Proposal could shrink insurance shelf

Canadian advisors may have fewer insurance options at their disposal in the future, as proposed accounting standards could make long-duration, investment-based contracts less attractive to carriers.

While the International Financial Reporting Standards (IFRS) are set to come into force in January 2011, this set of rules is not the culprit. Yet.

The financial services sector is likely further ahead than other sectors in converting to IFRS, which should come as no surprise, given the concentration of accounting professionals they employ.

The impact of IFRS as it stands will be modest when full implementation comes into force in January 2011. Insurance companies already use fair market valuation for their investment assets and existing actuarial valuations of insurance contracts will remain in place.

But additional changes have recently been proposed by the International Accounting Standards Board (IASB) which could come into effect in 2013. These proposals would govern the valuation of insurance contracts, and could play havoc with the balance sheets of Canadian insurers.

That could, in turn, affect the products they offer.

“Those proposals will have a more significant impact on measuring the liabilities for insurance contracts and, therefore, measuring income from the insurance business,” says Neil Parkinson, partner and national insurance sector leader at KPMG.

“This is fairly controversial for Canadian life insurers.”

The proposed insurance accounting standard would require insurers to use something close to a risk-free discount rate to present-value their policy liabilities.

“Life insurers price products — particularly longer term products that have a savings element in them — based on the fact that they’re going to invest in a portfolio of assets that is suitable to the timing of the cash flow they are going to have to pay out to their policyholders.”

Insurers tend to invest a large portion of their assets in vehicles other than risk-free government bonds. Corporate bonds, equities and rental property — to name just a few options — will experience far more volatility than a risk-free asset.

By using a risk-free rate, the insurers will see their liabilities artificially inflated, as that rate of return is lower than that they expect to earn on their actual assets.

“There is an expectation that there will be higher liabilities and probably some reduction in shareholder equity as a result of the change in valuation.”

“There’s likely to be more volatility going forward in their results. The existing Canadian liability framework ties together the way you value the policy liabilities and the assets you invest in to pay for those liabilities. If an insurer does a really good job of matching their assets to their liabilities, you don’t get nearly as much volatility because the assets and liabilities tend to move together. That connection is not part of the IASB proposal.

Because the fair values of the assets are bound to fluctuate, and the liabilities are based on a risk-free rate, there will likely be wild divergences from the two values over time.

“Life companies don’t like the volatility in income; they think the analyst community will be less comfortable with all that volatility,” Parkinson says.

“It may have an affect on the ability of Canadian insurers to offer those long-duration products. The accounting noise that may come with this may convince them that it’s just not practical to offer certain types of products.”

This migration has already been seen in the U.K. he says, where similar rules affect regulatory capital requirements.

The IASB proposal would affect North American insurers far more than their European counterparts, because long duration products are far more common on the west side of the Atlantic.

Because the U.S. is not as close to conversion to IFRS, there is less attention being paid to the new proposals. The IASB proposal is currently open for comment, until the end of November.

(08/06/10)