Accounting: International Standards and Solvency II

Accounting: International Standards and Solvency II
THE TOPIC
APRIL 2009

Accounting is a system of recording, analyzing and verifying an organization’s financial status. In the United States, all corporate accounting is governed by a common set of accounting rules, known as generally accepted accounting principles, or GAAP, established by the independent Financial Accounting Standards Board (FASB). The Securities and Exchange Commission (SEC) currently requires publicly owned companies to follow these rules. But starting in 2010, some large multinational companies may start using International Financial Reporting Standards.

Accounting rules have evolved over time and for different users. Before the 1930s corporate accounting focused on management and creditors as the end users. Since then GAAP has increasingly addressed investors’ need to be able to evaluate and compare financial performance from one reporting period to the next and among different companies. In addition, GAAP has emphasized “transparency,” meaning that accounting rules must be understandable by knowledgeable people, the information included in financial statements must be reliable and companies must fully disclose all relevant and significant information.

Special accounting rules also evolved for industries with a fiduciary responsibility to the public such as banks and insurance companies. To protect insurance company policyholders, states began to monitor solvency and, as they did so, a special insurance accounting system, known as statutory accounting principles, or SAP, developed to help them. The term statutory accounting denotes the fact that SAP embodies practices required by state law. SAP provides the same basic information about an insurer’s financial performance as GAAP but, since its primary goal is to enhance solvency, it focuses more on the balance sheet than GAAP. GAAP focuses more on the income statement.

Publicly owned U.S. insurance companies, like companies in any other type of business, report to the SEC using GAAP. They report to insurance regulators and the Internal Revenue Service using SAP. Accounting principles and practices outside the U.S. differ from both GAAP and SAP. But this may change.

In 2001 the International Accounting Standards Board (IASB), an independent international accounting standards setting organization based in London, began work on a set of global accounting standards. About the same time, the European Union (EU) started work on Solvency ll, a framework directive aimed at streamlining and strengthening solvency requirements across the EU in an effort to create a single market for insurance. This is conceptually in line with proposals for new insurance accounting standards.

Ideally, a universal set of accounting principles would facilitate global capital flows and lower the cost of raising capital. Some 100 countries now require or allow the use of the international standards that IASB has already developed and more adopters are on the way. Accordingly, FASB and IASB have, since September 2002, agreed to work toward a convergence of GAAP and international accounting standards.

Insurers support the IASB’s search for the highest quality financial reporting standards, but some are concerned that some aspects of the initially proposed standards for insurance contracts will confuse more than enlighten and introduce a significant level of artificial volatility that could make investing in insurance companies less attractive.


RECENT DEVELOPMENTS



Accounting

In the fall of 2008, FASB agreed to join the IASB’s Insurance Contracts project. At the same time, the National Association of Insurance Commissioners (NAIC) began to analyze how a transition from statutory accounting principles to International Financial Reporting Standards (IFRS) could be best accomplished.
In December 2008, FASB and IASB published for public comment a discussion paper on revenue recognition. The objective of the groups is to improve existing guidance on this subject by developing a single revenue model that can be applied consistently regardless of the industry. Under the model, a company would recognize revenue “when it satisfies a performance obligation by transferring goods and services to a customer as contractually agreed,” as is currently the case with GAAP accounting for insurance transactions. Some have suggested a similar concept for IASB’s insurance accounting standard since insurance services are not fully provided until the policy expires.
Under a plan laid out by the Securities and Exchange Commission (SEC) in August 2008, as many as 150 large multinational public companies will be allowed to use the IFRS as the sole basis for preparing earnings reports beginning in 2010. These companies have been issuing reports for the SEC under both the IFRS and GAAP. If this pilot project is successful, all public companies could be required to use the IFRS by 2014. IFRS markets represent 35 percent of global market capitalization, according to the SEC, compared with 28 percent for GAAP. In November 2007, the SEC voted unanimously to stop requiring non-U.S. companies that use IFRS to re-issue their financial reports using GAAP for U.S. investors.
In May 2007 the IASB asked for comments on its discussion paper on international accounting standards for insurance companies. The paper outlines a proposal to value insurance company liabilities—its reserves for losses. Reponses were submitted by various groups and individual insurance companies. These were reviewed and discussed at various meetings in 2008, but the schedule for implementation has been delayed. Earlier, IASB said that it expects to publish “firm” proposals toward the end of 2008, but industry observers expect this date to be pushed back as well the date for the new standard. That is now expected to be in place by 2011, a year later than initially posted.
The Property Casualty Insurers Association of America (PCI), which represents mostly medium to small insurance companies, said in its comments that while it supports the convergence concept it disagrees with some of the ideas contained in the paper, including the use of a single model for valuing property/casualty and life insurance reserves, the requirement that loss reserves be discounted to reflect the time value of money and then be adjusted with the use of a risk margin to compensate for any inaccuracy, and the recognition of profit at the inception of an insurance policy, among other things. PCI said that overall it was concerned about the cost of resources to implement the proposal and the minimal benefits that would be realized. Comments on the discussion draft are posted on the IASB’s Web site.
According to a study of insurance industry comments on the IASB discussion paper by Ernst & Young, an accounting firm, while there is strong support for an international accounting model for insurance transactions, there is disagreement about how to arrive at that point. Most believe accounting for insurance should reflect the economics of the business and are unwilling to accept the concept of “exit value,” as described in the discussion document. An IASB vice president, Tom Jones, acknowledged in a speech at Pace University in April 2008 that the board faces a challenge in revising accounting standards. He said the IASB came up with the “current exit value” approach to measure the value of insurance contracts because, since insurance company assets, contracts and liabilities lack a ready market, using fair value or mark to market could cause problems. Others suggest that a more appropriate way to measure the value of insurance contracts would be to reflect the expected cash flows needed to settle the contract.
Responding to the (FASB)'s “Invitation to Comment,” asking whether there was a need for a project on insurance contracts accounting and if so whether the work should be undertaken jointly with IASB, industry representatives from various insurance trade organizations said that the group should add a project on insurance contracts to its agenda but that the IASB’s Discussion Paper, see below, would not be a good starting point. They described the framework as explained in the discussion paper as “a complex method of mathematically estimating insurance liabilities” that appears “to be less reliable or decision-useful than the existing U.S. GAAP guidance for valuing nonlife insurance liabilities.” In addition, insurers strongly believe that one accounting model cannot be used for all insurance contracts, life as well as nonlife (property/casualty). The use of a single model would compromise the unique reporting characteristics of the various insurance products produced by different segments of the industry, they said.
FASB chairman Robert Herz has said that GAAP is “too detailed “and contained “too many exceptions” and is not good for specific industries like insurance. One major conceptual difference between GAAP and IFRS is that the latter is based on a set of principles in contrast to GAAP’s rule-based approach. U.S. insurance regulation is likely to move towards a principle-based approach, see Regulation Modernization report.

Solvency II

Key elements in the EU’s Solvency ll, a project to strengthen and standardize solvency requirements across the European insurance market, had included flexibility to move capital across national boundaries to support solvency requirements within insurance company groups, and group supervision. The concept of group support had been approved by the European Parliament and was favored by the European insurance industry. However, some EU member states were concerned that the provision allowing a subsidiary’s capital requirements to be guaranteed by the parent company would result in the withdrawal of funds, usually from the smaller countries where the subsidiary is based to larger states, such as the U.K., France or Germany. Smaller countries believed that such a provision could reduce their ability to oversee these subsidiaries and to protect their policyholders. To break the impasse that could have imperiled Solvency II, the European Parliament agreed at the end of March 2009 to drop group support language from the directive. The effective date of Solvency II is November1, 2012.
The NAIC has created a high level Solvency Modernization Initiative (SMI) Task Force that will report directly to the Executive Committee, suggesting that work on improving solvency regulation will receive greater prominence. The NAIC began work on its SMI in September 2008, the aim of which is to determine whether current U.S. solvency requirements need to be modified in light of regulations in other countries and the changes now being contemplated in the European Union under Solvency ll.

BACKGROUND



To assess the IASB proposal, it’s important to understand how the insurance industry functions and the current insurance accounting framework.

Insurance Basics: Insurers assume and manage risk in return for a premium. The premium for each policy, or contract, is calculated based in part on historical data aggregated from many similar policies and is paid in advance of the delivery of the service. The actual cost of each policy to the insurer is not known until the end of the policy period (or for some insurance products long after the end of the policy period), when the cost of claims can be calculated with finality.

The insurance industry is divided into two major segments: property/casualty, also known as general insurance or nonlife, particularly outside the United States, and life. Property/casualty insurers sell home, auto and commercial coverages; life insurers sell life, long-term care and disability insurance and annuities. In the United States, both types of insurers submit financial statements to regulators using a special set of accounting rules, see below, as opposed to GAAP, which is used for reporting to the SEC. But there are some significant differences between the accounting practices of property/casualty and life insurers due to the nature of their products.

Insurance is regulated by the states, whose main objective is to monitor and maintain the solvency of the companies they regulate. States also oversee rates, particularly for property/casualty insurers, to ensure they are adequate, not excessive and not unfairly discriminatory. To support these goals, all insurance companies are required to file annual financial statements with state regulators using an accounting system established by the National Association of Insurance Commissioners known as statutory accounting principles, or SAP. SAP generally recognizes liabilities sooner and at a higher value than GAAP and assets later and at a lower value.

Differences Between Property/Casualty and Life Insurance Contracts: Some differences between property/casualty insurance contracts have accounting implications. These include:

Contract duration: Property/casualty insurance contracts are usually short-term, six-months to a year. As a result, the final cost of most property/casualty contracts will be known within a year or so after the policy term begins, except for some types of liability contracts. By contrast, life, disability and long-term care insurance and annuity contracts are typically in force for decades.

Variability of Claims Outcomes Per Year: The range of potential outcomes with property/casualty insurance contracts can vary widely, depending on whether claims are made under the policy, and if so, how much the ultimate settlement (claims payments and claims adjustment expenses) costs. In some years, natural disasters such as hurricanes and man-made disasters such as terrorist attacks can produce huge numbers of claims. By contrast, claims against life insurance and annuity contracts are typically amounts stated in the contracts and are therefore more predictable. There are very few instances of catastrophic losses in the life insurance industry comparable to those in the property/casualty insurance industry.

Financial Statements: An insurance company’s annual financial statement is a lengthy and detailed document that shows all aspects of its business. The initial section includes a balance sheet, an income statement and a section known as the Capital and Surplus Account, which sets out the major components of policyholders’ surplus and changes in the account during the year. As with GAAP accounting, the balance sheet presents a picture of a company’s financial position at one moment in time—its assets and its liabilities—and the income statement provides a record of the company’s operating results from the previous year. An insurance company’s policyholders’ surplus—its assets minus its liabilities—serves as the company’s financial cushion against catastrophic losses and as its working capital for expansion. Regulators require insurers to have sufficient surplus to support the policies they issue. The greater the risks assumed, and hence the greater the potential for claims against the policy, the higher the amount of policyholders’ surplus required.

Asset Valuation: Property/casualty companies need to be able to pay predictable claims promptly and also to raise cash quickly to pay for a large number of claims in the event of a hurricane or other disaster. Therefore, most of their assets are high quality income paying government and corporate bonds that are generally held to maturity. Under SAP, they are valued at amortized cost rather than their current market cost. This produces a relatively stable bond asset value from year to year (and reflects the expected use of the asset.)

However, when prevailing interest rates are higher than bonds’ coupon rates, amortized cost overstates asset value, producing a higher value than one based on the market. (Under the amortized cost method, the difference between the cost of a bond at the date of purchase and its face value at maturity is accounted for on the balance sheet by gradually changing the bond’s value. This entails increasing its value from the purchase price when the bond was bought at a discount and decreasing it when the bond was bought at a premium.) Under GAAP, bonds may be valued at market price or recorded at amortized cost, depending on whether the insurer plans to hold them to maturity (amortized cost) or make them available for sale or active trading (market value).

The second largest asset category for property/casualty companies, preferred and common stocks, are valued at market price. Life insurance companies generally hold a small percentage of their assets in preferred or common stock.

Some assets are “nonadmitted” under SAP and therefore assigned a zero value but are included under GAAP. Examples are premiums overdue by 90 days and office furniture. Nonadmitted assets and limits on categories of investments may be reconsidered at some point in time in light of the European Union’s drive toward a single market for insurance, which includes a new regulatory framework for insurance company solvency known as Solvency II. While the frameworks for solvency regulation and accounting are not the same, the two are intertwined. Regulators look at balance sheets in evaluating solvency and balance sheets are the product of accounting. Solvency II envisions the removal of rules on nonadmitted assets. In their place will be a set of guiding principles based on the concept of a “prudent person.”

Real estate and mortgages make up a small fraction of a property/casualty company’s assets because they are relatively illiquid. Life insurance companies, whose liabilities are longer term commitments, have a greater portion of their investments in commercial mortgages.

The last major asset category is reinsurance recoverables. These are amounts due from the company’s reinsurers on claims that have been paid. (Reinsurers are insurance companies that insure other insurance companies, thus sharing the risk of loss.) Amounts due from reinsurance companies are categorized according to whether they are overdue and, if so, by how many days. Those recoverables deemed uncollectible are reported as a surplus penalty on the liability side of the balance sheet, thus reducing surplus.

Liabilities and Reserves: Liabilities, or claims against assets, are divided into three components: reserves for obligations to policyholders, claims by other creditors and policyholders’ surplus. Reserves for an insurer’s obligations to its policyholders are by far the largest liability. Property/casualty insurers have three types of reserve funds: unearned premium reserves, or pre-claims liability; loss and loss adjustment reserves, or post claims liability; and other.

Unearned premiums are the portion of the premium that corresponds to the unexpired part of the policy period. Premiums have not been fully “earned” by the insurance company until the policy expires. In theory, the unearned premium reserve represents the amount that the company would owe all its policyholders for coverage not yet provided if one day the company suddenly went out of business. If a policy is canceled before it expires, part of the original premium payment must be returned to the policyholder.

Loss reserves are obligations that an insurance company has incurred due to claims filed under the policies it has issued. Loss adjustment reserves are funds set aside to pay for claims adjusters, legal assistance, investigators and other expenses associated with settling claims. Property/casualty insurers only set up reserves for accidents and other events that have happened.

Some claims, like fire losses, are easily estimated and quickly settled. But others, such as products liability and some workers compensation claims, may be settled long after the policy has expired. The most difficult to assess are loss reserves for events that have already happened but have not been reported to the insurance company, known as "incurred but not reported" (IBNR). Examples of IBNR losses are cases where workers inhaled asbestos fibers but did not file a claim until their illness was diagnosed 20 or 30 years later. Actuarial estimates of the amounts that will be paid on outstanding claims must be made so that profit on the business can be calculated. Insurers estimate claims costs, including IBNR claims, based on their experience. Reserves are adjusted, with a corresponding impact on earnings, in subsequent years as each case develops and more details become known.

Revenues, Expenses and Profits: Profits arise from insurance company operations (underwriting results) and investment results.

Policyholder premiums are an insurer’s main revenue source. Under SAP, when a policy is issued, the pre-claim liability or unearned premium is equal to the written premium. (Written premiums are the premiums charged for coverage under policies written regardless of whether they have been collected or “earned.”) On the asset side of the balance sheet, premiums are treated as deferred revenues and on the liability side, they increase the unearned premium reserve. Premiums are earned on a pro-rata basis as coverage is provided over the policy period.

Under GAAP, policy acquisition expenses, such as agent commissions, are deferred on a pro-rata basis in line with GAAP’s matching principle. This principle states that in determining income for a given period, expenses must be matched to revenues. As a result, under GAAP (and assuming losses and other expenses are experienced as contemplated in the rate applied to calculate the premium) profit is generated steadily throughout the duration of the contract. In contrast, under SAP, expenses and revenues are deliberately mismatched. Expenses associated with the acquisition of the policy are charged in full as soon as the policy is issued but premiums are earned throughout the policy period. Consequently, the policy is expected to produce a profit that grows throughout the policy period.

SAP mismatches the timing of revenues and acquisition expenses to enhance the likelihood of the insurer’s solvency. By recognizing acquisition expenses before the income generated by them is earned, SAP forces an insurance company to finance those expenses from its policyholders' surplus. This appears to reduce the surplus available to pay unexpected claims. In effect, this accounting treatment requires an insurer to have a larger safety margin to be able to fulfill its obligation to policyholders.

The IASB Proposal for International Insurance Accounting Standards: IASB’s aim in creating new accounting standards for the insurance industry is to facilitate the understanding of insurers’ financial statements. Until recently, insurance contracts had been excluded from the scope of international financial reporting standards, in part because accounting practices for insurance often differ substantially from those in other sectors, both banking and other financial services and nonfinancial businesses, and from country to country.

The IASB plan divided the insurance project into two phases so that some basic improvements in insurance contracts could be implemented quickly. The first phase to enhance transparency and comparability was completed in 2004 with the publication of International Financial Reporting Standards 4, Insurance Contracts. Although these standards were adopted by the European Union in 2005, they have yet to be agreed to by FASB. The second phase is now underway with opportunities for comments as the work progresses.

Insurers’ Concerns: These concerns center on the IASB “exit value” approach to valuing liabilities. IASB defines exit value as “the amount the insurer would expect to pay at the reporting date to transfer its remaining contractual rights and obligations immediately to another entity,” and suggests that insurers measure their current liabilities using three “building blocks,” which together constitute the exit value approach. The three building blocks represent current estimates of liabilities, including loss reserves and unearned premiums reserves; a discount for the time value of money, meaning that the company can earn investment income on assets corresponding to these reserves until they have to be paid out at some time in the future; and a “risk margin,” which takes into account the uncertainty of the future outcome of the business and the possibility that the seller may need to provide assistance to the buyer.

Exit Value Does Not Reflect Reality: The exit value concept is based on the notion that there is a secondary market and a reliable price for insurance policies, as there are for securities of various kinds, and that, therefore, a profit or loss can be calculated immediately after the policy has been issued. However, in reality, such a transfer of liabilities would virtually never occur, particularly in the case of property/casualty insurance contracts.

Without a robust secondary market, the only way to value liabilities is to create a model to represent such a market. This would entail modeling cash flow patterns for all potential scenarios, establishing discount factors to calculate present value and setting risk margins to compensate for the uncertainty of results as envisaged by the IASB model. With inputs and assumptions that are not independently verifiable, the IASB model is likely to produce outcomes that are different from the reality of the insurance transaction.

This is particularly true for insurers that cover rare (low frequency) but potentially devastating (high severity) risks, where the range of potential outcomes is enormous and difficult to predict and where the timing of cash flows depends on many variables including legal proceedings which can be dragged out for years. The subjectivity of the estimates calculated in this manner and the possibility of errors is more likely to impair rather than enhance the understandability and comparability of financial statements. As recent experience with mortgage-backed securities including subprime loans shows, models can be wrong.

The Volatility and Complexity of the Exit Value Approach Could Lessen Investors’ Interest In Some Insurance Companies: Property/casualty insurers’ financial results naturally vary substantially from one year to the next, depending on the number and severity of natural and man-made disasters and the level and outcome of litigation, among other things. Many different factors could add extra volatility, including changes in the interest rates selected for discounting and risk margins. Artificial volatility could also come from all the various assumptions insurers are forced to make about how their business will develop over time. Some insurers will be forced to add voluminous notes to their financial statements to explain their assumptions and inputs to their model, dampening the enthusiasm of some potential investors who will be put off by the difficulty of weighing the import of each note. As a result, some companies fear it will be harder to raise money. If they have to pay more to entice investors, their cost of capital will increase which in turn will lead to higher insurance prices.

The Exit Value Approach and the Need to Satisfy Many Constituencies May Force Companies to Reveal Too Many Details of Their Business: Companies with a complex business model that requires them to reveal and explain proprietary information may find that competitors benefit from this information or that is misunderstood by readers of their financial statements.

”Field Test” Needed: Insurers note that the IASB itself was split in its approval of the exit value concept, voting 7-6 to accept it with one abstention. Some insurers suggest that the approach be given a dry run to test its acceptability before it is formally adopted. A field test, where companies actually filed financial statements using the exit value approach, would determine whether the new approach creates unintended or unrepresentative results, whether they can be reliably audited, whether the approach is expensive or unreasonably difficult to implement and whether there are ambiguities that might produce inconsistent interpretations of desired practices from one company to another.

Solvency II

Solvency II will completely restructure the EU insurance solvency regulation system, bringing all insurers and reinsurers doing business in the EU together under a single set of rules. Work on the project began in 2001. In July 2007, the European Commission, the EU’s executive branch, released the draft Solvency II framework directive, the equivalent of a bill in the U.S. Congress, and sent it to the EU’s two legislative bodies, the Parliament, which consists of 785 elected members, and the Council, a group of ministers representing each of the EU’s 27 member states. The European Parliament approved the directive at the end of April 2009 for an effective date of November 1, 2012. The directive will now be taken up by the EU’s top regulatory authorities, who will help the Commission prepare for implementation. Currently, according to the EU, there is a “patchwork of regulatory systems.” Many member states, dissatisfied with the Solvency I minimum requirements, strengthened solvency regulation with their own reforms.

Like the framework for international banking supervision and the IASB’s proposed insurance accounting system, Solvency II has three pillars which together are expected to strengthen policyholder protection.

Pillar I includes capital requirements based on an evaluation of the company’s entire operation, risks to its assets as well as the risks it has assumed as an insurer. If capital falls below a certain level, as in the United States, regulators can take action. A major difference from current insurance accounting and solvency regulation is that insurance loss reserves are to be valued according to “current exit value,” a key element in the IASB’s proposed international insurance accounting standards, see accounting section above. Most countries now value reserves at the ultimate amount expected to be paid to the claimant at some time in the future. In addition, insurer investments will not be limited by type and amount to reduce investment risk as they are now, see above. Instead, the directive applies a “prudent person” standard to the selection of investments.

Pillar II concerns corporate governance and risk management and how regulators are to supervise insurers under the new system. It is designed to encourage companies to integrate consideration of risk into decision making throughout the entire operation. As part of this process, companies will be required to conduct their Own Risk and Solvency Assessment and give the results to the regulator. This will force insurers “to devote significant resources to the identification, measurement and proactive management of risk” and to think about any future developments that might affect their financial situation. Solvency II also creates a supervisory review process intended to shift regulators’ attention from monitoring compliance with legal requirements to a focus on how the insurer is managing risk, known as a principles-based approach to regulation. This requires a hands-on system of review and an emphasis on outcomes rather than rules, and will likely result in a closer working relationship between insurers and regulators. A similar approach is being considered in the U.S.

Pillar III focuses on expanded public disclosure. The draft Directive is intended to streamline the regulation of insurance groups (holding companies) and allow them to more efficiently manage their capital. Under the plan, a single group regulator will coordinate the regulation of the parent and its subsidiaries, generally the regulator of the member state in which the parent is domiciled. Individual national regulators will oversee individual members of the group in their state.

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