Contradictions at heart of IFRS
The profound changes in the risk management of insurance companies, brought about by the increasing complexity and variety of risks over the last two decades, have made it necessary to revise prudential regulations (Solvency II) and to adapt the international accounting standards (IFRS).
The objective of the new accounting standards is to offer a better view of all companies, particularly with regard to the risks they run. However, our study shows that the definition of these regulations and their application to insurance companies are often at odds with their initial objectives: those who adopt traditional or more sophisticated asset management or asset-liability management (ALM) techniques in order to reduce their exposure to risk are often heavily penalised. These standards result in additional volatility in pure accounting terms, the extent of which does not correspond to economic reality.
In an effort to demonstrate the inadequacy, and even contradictions, which one may find between certain IFRS definitions and Solvency II proposals on the one hand, and the aim to make insurance companies accountable for their risk management approaches on the other, EDHEC has published a major report on the matter.1
The IFRS bring about an additional volatility constraint both with regard to hedging solutions for liability risk…
The hedging of liability risks can generally be done using three strategies: by constituting a bond portfolio, by using derivatives or by a combination of these two approaches.
The use of a bond portfolio to hedge liability risks immediately involves several challenges in purely financial terms: one must find bonds with appropriate maturity in relation to that of the liabilities, manage the hidden options in the insurance liabilities (which is almost impossible with bonds) and endure insufficient financial profitability. From now on, the accounting treatment of bonds and insurance contract liabilities where the risk is placed on the insurance company will generate increased volatility in the income statement (particularly with regard to immunisation techniques that require dynamic management of the bond portfolio) or in shareholders' equity (and therefore in the solvency margin).
While much of the bond portfolio is acquired with a view to securing returns paid to policyholders, as well as insurance liabilities, and as a result is generally held until maturity, the IFRS demand that the variations in quarterly or half-yearly unrealised bond profits (classified as available for sale (AFS)) be included in shareholders' equity, while the corresponding entry in liabilities remains part of historical costs. This volatility is completely artificial and in no way reflects either the value of an insurance company (dissymmetry in the treatment of the impact of an interest rate variation on assets and on liabilities) or the actual risk being run by an insurance company. The IFRS thereby reduce the financial management of liability risk hedging over several years, or even decades, to a scenario whereby assets are immediately liquidated (with no adjustment of liabilities).
Mindful of the excessive nature of this approach, the IASB suggested the implementation of a new asset category during the transition phase - HTM (held-to-maturity) - so as to correct this accounting mismatch (assets being valued at historical cost as with insurance liabilities). The accounting consequences for a HTM bond that is sold are so harsh as to have effectively dissuaded most insurance companies from using this asset category2 (in fact, some have no asset classified as HTM).
The second solution for hedging liabilities, involving the use of derivative instruments (swaps, swaptions, etc) should allow the establishment of improved financial management solutions by allowing customisation through, on the one hand, the implementation of better cash flow matching and, on the other, the management of non-linear risks that are included in the liabilities' hidden options. However, the appropriate treatment of derivatives requires either an overhaul of the IFRS or profound changes in the culture of financial markets. Today, the variation in value of the hedge performed using derivatives is fully included in the income statement, while, as we have seen, its contra-entry, which is constituted by the change in value of the liabilities, has no accounting status.
This mismatch can result in such volatility in the income statement that the IASB established exceedingly cumbersome procedures referred to as ‘hedge accounting', ‘shadow accounting' and the ‘fair value option'. Again, however, the conditions required under hedge accounting are so demanding (in particular proof of the effectiveness of the hedge) that insurance companies have made little use of it. The second problem for which, unlike in the banking world, there is no favourable and simple solution3 is that of macro hedging. In practice, the last half-yearly publications of 2006 have shown that these two issues alone are sufficient to bring about very high volatility in the income statement, which is then penalised by the financial markets.
The third solution for hedging liabilities is the creation of a bond portfolio that is complemented by derivative instruments (fixed-to-floated swaps, forward-start swaps) which, depending on the strategy used, make it possible to shorten or extend the duration of the bond portfolio. From an accounting point of view, this solution naturally combines the two mismatches mentioned for each of the last two strategies.
In practice, insurance companies maintain their mixed (bond-derivative) strategy at the cost of major efforts in communication (not without certain incidents, as seen with the last half-yearly publications): the financial community is not always inclined to delve into the depths of derivatives accounting and prefers to penalise those companies whose high volatility is accompanied by an explanation that is too complex or too opaque.
… and effective performance management
The second component of good financial management practices in an insurance company, based on the separation theorem, is the search for high-quality performance from the asset portfolio. EDHEC suggests the use of the core-satellite approach to performance management. The issue of optimising the management of and defining the asset risks is tackled in the core portfolio.
A company can go about this in two ways: by employing risk diversification techniques to determine the optimal asset allocation decisions, on the one hand, and, on the other, by employing portfolio insurance techniques whereby risk hedging is performed using derivative instruments or, equally, dynamic asset allocation strategies, generating non-linear returns (convex payoffs) that will ensure tight control of the risk of losses or underperformance.
The first strategy, consisting of risk management on the basis of an optimal asset allocation decision (for example, where a certain percentage of stocks and bonds is defined as the optimal reference), requires frequent transactions as prices fluctuate to ensure that the asset portfolio is constantly adjusted so as to match the reference percentages at least.4 Using simulations, we demonstrate the superiority of this strategy when compared to a buy-and-hold strategy, in terms of its capacity to reduce the volatility and/or the (C)VaR (extreme risks) of the portfolio performance. Generally, this strategy used to be implemented by mutual funds, which had the advantage of not being consolidated, meaning they caused no volatility in the income statement. Now, with the IFRS, major mutual fund shareholdings are usually consolidated. Furthermore, variations in minority mutual fund holdings are considered to be variations in liabilities and are recognised in the income statement.
The second risk management strategy is to consider optimal hedging with a view to generating non-linear returns as a protection against the risk of losses or underperformance. This strategy can be put in place using derivative instruments (an out-of-the-money put option, for example), structured products or even a dynamic asset allocation strategy (for which we have already mentioned the associated accounting problems). From an IFRS standpoint, the harsh constraint in derivatives handling of having to demonstrate and document the effectiveness of the hedge means that insurance companies must endure high volatility in the income statement, linked to the variation in the derivatives position with no corresponding variation in the underlyings. With regard to the treatment of structured products, the IFRS consider them as hybrid instruments made up of a host contract (the underlying) and one or more derivatives. Generally, the accounting treatment of these two components is done separately, which brings us back to the volatility and mismatch problems that are specific to derivatives.
Various numeric simulations were performed throughout this study to support our findings. One of the simplest, although not any less informative, is a comparison between the accounting results of a buy-and-hold strategy, which consists of a direct investment in the global DJ Euro Stoxx index where the position then remains unchanged, and those of a strategy designed to determine the optimal allocation of the different sector indices that make up the DJ Euro Stoxx (with dynamic readjustments making it possible to return at regular intervals to the defined optimal allocation level) so as to minimise the portfolio's extreme risk (CVaR) with no expected constraint on profitability. This simulation was performed for a period of 13 years (January 1993 to December 2005).
As shown in the table, dynamic management (PF Min CVaR) makes it possible to considerably reduce volatility and extreme risks in relation to the buy-and-hold strategy, ie, where one invests in the DJ Euro Stoxx and waits 13 years without making a single transaction.
However, the accounting treatment under the IFRS favours the buy-and-hold strategy, because it is possible to classify stock portfolios as AFS. Quarterly or half-yearly variation in the market value5 of the DJ Euro Stoxx index will have no impact on the income statement but will only affect shareholders' equity.
Finally, it is worth mentioning that this impact on the income statement is in no way a reflection of shareholders' equity (after integrating the results), as this equity varies as shown in the above table, with greater volatility, maximum drawdown, VaR and CVaR under the buy-and-hold strategy.
n conclusion, the IFRS represent a harsh restriction on financial management practices in European insurance companies
With regard to the application of the IFRS to insurance companies, EDHEC believes that neither the method chosen (two-phase approach) nor the adaptational decisions made are satisfactory; above all, they are at odds with the intentions of the body for international accounting standards and the European regulators:
o While the concept of fair value is at the heart of the IFRS structure, and in view of the importance of defining a consistent representation of a company's financial situation, the exclusion, on the one hand, of an insurance company's liabilities on the pretext that they are too difficult to evaluate because they are not traded on the market, is not consistent with the decision, on the other, to treat derivatives and structured products at fair value, even though they may be just as untradable and difficult to value. This inconsistency is one of the principal sources of volatility in the income statements of insurance companies. At a time when prudential regulators - mainly through Solvency II - and the body for international accounting standards (via the -liability adequacy test (LAT)) are promoting internal models for the evaluation of asset-liability adequacy, the idea of excluding the majority of an insurance company's liabilities from an actuarial analysis appears to be contradictory.
o We feel that the implementation of the IFRS undermines the very notion that financial accounts are a reflection of the value and risks of an insurance company. They impose constraints in terms of the volatility of the income statement and shareholders' equity that appear to be completely at odds with the objective of the IFRS to make insurance companies accountable for the management of their risks. While Solvency II encourages insurance companies to improve the measurement of the extreme risks of their assets and liabilities so as to better manage them, the accounting result of good practice in the management of extreme risks is most often a financial situation that appears to be more risky than if the insurance company had done nothing at all.
o Finally, a more conceptual and fundamental contradiction comes of this analysis. While insurance companies strive to improve the management of their long-term risks (liabilities often have a lifetime of several decades), this management approach is handled in accounting terms by an analysis of the quarterly or half-yearly variation in the market value (which generally reflects short-term risk premia) of assets, liabilities and their associated hedges. Such an approach leads to insurance companies being considered as liquidating their assets and liabilities on an ongoing basis, whereas, in fact, they employ long-term management techniques to protect their liabilities, an approach which justifies a policy of allocating to risky assets that are partly non-liquid. The IFRS do not allow the particular nature of insurance companies (long-term investors providing liquidity to the overall economy) to be taken into account.
It is likely that the failure to sufficiently distinguish between the role of accounting and that of financial analysis, a phenomenon that has been heightened in recent years by the prominence in accounting of the true and fair view principle, has led to the inconsistencies highlighted in this study.
Instead of simply recording a company's operations and possibly providing a discounted value of its worth, the IFRS, by also claiming to provide a consistent and universal framework for the analysis of a company's value and its risks, reveal an ambition that is in our opinion disproportionate and dangerous.
1 Assessing the Impacts of IFRS and Solvency II Rules on the Financial Management of European Insurance Companies, Noël Amenc, Philippe Foulquier, Lionel Martellini and Samuel Sender, EDHEC publications, November, 2006. This study, which is sponsored by AXA IM, will be presented at the EDHEC Institutional Days, to be held in Paris on the 21 and 22 November. This article presents a brief synopsis of the study.
2 More generally, the HTM category makes both dynamic management of interest rate risk and active management of credit risk impossible, which in turn means that the bond portfolio cannot be well managed in financial terms.More generally, the HTM category makes both dynamic management of interest rate risk and active management of credit risk impossible, which in turn means that the bond portfolio cannot be well managed in financial terms.
3 The report provides an analysis of the limits and inadequacy of the shadow accounting solution proposed in phase I of the implementation of the IFRS.The report provides an analysis of the limits and inadequacy of the shadow accounting solution proposed in phase I of the implementation of the IFRS.
4 Fixed mix strategy. One can also adjust in line with variations in the risk parameters, leading to rebalancing in order to preserve optimal allocation with respect to the new estimated values of these parameters.Fixed mix strategy. One can also adjust in line with variations in the risk parameters, leading to rebalancing in order to preserve optimal allocation with respect to the new estimated values of these parameters.
5 Opus cit. 1Opus cit. 1
6 According to the company's chosen frequency for publishing accounting results.According to the company's chosen frequency for publishing accounting results. Assessing the Impacts of IFRS and Solvency II Rules on the Financial Management of European Insurance Companies, Noël Amenc, Philippe Foulquier, Lionel Martellini and Samuel Sender, EDHEC publications, November, 2006. This study, which is sponsored by AXA IM, will be presented at the EDHEC Institutional Days, to be held in Paris on the 21 and 22 November. This article presents a brief synopsis of the study. More generally, the HTM category makes both dynamic management of interest rate risk and active management of credit risk impossible, which in turn means that the bond portfolio cannot be well managed in financial terms. The report provides an analysis of the limits and inadequacy of the shadow accounting solution proposed in phase I of the implementation of the IFRS.Fixed mix strategy. One can also adjust in line with variations in the risk parameters, leading to rebalancing in order to preserve optimal allocation with respect to the new estimated values of these parameters. Opus cit. 1 According to the company's chosen frequency for publishing accounting results.
Philippe Foulquier is a professor at EDHEC Business School in France