A.M. Best Report: The Impact of International Financial Reporting Standards on European Life Insurers

Business Wire, July 25, 2005

OLDWICK, N.J. -- The compulsory compliance with International Financial Reporting Standards by publicly listed insurers in the markets of European Union member states, effective this year, is a significant first step toward the global standardization of reporting standards, according to a special report released by A.M. Best Co. that focuses on European life insurers.

However, A.M. Best believes Phase I of the IFRS adoption will unnecessarily increase the risk of asset-liability mismatching and earnings volatility when compared with most current Continental accounting standards. Also, companies will incur high implementation costs, while the lack of standardized comparable data among EU member states is unlikely to have disappeared before the full implementation of IFRS. Above all, A.M. Best believes the key issue concerning Phase I is that the critical concept behind the whole project--the fair valuation of insurance liabilities--is unlikely to be clearly defined and implemented before the end of this decade.

One of the main drawbacks of Phase I is that assets will be valued at market value, whereas liabilities will be accounted for at amortized cost. Inevitably, this will generate asset-liability mismatching, which in turn will result in reported volatile earnings and fluctuations in shareholders equity--although the impact on economic capital as measured by A.M. Best is expected to be minimized significantly. Despite the lower equity component in Continental companies' investments compared with their U.K. counterparts and the generalized shift into fixed-income instruments in recent years, the impact on volatility mentioned above will be exacerbated in most Continental accounting regimes. This is due to assets currently being accounted for at book value, and valuation of liabilities following prescribed rules and assumptions that generally are not market related. By contrast, in the United Kingdom and Ireland, assets already have been market valued for several years, and valuation bases for liabilities already reflect the nature of the backing assets.

The volatility of the financial statements could be mitigated by companies applying transitional measures whereby insurance liabilities can be adjusted if policyholder benefits are deemed to be affected by movements in the market value of underlying assets -- the so-called "shadow accounting." This is most likely to be the case for participatory business, for instance, with-profits business in the United Kingdom, which in several cases represents more than half of an established life company's total technical reserves. For nonparticipatory business with mainly fixed benefits, such as term assurance or annuities, most companies will be allowed to use a discount rate that better reflects the characteristics of the underlying assets -- the discount rate "unlocking" option.

Overall, A.M. Best expects U.K. life companies to be more active in updating their liabilities on a valuation basis, removing unnecessary margins and reflecting economic changes with shorter delays.

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A.M. Best Co., established in 1899, is the world's oldest and most authoritative insurance rating and information source. For more information, visit A.M. Best's Web site at http://www.ambest.com.