Insurance regulators propose prudential filters
Banking regulators remain concerned that what's crucially lacking in the latest attempts to allay their fears about possible abuse of the so-called fair value option in new international accounting rules is a strong reference to risk management.
Further study and discussion of a paper issued in December by international accounting rule-makers confirms initial impressions that the document lacks a context of appropriate risk management within which banks would be allowed to apply the fair value option, regulatory sources say.
However, the sources believe there's a fair chance of reaching a solution to the vexed problem that would satisfy all the many parties involved, including banks and other financial firms and their regulators as well as accountants and non-financial firms.
The fair value option is part of the now notorious IAS 39 accounting rule for valuing financial assets and liabilities that in turn is part of the new International Financial Reporting Standards (IFRS) that came into effect in many countries around the world on January 1.
Regulators fear that weak financial firms could abuse the fair value option to paint a far rosier picture of their finances than is justified by reality. They believe that might have harmful consequences for financial stability.
The International Accounting Standards Board (IASB), the London-based accounting rule-making body that developed IFRS, provided the option to help avoid the accounting anomalies that might arise from the two valuation methods used in IAS 39.
Under IAS 39 items such as derivative contracts and shares and bonds held for trading must be measured in accounts at fair, or current market, value. Items such as loans, amounts receivable and bonds held to maturity, for instance, must be valued at amortised cost, a measure based on the accrual of interest.
But the fair value option allows firms to nominate any item for fair-value measurement to help avoid the accounting distortion that could arise where, say, an asset was measured at fair value while its matching liability was valued at amortised cost.
Regulators, however, are worried that the option would allow firms to put current values on assets and liabilities in situations where, in the absence of a liquid market, it's difficult to estimate fair value.
Rule-based approach
In response to regulator fears, the IASB proposed restricting the use of the option to five permitted categories, essentially those where markets existed to provide a price benchmark. This `rule-based' effort to resolve the problem received support from regulators, but was overwhelmingly rejected by the rest of the IASB's constituency - accountants and accounting bodies and firms both financial and non-financial - who saw little reason for change. Companies outside the financial world, in particular, objected to having their accounting policies restricted by the needs of banking regulators.
Principles-based approach
So IASB staff produced a paper in early December outlining a tentative `principles-based' solution. This aims at getting firms using the option to observe the spirit of its intent - to prevent accounting volatility. Proponents say the principles-based approach is more effective because it is specifically aimed at preventing abuse and in that sense is more restrictive than the rules-based approach. Under a rules-based restriction, a firm intent on misusing the option could have a freer hand, provided it kept to the letter of the rules.
In an initial and informal reaction to the December proposal, Arnold Schilder, who heads the Accounting Task Force of the Basel Committee on Banking Supervision, said one of the conditions for designating fair value - measurement simplification - must take place within the context of sound risk management practices (see GRR, December, 2004). Schilder said that in general the proposal seemed to employ a very wide principles-based approach.
Regulatory sources say that view now seems to have hardened in supervisors' minds.
Broad range of reactions
IASB sources say the December proposal has attracted a broad range of reactions, from rejection to support, from accountants and firms. No formal comments had been received from regulators by early January, but their views would doubtless be made known ahead of the IASB's regular late-January meeting.
The paper is being refined in the light of comments, but the sources declined to give details. The public meeting between all interested parties to thrash out differences is now likely to be held in London as part of the IASB's March meeting, and not in February as previously suggested.
Meanwhile, the Committee of European Banking Supervisors (CEBS), which comprises senior banking supervisors from the European Union's 25-member states, issued in late December its own guidelines to help maintain the quality of banks' regulatory capital in the IFRS context.
The guidelines list the so-called prudential filters that regulators will apply to prevent the IFRS regime leading to unintended increases or decreases in the capital needed by banks to absorb losses from the risks they face.
Among the CEBS guidelines are two filters excluding for the most part the effects on a bank's own equity of cash flow hedges, as well as any changes caused by alterations in a bank's own credit rating. These and other CEBS proposals reflect previous pronouncements by the Basel Committee, the body of senior banking supervisors from North America, Europe and Japan that regulates international banking and has developed the risk-based Basel II rules for improving the safety of the world's banking system.
The Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS), CEBS's counterpart in Europe's insurance industry, has also issued its suggestions for prudential filters (see box).
The role of both CEBS and CEIOPS is to advise the European Commission, the EU's executive arm that's responsible for initiating financial regulation, on drafting the directives that will bring Basel II and the parallel Solvency II insurance regime into law in the EU.
If there's no satisfactory solution to the fair value option problem from the regulators' perspective, they could create more prudential filters to block any undesired effects of the option's use on regulatory requirements. But the Basel Committee's Schilder has previously warned that increasing use of prudential filters could undermine the ultimate goal of creating a single global set of accounting rules acceptable to firms, investors and regulators around the world.
Critics say that purpose has already been undermined by the action of the European Commission in approving a diluted form of IAS 39 for EU countries. The watered-down version was a response to the fears of some banks, particularly in France, that some of the fair value provisions in respect of derivatives could distort their accounts. One aspect of this version of IAS 39 is that firms cannot use the fair value option in respect of their liabilities.
Europe's so-called entity-based insurance accounting approach, rather than the insurance contract definition embodied in new accounting rules, should be retained for regulatory purposes, according to European insurance supervisors.
The recommendation is one of several "prudential filters" proposed by the supervisors to prevent the new accounting regime, which will significantly change the financial statements of European insurers, leading to unintended increases or decreases in the capital assets needed to bolster solvency margins.
The hope is that the need for such filters will prove temporary as it is related to the two-stage introduction of the new rules, known as International Financial Reporting Standards (IFRS), as they apply to insurance firms. The development of the risk-based Solvency II rules (see page 1) for improving the safety of Europe's insurance industry, which are expected to be IFRS-compliant, could make the need for filters unnecessary or very limited. But the plethora of different accounting regimes co-existing in Europe in the meantime creates a need for filters.
Under Phase I of the two-part introduction, IFRS will apply to most of the assets of insurers listed on EU stock markets from January 1, 2005. But the new rules won't apply to liabilities until the accounting rule-makers of the International Accounting Standards Board come up with an agreed way of valuing insurance policies, the financial contracts that form the bulk of any insurers' liabilities.
The prudential filters are proposed in a consultation paper issued by the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) for comment by March 1*. CEIOPS is the body of senior insurance supervisors from the 25 European Union member states that advises the European Commission, the EU's executive arm, on drafting insurance industry regulations.
IFRS now operative
IFRS, which came into force on January 1 for some 7,000 firms listed on EU stock markets, defines insurance risk as a main feature of an insurance contract, whereas current EU directives on insurance accounting don't define an insurance contract. The directives apply accounting rules on an `entity', or category of business, basis - banks, insurers, or corporations, for instance.
Non-life insurance contracts generally fall within the IFRS insurance contract definition. On the life insurance side, pure life products are covered, but pure investment products are clearly not. This means that contracts classified as insurance contracts under pre-IFRS rules, could disappear from the insurance caption in the accounts. Instead they'll be classified as financial instruments under IAS 39, the rule for valuing financial assets and liabilities under IFRS.
The IFRS contract definition applies from January 1 to the consolidated accounts of listed companies. But otherwise for insurance companies, either IFRS or local GAAP (Generally Accepted Accounting Principles) can apply. This means that insurance firm accounts will be prepared on two different bases from 2005, posing comparison problems for supervisors and prompting the need for a prudential filter.
The paper proposes other filters for all EU jurisdictions during Phase I, some of them reflecting those developed by banking supervisors.
*Implications for IAS/IFRS Introduction for the Prudential Supervision of Insurance Undertakings - CEIOPS (www.ceiops.org).
