Challenges ahead for life insurers

Changes planned for IFRS rules could impact capital moves in 2012

One year after the adoption of International Financial Reporting Standards (IFRS), advisors are gradually becoming more familiar with the impact of the new accounting rules. But even the close of 2011 doesn’t mark the end of the story.

A significant IFRS drawback is the market volatility it will continue to create for several years.

Contending with change

First, there was the initial phase-in last year with all the major rule changes. Investors were given just one year of comparable data in most cases, which meant historical financial statement trends were wiped out, creating significant uncertainty and undermining, to a degree, the basis for valuation.

The second issue was with the rules themselves, such as revaluing certain assets on the balance sheet every quarter, often by significant amounts.

Consider RioCan REIT, which records a profit or loss every quarter for the estimated change in value of its real estate portfolio. Such up and downs are not generally received well by the market, and in essence, push investors into relying on adjusted earnings metrics that smooth out the volatility IFRS has injected.

The third area of contention was the extra choice embedded into IFRS, such as whether to approximate fair value or use historical cost on the balance sheet. This incomparability—even among close peers—created volatility in earnings comparisons and valuations.

For instance, RioCan’s close peer H&R REIT does not revalue its real estate portfolio every quarter. Advisors must now keep track of what major accounting assumptions each company is using, and adjust valuation accordingly in order to make reasonable and useful comparisons.

While it might seem better to say some assets are recorded at fair value, the lack of substance in such a claim can be witnessed in the details. For example, knowing whether externally employed valuators were used can shed light on the credibility of the fair market value figures.

RioCan used external appraisals to support just 16% of its valuations as of December 31, 2010, and no external appraisers were used to estimate Q3-2011 valuation changes. Yet these major factors are frequently overlooked.

A fourth level of volatility created by IFRS comes from the changes that will occur in future years as the accounting rules undergo significant updates and revisions.

Teething troubles

IFRS is relatively nascent in the world of accounting rules. By comparison, U.S. rules have been around ten times longer, and have benefited greatly from extensive field testing.

IFRS rules aren’t robust enough. Creators of IFRS are aware of the shortcomings, and are gradually addressing significant gaps.

Another critical area that requires attention under the IFRS regime is accounting for pension plans. The various aspects of volatility wrought by the new rules can be measured through their impact on accounting for corporate-sponsored pension plans.

Those invested in companies such as TELUS, Air Canada and Bombardier may already be familiar with the impact of pension plans on valuation, share price, and even the need to raise capital—as was the case with CP Rail this past November when it dedicated a $125-million debt offering to pay down its large pension deficit.

Change of guard

Under old Canadian accounting rules,many underfunded pension plans were carried off-balance sheet, meaning unless an adjustment was made to long-term debt for valuation purposes, the underlying impact went largely unnoticed by the market.

The arcane rules even meant some companies were able to record net pension assets on their balance sheets, despite having billion-dollar pension deficits. BCE Inc. is perhaps the best example, carrying a net pension asset on its balance sheet of $2.9 billion at the end of 2010, compared to a $1.5-billion funding deficit in its pension plans (a $4.4-billion swing).

BCE’s latest quarterly report under IFRS shows the impact of that $4.4-billion oscillation. It shows up as extra non-current liabilities and a reduction to shareholders’ equity retroactive to the start of 2010. BCE’s shareholders’ equity has decreased to roughly $14.4 billion as of Q3-2011 under IFRS, versus $17.2 billion as of Q4-2010 under the old Canadian accounting rules.

The accompanying impact to changing the balance sheet, and adjusting the equity downward, is that the previous off-balance sheet deficit is no longer being slowly amortized into earnings as part of pension expense every year.

Therefore, many companies are reporting lower pension expenses under IFRS than they did last year under the old accounting rules. This interrupts earnings trend lines and skews valuation to the extent that the market is not recognizing the accounting change.

What’s more, IFRS did not require every company to treat the transition in the same manner. While most companies brought their deficits on balance sheet by retroactively charging accumulated actuarial losses to equity, a large insurer, for instance, did not. The reason likely has to do with the potential impact on the company’s capital adequacy ratios, and has even greater relevance when considered against the accounting changes that are coming next.

There’s more to come

As with many IFRS transition choices, there are actually two steps investors must contend with when it comes to pension accounting adjustments. Under step one, companies had the initial choice of whether to retroactively adjust their balance sheets to eliminate past off-balance actuarial losses.

The second step has to do with future actuarial losses, and how they are recognized moving forward. Under current IFRS rules, companies have the choice of recognizing the full amount of any losses in the current year, or using the old corridor-smoothing method that allows for losses outside the corridor to be deferred and amortized into income.

Those two steps actually create four different options for companies under IFRS. But don’t get too comfortable with the current situation because the rules are about to change again.

Starting in 2013, companies will no longer be able to use the corridor method to smooth the impact on equity. Companies currently using that approach include the major life insurers: Manulife, Sun Life, Industrial Alliance, and Great-West Life. Again, the likely reason is the impact that large actuarial losses would have had on the companies’ minimum capital requirements.

Life insurers will have to go through the change anyway a year from now, as they implement the IFRS updates to pension accounting rules. Advisors are bound to hear about the potential impact even sooner than that, given how these rules will affect adequacy ratios, and possibly capital-raising efforts, in 2012.

Dr. Al Rosen, FCA, FCMA, FCPA, CFE, CIP and Mark Rosen, MBA, CFA, CFE, run Accountability Research Corp., providing independent equity research to investment advisors across Canada.