Institutional Investment - December 11, 2006

The Impact of IFRS and Solvency II on Asset-Liability Management and Asset Management in Insurance Companies

A new study jointly produced by the EDHEC Risk and Asset Management Research Centre and the EDHEC Financial Analysis and Accounting Research Centre entitled ‘The Impact of IFRS and Solvency II on Asset-Liability Management and Asset Management in Insurance Companies’ reveals the contradictions inherent in the current Solvency II and IFRS provisions for insurance companies.

The report shows notably that the numerous provisions proposed by the IFRS are at odds with the good risk management practices put forward by Solvency II.

While IFRS and Solvency II should lead to a genuine evolution in the management of insurance companies, by empowering them with respect to their risks (identification, measurement and management), one is forced to observe today that the standards implemented often oppose their initial objectives: the adoption of modern asset management and ALM techniques with a view to reducing the exposure to risks is considerably penalised by the IFRS treatment by leading to additional purely accounting volatility, without any connection to the economic reality.

More globally, while nobody would dispute the value of having a real view of the impact of the primary financial and actuarial risk factors on an insurance company’s accounts, the authors of the study feel it is regrettable not only for the insurance sector but for the economy as a whole that the fair value of assets and liabilities be a basis for analysing the financial soundness and solvency of insurance companies.

For most of their activities, insurance companies have long-term or even very long-term liabilities that in turn justify long-term allocation. Measuring their solvency on the basis of short-term values is not only incompatible with the need for investment in assets that, while risky, yield very positive average long-term returns, but also means that any genuine asset-liability management is an illusion, even though the regulators actually hope to promote ALM. Similarly, EDHEC feels it is contradictory to favour the implementation of internal risk analysis models within the scope of the new prudential provisions (Solvency II), while at the same time basing the ultimate assessment of a company’s solvency on ratios taken from accounting values.

EDHEC believes that the only basis for analysts and regulatory authorities to assess the financial soundness and durability of an insurance company should be an analysis of the consistency between the liability risks and asset risks and an evaluation of the consistency and robustness of the asset-liability management models used. This ALM-based approach to financial analysis presupposes that there is precise documentation of the company’s ALM allocation policy and the robustness tests that have been performed. This information should serve to support the LAT tests, which are planned for the transitory phase of the application of the IFRS to the insurance sector.

EDHEC believes that neither the solutions put forward by the IASB to circumvent or diminish the short-term nature of the IFRS nor the transitory provisions are satisfactory. They ultimately render accounts more complex, arbitrary and unclear, and they increase accounting risk without offering any real solutions to facilitate good financial ALM management practices in insurance companies. On the contrary, the study shows that good ALM, risk and asset management practices remain heavily penalised by the accounting provisions.

EDHEC hopes that European regulators and financial analysts will take full stock of the consequences of the new ‘financial’ approach to prudential regulation, Solvency II. This means abandoning all references to external and accounting approaches to solvency evaluation in favour of an evaluation of risk measurement and risk management procedures, internal models and the choice of risk parameters that underpin asset allocation and liability management decisions.

EDHEC feels that the particular nature of long-term investors’ liabilities, be they insurance companies or pension funds, is such that both regulators and financial analysts need to attach greater importance to the ongoing concern principle (which is an accounting principle), rather than suppose that the notion of fair value will transcend the whole of the accounting doctrine.

It is only by finding this necessary balance that the invaluable contribution of the IFRS to the transparency of risk, particularly market risk, will not be undermined by the legitimate aim of allowing institutional investors, and insurance companies in particular, to continue to operate as long-term investors and perform their invaluable role of constant liquidity providers for the market and the economy at large.

This report was sponsored by AXA Investment Managers.

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