Fair value accounting – also known as “mark-to-market” – has appeared in the headlines quite frequently, largely because of the ongoing financial catastrophe. Recent statements by the Securities and Exchange Commission (SEC), Financial Accounting Standards Board (FASB), and International Accounting Standards Board (IASB) have fueled the debate, and the U.S. government’s USD700 billion bailout package requires that the SEC perform a study on the impact of fair value accounting on financial institutions … and suspend the practice, if necessary.
In the midst of the public discourse on this accounting method, the convergence of U.S. and international standards is approaching, and changes to the accounting for insurance liabilities (based on Preliminary Views on Insurance Contracts, released by the IASB with the comments period closing in November 2007) are poised to affect the insurance and reinsurance industry further. Among the potential implications is the elimination of U.S. Generally Accepted Accounting Principles (GAAP) for financial reporting, possibly as soon as 2010 for certain companies. In addition to publicly traded carriers, mutual insurers could be impacted as well, since the National Association of Insurance Commissioners (NAIC) reviews each GAAP standard and determines whether to include it in statutory accounting standards.
Application of Fair Value
Under U.S. GAAP, insurance liabilities are generally recorded at an estimate of the undiscounted ultimate cost of unpaid claims. International Accounting Standards reverts to local GAAP (generally undiscounted loss reserves), until the IASB finishes its insurance contracts project. Portfolio securities (i.e., bonds) intended to be held to maturity are generally recorded at amortized cost (unless there is a permanent impairment in value) under GAAP and at fair value for all other classes. Under International Accounting Standards, on the other hand, most portfolio securities are typically recorded at fair value.
U.S. GAAP FASB Statement Number 157, Fair Value Measurements, became effective at the end of 2007 and was written to clarify all previously issued accounting standards requiring fair value. This statement created a single definition of fair value:
“The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”
The use of one definition is intended to increase consistency and comparability among companies. FAS 157 also calls for increased disclosures.
Under FAS 157, “sell an asset” defines fair value as an “exit price.” FAS 157 establishes a three-tiered hierarchy for measuring exit value:
- Level 1: quoted prices in an active or deep market
- Level 2: observable prices for the same or similar securities (e.g., using yield curves for similar assets)
- Level 3: significant unobservable inputs (for use in situations when there is little or no market activity)
A company’s use of Level 2 or Level 3 to determine fair value is sometimes referred to as “mark-to-model.”
During the current financial catastrophe, companies have struggled with how to determine an asset’s fair value if there are no market participants or there is no orderly market. The FASB issued a FASB Staff Position on October 10, 2008, which clarifies that the measurement is based on an orderly transaction that is not a forced liquidation or distressed sale. In a distressed market, it continues, management assumptions are a valid alternative to quoted market prices. Therefore, in the absence of a liquid market, Level 3 information, including internal models and expected future cash flows, may be used to ascertain the fair value of an asset or liability.
SEC to Study Use of Fair Value Accounting
The Emergency Economic Stabilization Act of 2008 requires that the SEC produce a study of mark-to-market accounting, to be completed by January 2, 2009, on the advisability and feasibility of modifications to the current standards. The study will include the effects of FAS 157 on bank failures in 2008.
Public reaction to fair value accounting has been mixed. Some believe that fair value accounting promotes a downward spiral, as write-downs force companies to liquidate assets to meet regulatory capital requirements (called “procyclicality”). Others counter that capital adequacy regulations should not drive the accounting model. Some analysts and accountants believe that fair market value is the only real indicator of an asset’s worth-and that more disclosure is better.
Convergence of International Accounting Standards with U.S. GAAP
The IASB has developed International Financial Reporting Standards (IFRS): the global standards for the preparation of public company financial statements. More than 12,000 companies in almost 100 nations have adopted IFRS, including listed companies in the European Union. Other countries, including Canada and India, are expected to transition to IFRS by 2011. The FASB and the IASB have been working jointly on a number of accounting projects since they agreed to move toward convergence in 2002.
On November 14, 2008, the SEC released the road map that would require U.S. issuers to use IFRS accounting beginning in 2014. In 2011, the SEC will decide whether to proceed if seven milestones are met:
- Improvements in the accounting standards, as both the FASB and IASB work jointly on key issues to produce a set of comprehensive, high-quality standards.
- Accountability and funding of the International Accounting Standards Committee Foundation.
- Improvements in the IFRS reporting, filing, information and disclosure process to make it similar to the current U.S. process in which companies are required to send data to the SEC in a format so that information can be automated and downloaded easily by analysts and investors.
- Education and training in the U.S. relating to IFRS.
- Early adoption of IFRS, beginning in 2010, for companies for which adoption would enhance comparability with large non-U.S. companies in the same industry. Eligibility would be based on both the prevalence of IFRS and the significance of the issuer in a given industry. The SEC estimates that a minimum of 110 companies could be eligible with the cost of the transition to be approximately $3.5 billion for the 110 issuers.
- Anticipated timing of future changes to SEC accounting and regulatory rules to allow full implementation of IFRS accounting.
- Implementation of the mandatory use of IFRS, including staggering the implementation dates over three years (starting in 2014) based on a company’s market capitalization.
There are certain issues that will need to be addressed, such as the cost of the transition and lack of comparable statements during the transition period.
Concerns are still being voiced about the use of the principles-based IFRS, compared to U.S. GAAP, which has become rules-based. Some observers have commented that U.S. GAAP has been tested over many years and should not be replaced. Others note that U.S. GAAP was originally principles-based and that abuses and confusion over the years have led to rules-based accounting. There are also concerns over whether countries that claim to be converging to international standards can actually attain 100 percent compliance or whether they might carve out or modify standards they do not consider to be in their national interests. If this happens, it could lead to incomparability – one of the very issues that IFRS seeks to resolve.
Fair Value Accounting of Insurance Liabilities
The IASB is in Phase II of the Insurance Contracts Project; more than 150 comments letters were received by the IASB for the Phase II Discussion Paper Preliminary Views on Insurance Contracts. With the convergence of accounting standards, changes to this standard may have important implications for U.S. insurers. The FASB announced it will join the IASB’s insurance contracts project beginning in the first quarter of 2009. The IASB expects to publish an Exposure Draft in late 2009, with the final standard issued in 2011.
The Phase II proposal will include:
A Single Accounting Model: The discussion paper proposes the use of the same standards for both life and property and casualty insurance companies; however, it is fairly clear that the discussion paper was written by life insurance accountants, with more emphasis on life examples. The differences in the duration of policies, expense structures and policyholder behavior-among other factors-make the application of a single model difficult.
Current Exit Valuation of Loss Reserves: Similar to the definition of fair value in FAS 157, loss reserves would be valued at “Current Exit Value” for an insurance company’s financial statements. An insurer would calculate the amount it expects to pay to transfer its remaining obligations immediately to another entity-somewhat like a loss portfolio transfer. The U.S. industry has been strongly opposed to this concept, since, without regulatory approval, an insurance company typically does not have the right to transfer insurance liabilities.
Immediate Recognition of Day 1 Gains: The discussion paper divides liabilities into two pieces: pre-claims liabilities (or “unearned premium reserves”) and post-claims liabilities (or “incurred losses”). The concept of unearned premium reserves is not included in the discussion paper, instead pre-claims liabilities are estimates of the cost of the insurer’s obligation to provide coverage and are estimated as the present value of future costs (losses and expenses) plus a risk margin. As such, any anticipated operating profit on an insurance policy or reinsurance contract would be recognized as soon as the premium was booked as written. In the current accounting literature, on the effective date of a contract, an insurance company creates an unearned premium reserve equaling the written premium on the contract, with no accounting gain allowed at inception. The proposals in the discussion paper would allow an accounting gain at inception.
Probability Weighted Cash Flows: The discussion paper calls for the use of probability weighted cash flows rather than management’s best estimate in establishing liabilities. The discussion paper specifies the use of market cash flows rather than the company’s own specific cash flows to value liabilities, though it does not address the sources or appropriateness of market data or define “market cash flows.” The concern is that, if an insurer has better claims handling abilities than other companies, it will be forced to use market data rather than its own data.
Discounting Cash Flows: The loss reserves would be discounted at current market rates to adjust for the time value of money, and then a risk margin, which is an estimate of what market participants require for bearing risk, would be added to the discounted reserve. This amount is intended to represent the Exit Value defined in an earlier bullet point. The International Association of Actuaries and others have worked to develop methodologies for measuring risk margins. To date, these organizations have not been able to provide sufficient guidance to support a robust global accounting standard.
Financial Statement Reporting: There have been concerns that the IASB might eliminate the income statement in exchange for some type of deposit accounting. This approach would change metrics that have been used to measure insurance companies, including loss, expense, and combined ratios.
Own Credit Risk: The discussion paper proposes that liabilities be measured based on the credit quality of the insurer. If an insurance company is downgraded, its liabilities would be decreased, creating the anomaly of generating an accounting profit from the insurer’s falling credit rating. Companies are generally opposed to this proposal.
Unbundling: IFRS proposes unbundling of insurance contracts into financing and insurance elements. As discussed in Guy Carpenter’s 2006 response to the FASB’s Invitation to Comment on Insurance Risk Transfer, Bifurcation of Insurance and Reinsurance Contracts for Financial Reporting, there are many drawbacks to this approach. It is generally opposed in the industry as well.
There are many contentious issues that need to be resolved before IFRS can be adopted.
The Financial and Capital Advisory Group (FCA) will continue to monitor changes to the accounting landscape, the future of convergence and changes to accounting standards. Questions regarding the proposed changes may be directed to the members of the FCA listed below.
- Susan Witcraft, Managing Director, Minneapolis +1 952 832 2143
- Frank Achtert, Managing Director, Munich +49 89 28 66 03 361
- Dave Lightfoot, Managing Director, Seattle +1 206 621 3954
- Scott Lohman, Managing Director, Seattle +1 206 621 2929
- Debbie Griffin, Senior Vice President, New York +1 917 937 3119
- Gina Carlson, Senior Vice President, Minneapolis +1 952 832 2224