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Return to: Home > News > Standards > News analysis: Insurance accounting discourages investors says Standard & Poor’s

News analysis: Insurance accounting discourages investors says Standard & Poor’s

Olav Jones, Insurance Europe deputy director general: "The accounting principles for insurance companies should capture the long-term nature of our business"
Rob Jones, S&P Financial Services Ratings managing director: "Convergence is an imperative for the IASB and the FASB"

The current incomplete approach to insurance accounting has created the perception that investing in insurers is only for specialists, which could discourage general investors from venturing into the sector, an expert of Standard & Poor's (S&P) has told The Accountant.

S&P Financial Services Ratings managing director Rob Jones said that many general investors stay clear of the sector because it's viewed as a difficult one to analyse and requires great effort and time to understand, partly due to its accounting.

Currently accounting practices vary substantially from market to market because there is no global standard to account for insurance contracts. IFRS 4 issued in March 2004 remains an interim standard that doesn't tackle specifically insurance issues, notably the valuation of insurance liabilities.

"It was something pragmatic at the time. Because the EU was moving towards recognising IFRS as the financial reporting medium in 2005, there was a bit of a race to get something into the accounting standards for insurance but it wasn't just sufficient time for it to be a comprehensive standard," Jones said.

Both the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) have published exposure drafts (ED) that closed for comment 25 October. S&P commented on both EDs and stated it welcomes the level of convergence that may emerge from these consultations.

The rating agency supports the objectives of both standard setters and even if the two EDs were to be implemented as presented, Jones observed, that in itself would represent a giant leap forward in terms of global consistency of insurance accounting.

"If you look around the world there are dozens of different approaches to insurance accounting because IFRS 4 didn't really address many of the insurance liability issues," Jones said.

Nonetheless, S&P regretted that the proposals of the IASB and the FASB are "unlikely to achieve" a fully unified standard as there are still clear differences between them which wouldn't solve completely comparability issues.

"Convergence is an imperative for the boards and we regarded as a real disappointment that there isn't one global standard being proposed. The difference between the two are unfortunate," Jones said.

In its response to the public consultations, S&P stated that both EDs although "similar they are not the same" and added that there are differences that would impede analysing and comparing insurance companies globally.

One of these differences relates to margin measurement and recognition as both EDs are likely to produce different earning patterns, according to the rating agency.

S&P argued that both EDs propose two distinct definitions of how to recognise revenue. In addition, the IASB's ED includes two elements that FASB doesn't.

First "an explicit risk adjustment" and secondly "requiring subsequent adjustment to reflect changes in cash flow estimates for future coverages or estimates," S&P wrote.

For Jones one recurring feedback that the proposals are receiving is on the issue of volatility. In his view the IASB's latest exposure improved in that respect, reducing volatility but adding complexity in turn.

"The sector is perceived to be one that has particularly volatile results. As long as the accounting volatility remains in the financial reporting, that would have an adverse effect on the insurance cost of capital," Jones said.

Jones added that in the corporate world there is much greater acceptance of IFRS but not when it comes to the insurance sector. For Jones insurance is perceived as being different from other corporate activities where general investors are relatively comfortable with the accounting framework in place.

"An objective for the industry would be to get towards a proposal that would attract more investors into the sector. Perhaps with fewer surprises than they might have been in the past, like large unexpected increases on insurance liabilities. Or at least a way of trying to communicate better the expected level of volatility of the insurance business," Jones concluded.

Insurers' view
Insurance Europe (IE), a federation of national insurance associations, agreed with S&P that the current approach to insurance accounting is putting investors off from embarking into the sector.

"We often hear that our business is difficult to understand and that current IFRS 4, being an interim standard, adds to the difficulty for potential investors to understand the business model and profitability," IE deputy director general Olav Jones said.

IE said the IASB proposals for insurance contracts, also known as IFRS 4 Phase II, and the standard for financial instruments (IFRS 9) are interrelated and therefore consistency should be ensured between the two.

"In order to reflect the insurance business models used across the European markets, it is particularly important that the accounting principles for insurance companies capture the long-term nature of our business and the links between assets and liabilities," Jones said.

According to IE, there are mainly two areas that can be difficult for investors to understand.

First, the way provisions for future liabilities (i.e. insurance claims) are built up and paid out over time. "For some business this process of building up and paying out can cover many years. These provisions can be funded from both new premiums and investment income from the assets backing existing provisions," Jones said.

Secondly, how investment performance on assets flows through both balance sheet and profit and loss accounts. According to Jones, due to the nature of the insurance business what matters more is the long-term performance rather than tshort-term performance.

For Jones the challenge for accounting measures is how to represent these long-term and often multi-year processes in quarterly or yearly financial reporting.

"If accounting measures are not appropriately designed for the insurance business models, it is easy for the investors to get confused by the way profit flows are reported or by short-term volatility due to temporary market fluctuation," Jones explained.

All in all, IE regarded the proposals on IFRS 4 Phase II as a step in the right direction, although they need further critical amendments to achieve a workable accounting standard.

Related article

News analysis: Insurance contract accounting revisited

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