Financial Standards - September 13, 2005

Interview with Philippe Foulquier, financial analyst, and associate professor at Edhec Business School

Philippe Foulquier, a top-rated financial analyst specialising in the insurance sector and associate professor at Edhec Business School, talks to us about the likely impact of IFRS and Solvency II on the financial management of insurance companies, and about his current research projects.

Philippe Foulquier

As a specialist of the insurance sector, what influence do you think IFRS and Solvency II will have on the financial management of insurance companies?

Philippe Foulquier: In the past few years, there have been an increasing number of initiatives aimed at adapting accounting and prudential rules to the evolution of risks, which have led to the drawing up of IFRS, Solvency II, Basel II, rules on financial conglomerates and the European Embedded Value (EEV) principles. Even if the ends are sometimes different, the means of implementation all converge towards the same goal: providing a better perception of each company, notably with regard to the risks that the company is running.

The IFRS have thus led to an evolution from a form of accountancy in which guiding the volatility of the profit and loss account was the deciding factor (through capital gains, the capitalisation reserve and all sorts of provisions) towards a form of accountancy in which the balance sheet and the management of balance sheet risk are becoming the governing factors in managing a company. The profit and loss account no longer appears to be a resonating chamber for the variations in the items on the balance sheet.

This profound metamorphosis in accounting philosophy has led to the disappearance of numerous smoothing tools (which no longer have any reason to exist with regard to market value accounting) in favour of improved evaluation of the risks (hidden options, credit risk, correlation of risks, etc.).

Therefore, while phase I of the IFRS has not revealed any genuine information to the financial community, which was already employing market value reasoning on the asset side, we consider that phase II, notably the fair value determination of technical provisions, constitutes the beginning of a revolution in asset management and ALM, which will be confirmed by the implementation of Solvency II.

The new accounting volatility of profits and shareholders’ equity engendered by the IFRS is of a nature that might possibly endanger the margin of solvency and could therefore lead to a bankruptcy, following a crisis of confidence on the part of policyholders, leading to large-scale redemptions of their contracts.

The existence of the IFRS therefore requires immediate rethinking of the systems for managing profits, and adjusting, or defining on the basis of the IFRS classification of assets, new asset allocation and/or revising the hedging policy, rejigging the information systems, mapping the contracts and setting up an inventory of the risks.

Solvency II necessitates a few additional developments related, on the one hand, to a more complete risk analysis than that advocated by the IFRS (type of risks, distribution law, correlation, study of rare events, etc.), and on the other, to a different end which incites the insurance companies not only to measure their risks, but also to manage and control them. The ability to achieve these objectives will lead to a greater or lesser capital requirement. This mobilisation of capital has a cost, which could come to upset one of the challenges of the insurers: the optimisation of capital allocation by activity, with regard to their profitability, their volatility and, therefore, their cost.

In other words, an adaptation or a recasting of the internal asset allocation and ALM models is necessary in order to integrate the new definition of risks and the consequences for the volatility/return combination of their assets, the economic capital cost and needs.

Do you think that Solvency II will have a significant impact on insurance companies' risk management?

Philippe Foulquier: With Solvency II, the European Union wishes to establish solvency requirements that are more appropriate for the risks that are actually taken on by the insurance companies and encourage them to evaluate and control their risks better through their own internal models.

Compared to the IFRS, Solvency II leads to an additional constraint on the AM and ALM policy, by enlarging the scope of the risks (financial market, underwriting, credit and operational), and the analysis and management of their volatility and extreme risks. More specifically, Solvency I is today based on backward-looking accounting statements, which leads to a decorrelation between the margin of solvency and future cash flows. This leads to numerous paradoxes: the fewer technical provisions a company has, the less share capital it needs; the asymmetric treatment of fixed income capital gains and losses; and integrating fixed-income capital gains without simultaneously restating the liabilities (artificial wealth).

The consequences of extending the scope of the risk, integrating future cash flows, the correlation and/or dispersion of the risks and their modelling (distribution of the risks, from the best estimate to the VaR), of the hedging policy (structured products, reinsurance, securitisation) will naturally be substantial on risk management in particular and more generally on asset allocation and ALM.

There has been a lot of criticism of the way in which the IFRS standards have been applied in the insurance sector. What is your opinion on the subject?

Philippe Foulquier: While the insurance sector wasn’t initially opposed to the implementation of international accounting standards, it became hostile when it realised that the specific characteristics of insurance (notably the asset liability adequacy and the duration of the commitments with regard to the policyholders) could not be integrated in 2005 (a timescale that was too short for the IASB). The insurance companies therefore proposed a temporary exemption during phase I where the majority of the pre-existing local standards would have been maintained, with, nonetheless, a few arrangements from time to time so as not to go against the philosophy of the IFRS (for example, the removal of the equalisation reserve), an excessively detailed appendix (presenting notably the assets at market value) and the adoption of a standard for determining the embedded value (produced in the end by the CFO Forum and in force from 2005). Another solution explored was that of creating a class of specific admitted assets, to represent the insurance company’s commitments.

It is difficult not to share the insurance companies’ bitterness when we observe the choices made for the transitional phase, where the principle of goodness of fit between the assets and liabilities, which is at the very heart of the insurance profession, is not respected:

  • The goal of comparability between accounts runs the risk of ending up as a complete failure during this phase. Since it was impossible to produce a definitive standard for insurance operations in time, the simultaneous application of asset accounting at market value and liability accounting at depreciated cost has led to a certain number of totally open options being adopted (shadow accounting, adjustment of the discount rate). It is very likely that these choices of options, which were carried out individually by the insurance companies without prior justification, will lead to more significant biases in the comparison between companies than in the previous system, where the accounts were homogenous in each State and the considerable disparities between States were well known and restated by the financial community.

  • The goal of better reflecting the financial situation of companies, notably their exposure to risks, is also called into question in phase I. The mismatch engendered by this two-speed system of accounting for assets and liabilities should, in spite of the abovementioned options, lead to a totally artificial volatility in profits and balance sheets.
In spite of all that, I remain optimistic on the outcome to these problems. The IASB and the insurance companies have a few years to analyse the failings of phase I and arrive at a more rational solution with the adoption of definitive standards. Phase II now appears to be planned for 2008-2009 instead. In addition, the disappointment in the content of phase I should not take anything away from the merit of the goals of the IFRS, and should lead in the end to better management of insurance companies, thanks to an improvement in the perception of their risks and the control of those risks.

As a top-rated financial analyst, what were the reasons that led you to join EDHEC as an associate professor?

Philippe Foulquier: I have been working in the insurance and financial sector for more than fifteen years (PhD, 6 years in an insurance company and 10 years in brokerage firms as a sell-side financial analyst in charge of the insurance sector) and I also teach a number of classes every year in major engineering and business schools (including EDHEC for the last five years). In view of recent developments in the financial analyst’s profession, where the sales dimension of the job has considerably reduced the time given over to analysis, I was looking for an environment which would allow me to pursue analysis and research work in the European insurance area, while continuing to work closely with practitioners.

EDHEC is to my knowledge the only platform where international academic researchers and practitioners work alongside each other via numerous partnerships with businesses (the Edhec Risk and Asset Management Research Centre is the largest financial research team in France). What I find attractive with EDHEC is their original approach: producing high-level fundamental research work, while at the same time being able to introduce the fruit of that research into businesses, notably through its two consultancy firms. As an illustration, EDHEC’s research work has led to the launch of two very innovative alternative investment funds with Société Générale and a new method for rating European fund managers with EuroPerformance. That is far removed from the classic scenario which involves producing research work in an ivory tower without any real immediate application for the industry. Other applications in the areas of asset management and ALM are currently being developed.

I’m totally in step with this approach and wish to develop my expertise in finance and insurance in cooperation with the EDHEC researchers, in order to implement asset allocation and ALM solutions in the new environment that is being shaped by IFRS and Solvency II. As I mentioned previously, taking risks into account in this new referential context will constitute a genuine revolution in the management of insurance companies, which is particularly stimulating.

Moreover, as an associate professor, I will enjoy devoting more time to lecturing. For me, teaching represents an eternal source of inspiration that allows me to explore concepts more thoroughly and formalise the pedagogical side. On the basis of my experience in finance, I will also be trying to respond to the students’ growing demand for building bridges between the classes taught and the professional world.

What are your research projects for the coming months?

Philippe Foulquier: For the next few months, two research projects have been defined:

  • IFRS – Solvency II: What Consequences for the Financial Management of Insurance Companies?

  • Accounting Uncertainty and Stock Picking: IFRS Challenges and Opportunities
With regard to the first research project, the new referential context defined by IFRS and Solvency II should accelerate the movement of “financialisation” of ALM that we have been observing for the past few years in Europe. The removal of certain accounting tools for smoothing the volatility of results engendered by the IFRS will notably force insurers to better evaluate the financial risks of their assets and liabilities.

Simultaneously, Solvency II enlarges the notion of risk, by requiring the development of models (the internal company approach is favoured) which integrate a forward-looking approach (future cash flows), the correlation and/or dispersion of the risks and their modelling (distribution of the risks: from the best estimate to the VaR) and hedging (structured products, reinsurance, securitisation). The challenge is considerable because the capacity to control these risks will result in capital requirements that will be of greater or lesser significance.

The goal of this first research project is therefore to evaluate the consequences of this new IFRS-Solvency II referential context, both for ALM and for asset management.

The goal of the second project is to answer the following questions: Which standards have the most impact on financial returns in Europe? In which sectors? In which countries? What are the disagreements on investment strategy linked to the IFRS? Do IFRS play a central role in return variability?

We propose to integrate the “accounting uncertainty” dimension in the financial analysis, which could lead to new approaches and forms of stock picking, and notably in the hedge fund universe, techniques for “shorting” the volatility of the results published by companies.

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