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TMCNet: New Insurance Accounting Methods Are Undergoing a Real Trial by Fire

[March 09, 2009]

New Insurance Accounting Methods Are Undergoing a Real Trial by Fire

(BestWire Services Via Acquire Media NewsEdge) As insurers continue to release 2008 results, the difficulties of pinning down financial performances in volatile markets are becoming more evident.

Several relatively new accounting methods used by insurers in Europe are undergoing real-life stress tests in the current economic downturn, and interestingly, these methods that are designed to bring clarity to financial reporting are coming up with divergent pictures of what is going on in terms of company performance.

The insurance industry in Europe is calling for swift action on adoption of the European Union's Solvency II standard for insurers, but it may be difficult to finalize that system if the underlying accounting cannot be nailed down.

Moving Target A good example of the problem can be seen in Aviva plc's 2008 preliminary results. Aviva, the U.K.-based multiline insurer, reported a 4% rise in operating profit to 2.3 billion pounds (2.6 billion euros) and an after-tax loss of 885 million pounds under the International Financial Reporting Standard.

But using the market consistent embedded value basis, operating profit rose 10% to 3.36 billion pounds and the after-tax loss was 7.7 billion pounds. Aviva had recently switched to MCEV from a predecessor method -- European embedded value -- as a more precise method of accounting for life insurance and pensions sales.

Like EEV, MCEV was developed by the CFO Forum, a group of European life insurance chief financial officers that sets reporting standards for the sector. According to the CFO Forum, MCEV is designed to work with the European Union's proposed Solvency II directive and with IFRS.

But the current volatility in global equity and debt markets, along with interest rates, may be driving a divide between what can be expected from MCEV accounting and IFRS, and perhaps creating a problem for Solvency II.

"The MCEV result will be volatile in difficult investment markets and further work is being done by the CFO Forum on the methodology to ensure it remains robust in such market conditions," said Aviva in its 2008 results statement. "MCEV does not change the economics of our business, just the timing of when we report the profit we earn from our long-term savings business." Efforts to capture the present value of investment instruments on an insurer's balance sheet are producing a wide range of results, depending on the underlying assumptions. Did Aviva post an 885 pound loss in 2008, or a loss of 7.7 billion pounds? No small difference there.

Differences in results can also be affected by the varying natures of regional markets. For Aviva, 2008 life operating results by region were as follows: -- United Kingdom: IFRS operating profit up 4%, MCEV up 7%; -- Europe: IFRS operating profit up 13%, MCEV up 9%; -- United States: IFRS operating profit down 80%, MCEV up 62%; -- Asia/Pacific: IFRS operating profit up 48%, MCEV down 17%.

So the U.K. MCEV gain is greater than IFRS, but in Europe it is less than IFRS. In the United States, IFRS gives us a big drop in results, while MCEV shows a big gain. And reverse that in the Asia/Pacific market. An investor might well ask, what does this all mean? Aviva acknowledged in its results presentation that MCEV principles "were designed during a period of relatively stable market conditions," and that the CFO Forum in December agreed to conduct "a review of the impact of turbulent market conditions on the MCEV principles, the result of which may lead to changes" in those principles. Those areas under review include implied volatilities, cost of non-hedgeable risks, use of swap rates as a proxy for risk-free rates and the effect of liquidity premia.

The good news is that new accounting methods are undergoing real-world tests, and with luck, insurers may come away with a clearer method of accounting for their risks.

(By David Pilla, international editor, BestWeek: David.Pilla@ambest.com) Copyright ? 2009 A.M. Best Company, Inc.

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