The Insurance Industry, Fair Value Accounting and Systemic Financial Stability

IMF News, June 13, 2003

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Published: June 13, 2003

Overview and key points

Author: Gerd Häusler, Counsellor and Director, International Capital Markets Department, International Monetary Fund.
Event: Given at the 30th General Assembly of the Geneva Association, London.
Date: June 13, 2003.
The speech addresses three subjects:
- The increasing importance of the insurance industry for systemic financial stability and the need for stronger supervisory focus on financial risks and greater disclosure.
- How fair value accounting, if properly implemented, will likely make explicit the redistribution of risks over time performed by insurers and could improve pricing of those risks.
- Possibilities for a middle ground in fair value accounting approaches to retain benefits (transparency, consistency) while addressing practical problems.

The views expressed are those of the author, and do not necessarily reflect the views of the IMF.

I. Systemic Financial Stability — findings and implications

Findings on changing role of insurers:

Traditional view: systemic risk associated primarily with banks because of maturity transformation and central role in the payment system; insurers seen as unlikely to be systemic due to "slow-moving" liquidity shocks from long-term liabilities.
Changing dynamics increasing systemic relevance of insurers:
- Blurring of boundaries between banks and insurers, particularly in OTC derivatives markets.
- Intensified financial market activities by insurers and considerable counterparty relationships with banks.
Three perspectives to assess insurers from a financial stability standpoint:
- The insurance industry as a major source of long-term capital.
- Consolidation between banking and insurance (bancassurance).
- The insurance industry as an intermediary of credit and market risk.

Detailed observations:

Life insurers historically funded long-term liabilities with long-term investments (mostly bonds and loans) and relatively little equity; but during the 1990s equity investments by life and non-life insurers rose considerably.
- Example effect: life insurers may be prompted—partly by regulatory rules such as "Regulatory Minimum Margin" in the U.K.—to sell equities into declining markets, potentially amplifying equity price declines.
Bancassurance and consolidation:
- Closer integration may facilitate transmission of insurance problems to affiliated institutions within large complex financial groups.
- Perception of links can cause "contagion" between banking and insurance in times of market stress.
Insurance as intermediary of financial risks:
- Increasing insurer activity in OTC derivatives and complex financial products creates counterparty exposures vis-à-vis banks.
- Some credit risk transfers are partly driven by "regulatory arbitrage" due to different regimes for banks and insurers (specifically capital adequacy rules).
- Insurers are major intermediaries of retail savings and large holders of financial instruments; major purchases or sales by them could create market volatility.
- Migration of risk between insurers and banks complicates tracking risk distribution and may concentrate risks (e.g., reinsurance concentration).

Questions raised:

Are risks more efficiently distributed to those willing and better able to bear them?
- Assumption of credit risk by insurers may provide diversification within insurance and for markets, but consolidation may concentrate risk in a few large reinsurers.
Are insurers equipped to manage new financial risks?
- Limited public information on insurers' internal risk management and control systems for asset market activities and credit risk.
- Concern that risk management may not have kept pace with expanding financial market involvement and off-balance-sheet activities.
- Many credit risk transfer activities straddle "underwriting" and "investment," requiring integrated risk management.

Implications for regulation and disclosure:

Insurance regulation and supervision need to shift focus toward assessing financial risks as these gain importance.
- Capital/solvency requirements in many jurisdictions largely reflect insurance risks (liability side) rather than investment risks.
- Official oversight is generally less focused on financial market risks than that of commercial banks.
- The author welcomes revisions to the Insurance Supervisory Principles (to be completed in October) that explicitly emphasize financial risk management by insurers and market analysis by supervisors.
Disclosure and transparency must increase:
- Information on investment risks and off-balance-sheet exposures is relatively limited.
- Complex actuarial assumptions underlying valuations can complicate oversight by outside investors.
- Supervisors and market participants need more information on insurers' internal risk control systems for financial market activities.
- The Financial Stability Forum is taking stock of improving public disclosure and aggregate data on credit risk transfer activity.
- Steps are underway to enhance transparency in the reinsurance sector, including development of global reinsurance market statistics and analysis for public use.

II. Fair Value Accounting and the Sharing of Risk over Time — analysis

Core observation:

Fair value accounting will make more explicit insurers' intertemporal risk sharing (smoothing returns to policyholders over time) distinct from cross-sectional risk pooling.
Intertemporal risk sharing arises from asset–liability mismatches; fair value accounting will reveal associated earnings volatility that reflects real risk rather than merely accounting noise.

Implications:

Making intertemporal risk sharing explicit will:
- Reveal costs of smoothing returns more clearly.
- Likely lead to more appropriate market pricing of these costs.
- Overall, potentially enhance financial efficiency by improving transparency of asset/liability mismatches.

III. Fair Value Accounting — scope for a middle ground and policy options

Practical concerns:

Market values at a point in time may not indicate long-term firm health when they reflect transitory volatility or distorted market prices—this is especially relevant for long-term assets whose prices may be volatile.
Snapshot fair values could mislead observers and, if markets overreact, add to financial stability risks.
Concern that fair value calculations could cause insurers to breach regulatory limits too easily and trigger forced asset sales into falling markets.

Proposed middle-ground approaches and measures:

Supplemental accounting information to:
- Preserve transparency while softening apparent volatility of results.
- Prevent misleading accounting from causing unwarranted market reactions.
- Avoid premature supervisory requirements to sell assets that could worsen insurers' long-term condition and broader market conditions.

Asset-side measures:
- Valuing traded financial assets (e.g., equities) based on averages of market prices over time.
- Averaging over relatively short periods: "from 1 week to 3 months" to reduce day-to-day noise.
- Averaging over longer-term periods: "up to one year" to smooth effects of the financial cycle—though under normal circumstances ignoring up-to-date market price signals for extended periods may be hard to justify.
- Averages could be provided as supplemental, more stable results or used in main earnings calculations.
- Grouping assets into "books" (e.g., trading book vs. long-term investment book):
- Trading book: marked to market.
- Long-term investment book: valued on an amortized cost basis (not limited to held-to-maturity assets but for assets used for specified long-horizon investment needs).

Liability-side and model disclosure:
- Use supplemental explanations describing sensitivity of liability values to changes in pricing-model parameters to indicate uncertainty behind earnings.
- Disclose sensitivities of key asset and liability values to underlying factors (e.g., interest rates) to help investor interpretation.

Reporting and transition considerations:
- Financial reporting based on alternative assumptions should be presented as part of insurers' explanations of earnings.
- Dual reporting would be particularly important during the transition phase "between 2005 and 2007" if fair value accounting applied to assets but not yet liabilities, which could cause particular earnings volatility.

Safeguards for regulatory limits:
- Use more stable valuation methods for regulatory-limit purposes than for published accounts.
- Allow appropriately long periods for companies to adjust holdings, potentially after case-by-case consultation with supervisors.

Conclusion on policy stance:

There is possible scope for middle-ground solutions that supplement fair value reporting with information enabling investors to take a longer-term view of insurers' financial health while retaining transparency and consistency benefits.