Are the accounting practices of insurers sufficiently transparent?

Are the accounting practices of insurers sufficiently transparent?

The European Insurance and Occupational Pensions Authority (EIOPA) warns that insurers' accounting practices are too opaque and fail to highlight the damage caused by low interest rates. Adam Bogdanor of Berwin Leighton Paisner suggests how the risks could be minimised.

Original news

Insurers' accounts hide the dangers of interest rates, LNB News 13/12/2013 1

Financial Times, 13 December 2013: Insurers' accounts are failing to show the effect of persistently low interest rates, a European regulator has warned. The comments were made after a 15 year project to reform the sector was halted by a dispute between the insurance sector and regulators.

What are the regulators' concerns?

In its second half 2013 financial stability report, EIOPA says the main risks facing European insurers are mostly unchanged and their financial position is relatively stable. However, challenges remain. EIOPA describes the 'most prominent risk' as being low interest rates, which is a particular issue for life insurers and occupational pension funds.

What are the main difficulties insurance companies face due to low interest rates?

Low interest rates create a number of issues for insurers, especially life insurers which offer guarantees to policyholders:

  • the lower the interest rates, the higher the premium required to fund the same level of policyholder benefits
  • lower interest rates generally mean lower policy benefits such as annuity rates for the same level of premium, reducing demand for the product
  • the duration of a life insurer's assets are often shorter than its liabilities (a significant issue in Germany) and this duration mismatch means a decline in interest rates increases the value of the insurer's liabilities more than the value of its assets--in particular, the discount rate applied to liabilities will reduce as interest rates fall and the present value of liabilities therefore increases--high guaranteed rates of return brings this challenge into sharp relief
  • low interest rates reduce investment income because insurers tend to hold some of their assets in bonds

The accounting impact may not be so apparent though. The EIOPA report points out that most European countries use historic cost accounting, which means a fall in interest rates does not need to be recorded immediately in the discount rate used to value liabilities in the accounts. EIOPA warns this could build up hidden problems.

This should be distinguished from regulatory solvency standards. Solvency II will require insurers to assess all risks to which they are exposed including interest rate risk ie 'the sensitivity of the values of assets, liabilities and financial instruments to changes in the term structure of interest rates, or in the volatility of interest rates,' Directive 2009/138, art 105(5).

The discount rate used to value long-term liabilities was one of the main reasons that Solvency II was delayed owing, in particular, to concerns from German life insurers. Last month the Trialogue (European Commission, European Parliament and Council of the European Union) finally reached agreement on this issue. The European Parliament stated:

'The biggest hurdle cleared...was the size of the capital buffer that insurance companies would need to hold for investments they declared they would hold on to for a long time (so called "long-term guarantees"). The agreed rules acknowledge that insurers hold on to their investments for comparatively long periods and are therefore less affected than others by sudden and severe market shocks. However, the rules would still require insurance companies to hold more buffer capital than they do now and to take more realistic views of their liabilities.'

How could these risks be minimised? Are transparency rules needed?

Insurers can consider several options to mitigate this risk, many revolving around 'asset-liability management':

  • while perfect duration matching is perhaps a nirvana, it is possible to align the two more closely, as shown by the contrast between the UK and Germany--Solvency II will make closer matching even more attractive
  • another strategy is to invest in assets which generate higher returns but EIOPA notes that the 'search for yield' poses its own issues if insurers fail to take sufficient account of the higher riskiness of these assets
  • interest rate hedging products are available, although long-term hedging can be expensive
  • UK insurers have reduced the extent of the guarantees offered on new products

Insurers will want to ensure product design and pricing balances policyholder flexibility against the insurer's risks, for example, offering guarantees that are conditional on market conditions or that are only due at maturity.

Interviewed by Nicola Laver.

The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.



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