Efforts to shed light on insurance’s black box

Faced with one of the most unflattering corporate comparisons imaginable, Sir David Clementi, chairman of Prudential, bristled earlier this year at the insurer’s annual meeting.

One puzzled private investor, who had just seen this year’s film about Enron, asked the City grandee if there was any difference between the “hypothetical future accounting” employed by the energy trader and accounting for insurance contracts.

“I have to say I very much regret your reference in the context of the Prudential AGM,” said Sir David. But behind it, he acknowledged, there was “a serious question about the accounting system we use”.

Private investors are not the only ones perplexed by the mysteries of insurance accounting, which can make totting up profits in other sectors seem like child’s play.

Companies themselves, along with professional investors and accounting standard-setters, recognise that it can be almost impossible to fathom the origins of insurers’ reported numbers.

Helmut Perlet, chief financial officer of Allianz, one of Europe’s largest insurers, recently acknowledged that accounts in the sector were perceived as a “black box”.

The point is of more than academic interest. It has billions of pounds worth of consequences.

Troubled by uncertainty about the risks and returns of the businesses they are buying, some investors apply an “accounting discount” to insurers. Industry executives say their valuations are depressed as a result, raising the cost of capital.

One official at the International Accounting Standards Board says: “The industry recognises that it’s to everyone’s advantage – to the degree it is possible because part of it will always be a black box – to shine some light in there.”

Three landmark initiatives – run by the IASB, the European Union and the industry itself – have the potential to better illuminate insurers’ financial position, but only if they develop in concert over the next year. If they clash, they could make matters worse.

Insurance accounts have always seemed to involve some alchemy. Insurers themselves sell nothing tangible and one of the most important items in their accounts – the size of their liabilities – pivots on judgements and guess work that stretch decades into the future.

The complexity was underlined by the fact the IASB, which sets rules now in force across Europe, could do no better than produce a half-finished insurance standard in time for last year’s implementation deadline. It has this year stepped up its “phase two” project on developing a more permanent standard.

Its work centres on how to measure insurance liabilities and the board has tentatively decided to go for a “current exit value model”, based on how much an insurer would expect to pay to transfer its obligations to another entity.

But some in the industry – which has made its own proposals for IASB accounting through the CFO Forum – are not happy. They would prefer to link liability measurement to the premiums they have received, because an “exit value” model would force them to book future “profits” that are still far from certain.

There is also another force to be reckoned with: a new piece of European Union legislation that will overhaul solvency requirements in the insurance sector. The Solvency II directive, due to replace a patchwork of local regulations, is designed to make insurers match the capital they hold more closely to the risks they face.

That means the drafters of Solvency II – in common with the IASB – must come up with their own means of measuring liabilities, but this time for the purpose of prudential regulation.

Hitesh Patel, partner at KPMG, says it is crucial for the IASB to develop a definition of liabilities on which regulators can build their solvency requirements. Without this, insurers could end up either using two different liability measurement systems, or find liability valuation in their accounts being driven by Solvency II.

“The two regimes are building blocks and therefore they should be interdependent,” he says.

The IASB also recognises the interface between the two. Warren McGregor, one of 14 board members, says: “Our aim is making sure people in the capital markets are fully informed. The solvency people are concerned with protecting policy-holders. But establishing some common ground is highly desirable.”

The European Commission is scheduled to make a formal proposal on Solvency II in July 2007. But one worry is that the big decisions on international accounting standards will not be made in time. The IASB plans to publish a discussion paper on insurance accounting by the end of this year, but a new standard is not due until 2009 or 2010.

Liabilities are a crucial ingredient in another area: determining the profitability of life assurance policies. Insurers recognise that if they are to be given realistic valuations, investors need more help in estimating the profit likely to emerge from this long-term business.

So the industry came up with a third way of measuring performance: embedded value, which indicates the future earnings of contracts that can run for decades.

Embedded value has become the basis of a parallel set of books, published alongside statutory IFRS accounts, which have split the attention of investors.

Since the beginning of last year, leading European insurers have been using a new standard for embedded value reporting to make
it more consistent and
transparent.

Some analysts want insurers to go further, and use a methodology under which assets and liabilities are valued in line with market prices. But on this the industry is divided.

There is agreement on one thing. Even though statutory and embedded value accounts will remain separate, insurers recognise that for the sake of investors the two must be reconcilable.

Allianz’s Mr Perlet, who unveiled the industry’s recommendations to the IASB as head of the CFO Forum, says: “I think what we are proposing is pretty much consistent with what is being discussed in the areas of embedded value and Solvency II.”

Technical bickering on a range of fronts is yet to be resolved, but there is a growing recognition that convergence between the three systems would be advantageous.

Another finance director at a European insurer says: “Anyone observing the situation recognises that one solution that meets all needs is not achievable. If, however, we could end up with one underlying accounting system, and different outputs from that accounting system produced either Solvency II, EEV or IFRS financial statements, then that is clearly a step forward.”

Mr McGregor at the IASB, at least, is optimistic. “You don’t often see the planets getting aligned,” he says. “But they are on this one.”