Academics from the London School of Economics and Political Science (LSE) have published findings from a review of life insurance accounting practice in the UK and continental Europe and of proposals for future development put out by the International Accounting Standards Board (IASB) earlier this year.
'Fair value' is currently the central topic of debate in the development of accounting standards. While it has now been defined to mean an exit price in US GAAP, the IASB is still considering its own definition. In May 2007, the IASB issued a discussion paper on Phase II of its project on insurance contracts, entitled Preliminary Views on Insurance Contracts, examining these issues and proposing as a measurement basis 'current exit value' (CExitV). IASB has not so far been able to identify any significant differences between CExitV and 'fair value' (FV).
An Experiment in Fair Value Accounting? The State of the Art in Research and Thought Leadership on Accounting for Life Assurance in the UK and Continental Europe by Professor Richard Macve and Dr Joanne Horton of LSE's Department of Accounting, and George Serafeim, now a DBA student at Harvard Business School, reviews the IASB's discussion paper as well as other areas of IASB's programme that relate to measurement issues and the potential role of FV more generally in performance measurement and reporting.
The authors conclude that the IASB's 'asset/liability' model leads to questioning, or having to find seemingly forced justifications for, many longstanding life-insurance accounting practices in the UK and Europe. For example the recognition of the value of future premiums; appropriate offsetting of reinsurance; treatment of acquisition costs; recognition of relative policyholder and shareholder interests in 'unallocated divisible surplus' from with-profits business (including any 'estate'); and treatment of 'investment contracts'. Areas of particular concern with IASB's measurement proposals include 'service margins'; cost efficiency estimates; and changes in credit risk.
The review paper concludes that:
Thinking directly about the relevant expected cash flows and their risk seems often to give a clearer answer than the IASB's asset/liability model.
The momentum towards FV in the discussion paper's adoption of CExitV as the proposed measurement basis for insurance contracts has led to ongoing controversy over its relevance and reliability, in particular in the narrow, specialised insurance markets.
One cannot write accounting rules to determine what would enter the valuation processes that 'market participants' use to price insurance contracts. As a result there is controversy over what are appropriate risk (and 'service'?) margins to be built in, and over the validity of alternative resulting profit recognition patterns - including the issues of any 'Day 1' profit; of recognition of changes in own credit risk; and of how results should be analysed and presented in the financial statements.
There is concern that where markets are out of equilibrium, or behaving irrationally, reliance wholly on (often simulated) market prices as the arbiter of achieved performance may provide misleading signals.
Performance measurement needs addressing directly. The insurance project brings out how the 'asset/liability' approach, while providing some useful benchmarking information, appears insufficient to answer the central accounting questions of performance measurement and profitability analysis.
Richard Macve, professor of accounting at LSE, said: 'Future research needs to focus both on further analysis of the conceptual issues relating to fair value and other current value measures (such as 'deprival value/relief value'), drawing from the economic theory of market prices and in particular on how far the IASB's proposed measurement basis (CExitV) now differs from the embedded values (EV), and in particular the 'market consistent embedded values' (MCEV), now increasingly reported as "realistic" performance measures supplementary to the main IFRS accounts - and on which analysts focus.
'What is to be the role of the main International Financial Reporting Standards (IFRS) accounts for life insurance when, as well as supplementary MCEV, there are also already reports based on measures more suitable for the solvency regulation requirements of the FSA, prepared on the traditional 'statutory solvency basis?'
Dr Joanne Horton, senior lecturer in accounting at LSE said: 'This analysis needs to be complemented by further empirical work on the practical experience of companies in Europe and increasingly worldwide, in using and refining EV based methodologies - both internally and for external reporting - and on the consequences of this on stock market valuations and for other institutional and professional structures and practices. Empirical work that both I and George Serafeim (now at Harvard) have done indicates the importance of EV measures as 'value relevant' for insurers' share prices. Of particular importance therefore is the need to understand the apparent current resistance in the US and Japan to 'value based' approaches to life insurance accounting and reporting.
'The outcome of IASB's proposed 'fair value' experiment in insurance accounting is therefore of central importance for the future development of accounting and financial reporting generally.'
An Experiment in Fair Value Accounting? The State of the Art in Research and Thought Leadership on Accounting for Life Assurance in the UK and Continental Europe by Joanne Horton and Richard Macve, of LSE's Department of Accounting, and George Serafeim, Harvard Business School, is published by the The Institute of Chartered Accountants in England and Wales and is available at £20 per copy. To place an order, call the ICAEW's Centre for Business Performance (CBP) on 020 7920 8634, email firstname.lastname@example.org or write to Tracy Kenny, CBP, ICAEW, Chartered Accountants' Hall, PO Box 433, Moorgate Place, London EC2P 2BJ.
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