From the beginning of 2005, all listed insurers in the European Union (EU) will be required to comply with International Financial Reporting Standards (IFRS). The latest Swiss Re sigma study, “The impact of IFRS on the insurance industry”, finds that while the standards will increase transparency, they may also bring higher earnings and capital volatility.
14 Dec 2004 – Currently, insurers operating internationally are confronted with many different national accounting standards, making financial reporting a challenging task. IFRS have been developed in response to this challenge, and together with US GAAP, are forming a viable basis for international alignment. The EU will adopt IFRS on a mandatory basis for all listed companies from 1 January 2005 and other countries, such as Australia, will also make the change. To date, a fully developed accounting standard for insurance contracts does not exist.
Rainer Helfenstein, senior economist at Swiss Re and co-author of the study, comments: “From 2005, most of insurers’ financial assets will be reported at market values instead at amortized costs, while at the same time the treatment of liabilities remains unchanged. In addition, insurers will no longer be allowed to hold equalisation reserves. As a result, earnings and capital of many companies will become more volatile.”
When the standard was being developed, it was split into two phases. Phase 1, which becomes effective from beginning 2005, will have the following strategic consequences for insurers.
The long-term liabilities held by life insurers, which are often focused on savings business, will become more transparent. Companies will have to show, for example, how profitability will develop if interest rates, equity markets or assumptions on insurance risk change. In addition, many life insurance contracts contain long-term options and guarantees and certain of these contracts will have to be reported at market values under IFRS.
In some markets, non-life insurers have built up catastrophe and equalisation reserves, which can be used against exceptional large losses. Under IFRS, these reserves will no longer be allowed. Exceptional large losses will now directly hit equity capital. This may lead to an increase in the volatility of earnings and capital.
Asset-liability management will become even more important. To offset some of the greater volatility, insurers may choose to more closely align the duration of assets with liabilities, or adopt a different investment approach with regards to their asset mix.
Phase 2 of the project, originally scheduled for 2007, is now unlikely to come into effect before 2009. Phase 2 will deal with some highly controversial issues, for example how insurance liabilities should be valued. The challenge will be to find a solution which avoids the asymmetric treatment of assets and liabilities.