives and protected captive cells differently to commercial insurers, however, there is a real need for the whole insurance industry to recognise the accounting burden that may fall on smaller commercial insurers themselves which could significantly increase the accounting disclosure requirements and, therefore, cost of compliance, for no actual benefit to the majority of policyholders of insurers who will not be sophisticated readers of such financial disclosures, and who may end up more, rather than less, confused by the changes.

Martin LePelley is the compliance director of Heritage Insurance Management and chairman of the Guernsey International Insurance Association