Scand. Actuarial J. 2004; 5: 372 /394
INVITED ARTICLE
!
On Accounting Standards and Fair Valuation of Life
Insurance and Pension Liabilities*
PETER LØCHTE JØRGENSEN
Julietta, the Accountant: ‘‘Would you like to check my figures? ’’
James Bond: ‘‘Oh, I’m sure they are perfectly rounded! ’’
/
James Bond: The World is Not Enough , MGM/United Artists (1999).
Jørgensen PL. On accounting standards and fair valuation of life insurance
and pension liabilities. Scand. Actuarial J. 2004; 5: 372 /394.
The actuarial profession is increasingly teaming up with financial
economists for a fruitful cooperation on the proper valuation of life
insurance and pension (L&P) liabilities. This has been a natural consequence of a recent sharply increased focus on market values in financial reports of L&P companies from regulators, standard setters, the
financial press, stakeholders, and others with an interest in the L&P
business.
This article provides a financial economist’s point of view on recent
developments in relation to the fair valuation of L&P liabilities. The role of
accounting standards and the background for the international harmonization in this field are first discussed. We then review and explain the
concept of fair value and provide a general view on appropriate techniques
for estimating fair values of L&P liabilities in accordance with the
definition of the concept. The paper also contains a section which briefly
reviews recent and quite innovative regulatory initiatives in relation
to market value reporting in the Danish market for life and
pension insurance. Key words: Accounting standards, fair value, financial
valuation, regulation.
* I am grateful for the comments and suggestions of an anonymous referee, Morten Balling, Anders
Grosen, Peter Hermann, Jan Bo Jakobsen, Per Linnemann, Jens Perch Nielsen, Mogens Steffensen, and
Frank Thinggaard. I am particularly indebted to Søren Andersen, Michael Harboe-Jørgensen, and
Charlotte Møller for fruitful discussions and for sharing their insights on the Danish market value rules
and regulation. I would also like to thank Henrik Steffensen of PriceWaterhouseCoopers for granting me
access to PWC’s excellent Comperio database. All errors are my own responsibility.
# 2004 Taylor & Francis. ISSN 0346-1238
DOI:10.1080/03461230410000556
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1. INTRODUCTION
The greatest of all gifts is the power to estimate things at their true worth.
/
Francois de La Rochefoucauld1 (1613 /1680)
Looking back a decade or so, financial accounting was an area that was not
regarded by managers of life insurance and pension companies (henceforth: L&P
companies) as critical to their business. This has changed drastically in the new
Millennium. Today, few other topics can capture the attention / and sometimes also
emotions / of the top management of L&P companies as much as the new
international accounting standards for insurance, some of which have been released
during the first half of 2004 and some of which are still undergoing much disputed
revision. According to the current plans of the EU Commission, all listed companies
in the EU must prepare their consolidated financial statements in accordance with
international accounting standards from 2005 onwards.
From a naı̈ve point of view, the heated debate surrounding the work towards new
international accounting standards is somewhat paradoxical. In an ideal world,
accounting systems should merely reflect / not affect / the way companies operate.
Realities are different, however, and accounting standards must be seen in close
connection with the regulatory environment for the L&P industry, which has also
been undergoing a regular overhaul in recent times. The focus on capital adequacy
and solvency requirements has sharply increased, and regulation in this area
inevitably takes accounting information as its starting point. Changes in financial
reporting requirements and accounting standards may thus negatively affect firms’
ability to meet stated solvency requirements and thus in turn have real effects for
companies’ opportunity and ability to perform their business.
For the optimal fulfillment of its role, a financial regulator or supervisory authority
must receive accounting and other information reflecting the economic realities of
firms as accurately as possible. It is basically this simple insight which has fueled a
generally increased interest in the concept of fair value in relation to financial
reporting in all areas of business. Over the last decade, market participants in many
parts of the world have witnessed a gradual reformation of accounting conventions
from being based largely on historical costs to being based to a larger and larger extent
on fair values.2 Today, the fair value concept is underlying almost all work of the newly
reformed International Accounting Standards Board, cf. also later.
The application of fair values in L&P companies’ balance sheets means that
assets and liabilities will have to be marked-to-market. To a financial economist,
this is a requirement of the ‘‘bloody obvious’’ as one colleague recently put it. But
apparently it has not been equally obvious to the L&P industry, which has a long
1
2
As quoted by Malkiel (1996).
This process is sometimes referred to as a transition from transactions based to value based accounting.
374 P. L. Jørgensen
Scand. Actuarial J.
history of reporting asset values at smoothed or historical acquisition costs and of
assessing liability values using traditional deterministic actuarial approaches with
little / if any / account taken of the options and guarantees typically embedded
in liabilities. Such approaches have the ‘‘advantage’’ of making L&P company
profits and balance sheets look stable and secure, but the recent development in
the regulatory environment reflects the facts that financial markets will not be
fooled, and that smoothed profit and loss statements and balance sheets are an
illusion. While accounting conventions cannot change the true current financial
position of an L&P company, inappropriate accounting systems can certainly
conceal information and blur the true picture of a firms financial position
whereby the discovery of financial problems and imbalances can be delayed.
Needless to say, policy holders, tax payers, and investors may suffer unnecessary
losses as a consequence. Unfortunately, financial history is littered with
examples of this. To mention a few recent ones, Australia experienced its biggest
ever corporate collapse in March of 2001 when HIH Insurance defaulted
with debts estimated at 5.3 billion USD. The primary reason for losses becoming
so large was stated as ‘‘inability to correctly estimate its liabilities’’ in due course,
see e.g. Dyson (2004). In Britain, the industry’s former star and the world’s
oldest life insurer, Equitable Life, nearly collapsed in 2000 following years of
negligent asset liability management, application of inappropriate accounting
principles and, finally, a House of Lord’s ruling ordering guaranteed
annuity options with an estimated fair value of 2.25 billion USD to be properly
reserved for (see e.g. The Economist (2004e)). On the European continent,
Mannheimer Leben went bust in June of 2003 as the first German life insurer to
do so in more than 50 years. Mannheimer’s default was apparently triggered when
the company failed a fair value based solvency check at the end of the first
quarter of 2003.
The purpose of this paper is to review and discuss / from a financial economist’s
point of view / the fair value concept and fair value based accounting standards
and regulation particularly in relation to the estimation of liability values in the
L&P industry. The remainder of the article is organized as follows. Section 2
provides some background on accounting standards and the organizations that set
them. It argues that fair value has been the common theme underlying standards
that have been issued in recent years. The fair value concept is explained and briefly
discussed in Section 3. Section 4 discusses how fair value estimates for life insurance
and pension liabilities can be obtained using various sorts of financial models.
Denmark is widely held to have been a leading country with respect to its regulation
on ‘market values’ in life and pension companies’ financial reports. Section 5
therefore explains and discusses L&P regulations that have been implemented in
Denmark recently. Finally, Section 6 contains a general discussion and some
concluding remarks.
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375
2. BACKGROUND ON ACCOUNTING STANDARDS
Truth needs a soldier.
/
Tagline for Clear and Present Danger, Paramount Pictures, (1994).
Accounting standards are rules and guidelines which should be followed by those
who prepare financial statements of companies. Individual countries such as
Australia/New Zealand, Canada, France, United Kingdom, Germany, Japan, and
USA set their own national standards some of which have the force of law, while
others are just ‘‘generally accepted’’. In any case, the common purpose of the
accounting standards is to define what is meant by a true and fair view in various
contexts and circumstances. Since company law requires that the accounting
statements show a true and fair view, this gives accounting standards an
important role in preparing company financial statements.
With increasing internationalization of business and globalization of capital
markets has come the need for international harmonization of accounting rules.
Financing across borders creates a need for common standards, which should pave
the way for a better understanding of financial statements and in the process
should lower the cost of capital and benefit financial markets. To meet this
demand, a new standard setting authority / the International Accounting
Standards Board (IASB) / was formed in April 2001 as the successor body to
the International Accounting Standards Committee (IASC), which was initiated as
a private organization back in 1973. Despite its rather limited resources the former
IASC did a formidable job in issuing a large number of international accounting
standards (IASs) on a wide selection of areas. However, the IASC also faced some
adversity along the way. It is generally viewed as having struggled with gaining
worldwide acceptance of its standards and with encouraging its more than 200
national delegates to work towards a mutual goal. Moreover, with the powerful US
not always being a cooperative partner, progress on harmonization was not easily
made.
The new IASB started its work in 2001 with much more promising prospects
and with an aim which was more unambiguously international. It obtained the
support of the EU Commission early on, and the UK government soon followed
up by issuing a consultation paper proposing that IASB standards replace UK
accounting standards. Judging also from various signals from the US Federal
Accounting Standards Board (FASB), prospects of fruitful trans-Atlantic cooperation and convergence on standards are promising, see e.g. Dyson (2004). The
new IASB is also better funded and supported with 12 of 14 board members on
full-time contracts. Whereas the selection of board members of the former IASC
faced geographical restrictions, the constitution of the IASB now states that ‘‘The
foremost qualification for membership of the IASB shall be technical expertise ’’.
376 P. L. Jørgensen
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According to the constitution document the objectives of the IASB are:3
. to develop, in the public interest, a single set of high quality, understandable and
enforceable global accounting standards that require high quality, transparent
and comparable information in financial statements and other financial reporting
to help participants in the world’s capital markets and other users make economic
decisions;
. to promote the use and rigorous application of those standards; and
. to bring about convergence of national accounting standards and International
Accounting Standards and International Financial Reporting Standards to high
quality solutions.
The IASB has adopted and will continue to promote and improve the effective
standards (IASs) issued by the IASC and has already issued a handful of new
ones and, as previously mentioned, more are under way. Standards issued by the
new IASB will be called International Financial Reporting Standards (IFRS).
Of significant interest from a European perspective is the fact that IASB standards
were endorsed by EU regulation already in 2001. According to current plans, all EU
listed companies must prepare their consolidated financial statements in accordance
with IAS and IFRS standards from 2005 onwards. It is hoped that other types of
companies will also adopt the IASs and IFRSs. The EU requirement is a milestone in
the history of financial reporting. It means that across a large continent of 25
countries and 455 million people about 7000 listed companies will be complying with
the same company law and the same accounting standards. As a result, the
comparison of financial performance among companies in different countries should
become much more realistic and reliable.
At the time of this writing, there are 33 effective IASs. Of these, IAS 19 (Employee
Benefits), IAS 32 (Financial Instruments: Disclosure and Presentation), and IAS 39
(Financial Instruments: Recognition and Measurement) are of particular relevance
to pension funds and life insurers, but previously there has been no accounting
standard entirely devoted to insurance and/or pensions. However, already in 1997 the
IASC launched an Insurance Project that was also adopted by the new IASB in 2001.
The goal of the Insurance Project was to come up with an IFRS specifically for
insurance in 2005. The IASB also announced its intent to renew the above-mentioned
IASs with relevance to pension and insurance companies.
The insurance project suffered from various delays and was later split in two
phases, but by the issuance of the Exposure Draft 5 in July 2003 and then the new
IFRS 4 in March 2004 (see IASB (2004)), the first phase of the Insurance Project has
now been completed. Amendments to IAS 19, IAS 32, and IAS 39 have also been
3
See IAS Committee Foundation (2002) in particular Part A, Sec. 2(a), and the Annex.
5
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issued in the new Millennium. The most complex and controversial of these, IAS 32
and IAS 39, are still in the process of being revised. This has generated a particularly
heated debate, see e.g. The Economist (2004c).
This is not the place to go into the technicalities of the new IFRS 4 or the
changes to the related IASs. What is relevant at this point, however, is the overall
conclusion that emerges from reading through these documents. This conclusion is
that the adoption of fair values in financial reports has been the general theme
underlying the work of the new IASB. True, there are still a lot of exceptions, and
definitions and product classifications are still in many cases relatively open to
interpretation,4 but the trend in the IASB’s standards is clear: ‘‘Fair value’’ is the
concept that must be learned, understood, and applied in the future.
3. THE FAIR VALUE CONCEPT
Res tantum valet quantum vendi potest. (A thing is worth only what someone else
will pay for it.)
/
Latin maxim.
Fair value is an accounting term which originated with the US accounting standards
setter, the Financial Accounting Standards Board (FASB), as for example in
Statement of Financial Accounting Standard (SFAS) 87 (1986) with respect to
pension assets, and in SFAS 107 (1992) with respect to financial instruments. One
common definition of fair value in relation to financial instruments has been
‘‘The amount of the consideration that would be agreed upon in an arm’s length transaction
between knowledgeable, willing parties who are under no compulsion to act ’’, see e.g. Scott
(2003).
This definition has been recently revised and expanded upon as part of the work with
a Fair Value Measurement Project , which the FASB launched in June 2003. The
FASB now defines fair value as (see FASB (2004))
‘‘The price at which an asset or a liability could be exchanged in a current transaction between
knowledgeable unrelated willing parties ’’.5
In the brand new IFRS 4 the definition of fair value is essentially identical and reads
(see Appendix A of IASB (2004))
‘‘The amount for which an asset could be exchanged, or a liability settled, between
knowledgeable, willing parties in an arm’s length transaction. ’’
4
An example: Accountants will have to decide on whether the insurance element or the financial element
is more important in a life insurance policy. The answer will determine whether IAS 39 or IFRS 4
guidelines should be followed in reporting for the liability.
5
See also Vanderhoof & Altman (1998).
378 P. L. Jørgensen
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The new FASB and IASB definitions of fair value are of course not much different
from the earlier stated version, except for the fact that both organizations now
explicitly state that the definition is intended to apply for all assets and liabilities and
not just financial instruments.
What is an innovation and of significant interest, however, is the clarifications,
comments, and amendments to the definition which the FASB provides in the recent
fair value measurement project update. We will present and discuss some of these
below.
First of all, and in direct continuation of the short definition, it is clarified that
‘‘fair value measurement presumes that an entity is a going concern without intention or
need to liquidate. In that context, the objective of a fair value measurement is to
estimate the single agreed-upon exchange price between willing parties in a transaction
other than in a forced liquidation transaction or distress sale. Willing parties are all
marketplace participants (hypothetical buyers and sellers with access to the same
markets) that are willing and able to transact .’’
Secondly, the FASB document recognizes that valuation techniques may be used
for obtaining fair value estimates. It is explicitly stated that such valuation techniques
include simple present value techniques as well as expected present value techniques
consistent with the use of probability-weighted cash flows that are either (a) explicitly
adjusted for systematic risk and discounted at a risk-free rate or (b) discounted using
a rate that incorporates a risk premium for the systematic risk inherent in the
expected cash flows. Here, the FASB is being rather detailed and technical on specific
financial modeling techniques / an issue that we shall return to in the next section of
the paper.
Thirdly, and perhaps most interestingly, FASB (2004) introduces a fair value
hierarchy.6 This hierarchy states that valuation techniques used to estimate fair values
should maximize the use of market inputs and it prioritizes the market inputs that
should be used. In general, quoted prices in active markets are preferred and
should be used whenever available. Fair value estimates are classified at three quality
levels:
. Level 1 estimates are obtained using quoted prices for identical assets or liabilities
in active markets to which an entity has immediate access.7
. Level 2 estimates are obtained using quoted prices for similar assets or liabilities in
active markets, adjusted as appropriate for differences. The difference between
measuring and measured assets and/or liabilities must be objectively determinable.
Otherwise the estimates will be Level 3 estimates.
. Level 3 estimates are based on results of valuation techniques generally consistent
with those used by marketplace participants in pricing the types of assets and
6
This hierarchy was first presented in the June 2002 Exposure Draft for a revised IAS 39.
In the June 2002 Exposure Draft for a revised IAS 39, recent transactions prices were allowed as a basis
for fair value measurement. This possibility has now been removed.
7
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liabilities being measured. FASB recognizes that Level 3 estimates will vary to the
extent of market inputs used, but emphasizes that the valuation techniques must
be consistently applied.
Now, in relation to insurance and pension liabilities in particular it is fair to say that
an active market for identical products rarely exists. One can therefore typically at
most hope to obtain Level 2 estimates, and this will only be in the case of particularly
simple liabilities where similar products are actively traded. However, for typical
life insurance and pension savings products with complex contingencies and
embedded option elements, company accountants will have to aim for Level
3 fair value estimates and this will involve some kind of estimation process
based on financial valuation models / an issue that will be reviewed in the next
section.
4. OBTAINING FAIR VALUE ESTIMATES FOR LIFE AND PENSION
LIABILITIES
Model building is like spinach. You may not like the taste, but it is good for you.
/
Brealey and Myers (2003), Chap. 10.
This section will provide a brief overview of the financial economist’s typical
approach to obtaining fair value estimates for the various entries on both sides of a
financial company’s balance sheet. The discussion will focus mainly on the problems
surrounding the fair valuation of L&P liabilities. The reason for this is of course that
the asset side of an L&P company is a lot less problematic since to a large extent it
will consist of more or less liquid tradeable securities for which Level 1 or Level 2 fair
value estimates, cf. the previous section, will be readily available. It is worth noting,
however, that not all investment assets have accurately measurable fair values. Real
estate investments and complex over-the-counter derivatives are examples, but these
may be analyzed using the same conceptual framework as will be discussed for the
valuation of liabilities.
As indicated earlier, market prices for life insurance policies and pension savings
contracts are rarely available.8 It will also typically not be possible to find traded
securities with a sufficiently close similarity to the L&P obligations such that Level 2
fair value estimates can be obtained (via some sort of extrapolation for example).
With respect to obtaining fair value estimates for L&P liabilities, we must therefore
step down in the fair value hierarchy and aim for Level 3 estimates. This inevitably
involves the implementation of some financial modeling techniques. Note that in
8
Dicke (1998) mentions rare cases where secondary markets for insurance policies have existed.
380 P. L. Jørgensen
Scand. Actuarial J.
general classical actuarial techniques will not meet the requirement underlying the
Level 3 classification stating that the valuation techniques applied should be
consistent with ‘‘those used by the marketplace participants in pricing (similar) types
of liabilities’’. Market participants do not use classical actuarial methods for
assessing their financial investments.
For a financial economist it is logical to analyze life insurance policies and pension
savings contracts in much the same way as he would analyze financial securities. As
was discussed above, there are some fundamental differences / the most important of
which is that life insurance policies are personalized contracts for which there is no
liquid secondary market / but there are also many similarities. Financial securities
offer a (string of) future payoff(s) in return for the price paid for them at the time of
purchase. Similarly, by paying a premium today, an ‘‘investor’’ may acquire a life
insurance policy which entitles him to receive future financial benefits. L&P policies
are diverse and come in many forms and designs, so the payoff of a life insurance
policy can be very complex. But as long as the payoff is a reasonably well-specified
function of some observable underlying variables, then financial economists will be
ready to apply some sort of financial valuation model in order to assign a fair value
to the contract and to assess its inherent risk.9
The appropriate financial valuation model will vary in complexity with the
particular liability to be analyzed. For the purpose of valuing the simplest forms
imaginable consisting simply of one or more non-stochastic future benefits, the
starting point should be a term structure of zero-coupon interest rates estimated
on the basis of market prices of non-callable bonds (or swap rates) of the highest
credit quality (read: government bonds). An estimated zero-coupon interest rate
curve can also serve as an input and a starting point for more advanced dynamic
models. The term structure consists of interest rates specific to every future point
in time. Future cash flows should be discounted with the interest rate specific to
the point in time where the cashflow has been promised. If there is more than one
cash flow, a single mutual discount rate will not do, as it would not correspond
with financial market practice and thus with fair value standards. In other
words, using a single common rate for all maturities will (almost surely) be in
conflict with the no-arbitrage principle underlying almost all modern financial
models.
Estimation of the term structure of interest rates is not difficult provided good
bond price (or swap rate) data is available.10 Undergraduate students of economics
can learn to do this using a spread sheet like Microsoft’s EXCEL in 1 /2 class hours,
9
See International Association of Actuaries (2000) for a deeper discussion of the possibilities for
estimating fair values of liabilities when financial markets are complete and incomplete, respectively.
10
One challenge here is to get good bond price observations covering the far end of the maturity spectrum.
Unfortunately, government bonds with maturities above 20 /30 years are relatively rare in most countries.
In contrast, corporate bonds with maturities up to 100 years are not uncommon. IBM, Walt Disney, ABNAMRO, and Coca Cola are examples of large international corporations that have issued 100 year bonds
(see e.g. Grinblatt & Titman (2002)).
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and the subject is covered in best-selling finance textbooks such as Luenberger (1998)
and Hull (2003).
However, most life insurance policies and pension savings contracts are not so
simple that fair values can be obtained merely by discounting future cash flows using
risk free zero-coupon interest rates. If one takes a closer look at typical L&P
contracts, then it is quickly realized that they often contain a varying number of
separate guarantees and claims, some of which have option-like payoffs / and hence
present values / that are contingent on the future value of one or more variables.
Some common examples of option elements of life insurance contracts are surrender
options, bonus options, policy loan options, and minimum return, renewal, and
annuity rate guarantees. As amply shown by theory as well as painful experience (cf.
the Introduction) such embedded option elements are risky and can become very
valuable. In order to comply with fair value requirements, one should therefore take
all such guarantee and option elements into account and value them properly. In this
respect, it must first be realized that simple deterministic approaches cannot allow for
the optionality included in the embedded contingent claims. It must also be realized
that it will not be sufficient to just assign some rule-of-thumb value to these claims.
Options and guarantees embedded in L&P liabilities must be valued in a manner that
is consistent with how similar options are valued by financial markets.
Fortunately, the financial economists’ toolbox for such valuation tasks is rich and
well-developed. In the case of L&P contracts it has long been recognized in the
financial literature that the theory of contingent claims pricing is a particularly strong
and appropriate tool for analyzing L&P products. The recommendation of this
literature would be to regard these products as composite option packages, and for
purposes of proper valuation one should analyze each of these elements in turn. As
regards proper and fair valuation, modern financial models that account for all
relevant sources of uncertainty and risk in cash flows and discount factors can do
this better than traditional actuarial approaches.
The theory of contingent claims pricing and in particular the option pricing theory
started developing in the late 1960s and early 1970s catalyzed mainly by the works of
Merton (1973) and Black & Scholes (1973) (which earned Robert C. Merton and
Myron S. Scholes a shared Nobel Prize in economics in 1997). The fundamental
insight of these authors was that in ideal market conditions the price of a claim whose
payoffs can be perfectly replicated via trading in a self-financing portfolio of
fundamental securities should equal the price of initiating the replicating strategy. If
this is not the case then riskless arbitrage opportunities can be pursued.
During the 30 years that have passed since the publication of the Black-ScholesMerton papers, their theory has been further developed, refined, and of course,
applied in many different contexts. Financial economists were also not slow to
identify the field of insurance as an area for fruitful application of option pricing
theories. Many insurance and pensions contracts / it has been argued / have payoffs
that are (approximately) replicable in the sense of Black-Scholes-Merton and
382 P. L. Jørgensen
Scand. Actuarial J.
therefore priceable via no-arbitrage arguments and contingent claims theory. To
mention a few examples, Brennan & Schwartz (1976) and Boyle & Schwartz (1977)
contributed with early papers that analyzed equity-linked life insurance policies using
the contingent claims pricing framework, and Smith (1982) provided early insights
into the life insurance contract as an options package, cf. the above discussion. In
recent influential work, Babbel & Merrill (1998) and Babbel & Merrill (1999) provide
a more general discussion of the merits of contingent claims pricing theory for
estimating the fair value of insurance liabilities.11 Below we briefly recapitulate some
of their most important insights.
First of all, an insurance company faces three main types of risk: actuarial, market,
and non-market risks. Actuarial risk, that is for example mortality and disability
risks, are well-handled by classical actuarial methods and can be adequately dealt
with by writing a sufficiently large number of similar policies. As regards liability
valuation, actuarial risks need not be accounted for beyond their expected costs.
Non-market risks are unhedgeable systematic company risks in relation to e.g. the
legal, regulatory, and/or tax environment. These risks are hard, if not impossible, to
account for and will not be discussed further in this paper.
The question of how to take financial market risks into account is where financial
economists may have some answers. In their papers Babbel and Merrill first provide a
list of requirements that must be satisfied by valuation models and they then move on
to provide a fine discussion of exactly which types of financial models are appropriate
in the insurance context. This discussion uniquely points to the general framework
for arbitrage pricing of contingent claims and, for example, it dismisses with the
practice of valuing complex contingent claims by unconsciously calculating expected
payoffs and discounting these with the treasury yields plus a ‘‘spread’’. To quote
Professor Babbel from elsewhere (Babbel, 1998, pp. 121 /122):
In finance, we do not usually value interest-sensitive securities by discounting their cash flows by
a treasury rate plus a spread. Rather, we use lattices or simulations to discount interest-sensitive
cash flows. Those are the only ways that work. . . . In the finance field we have learned that we
cannot use yield-to-maturity to value anything with precision. Indeed, we can come up with
yield-to-maturity on an instrument only after we have already valued it using something else. So
all of these methods that just add spreads to a yield are not going to give you precision. Sure,
they give you ballpark notions, but nothing more. On Wall Street, sometimes we talk about
spreads / but that is only after we have determined price. We say, ‘‘This translates into a
spread,’’ but we would never use the spread to come up with what the price should be.
Instead of reviewing the text-book essentials of contingent claims pricing theory,
we will end this section by pointing to some key references to literature that has
applied financial valuation and/or option pricing models to specific problems in
relation to L&P contracts.
We already mentioned the papers by Brennan & Schwartz (1976) and Boyle &
Schwartz (1977) as pioneering the use of contingent claims pricing theory in the field
11
The reader is also referred to Sheldon & Smith (2004) for a general introduction to market consistent
valuation of L&P products.
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of (equity-linked) life insurance. Other contributions to the analysis of options and
guarantees embedded in equity- or unit-linked life insurance products include
Brennan & Schwartz (1979), Baccinello & Ortu (1993), Persson & Aase (1994),
Nielsen & Sandmann (1995), Ekern & Persson (1996), Grosen & Jørgensen (1997),
Persson & Aase (1997), Miltersen & Persson (1999), and Møller (2001). The much
more economically significant class of L&P products labeled with-profits or participating policies have been analyzed from the financial economist’s point of view in
for example Brennan (1993), Briys & de Varenne (1994), Briys & de Varenne (1997),
Grosen & Jørgensen (2000), Jensen, Jørgensen, and Grosen (2001), Miltersen &
Persson (2003), Grosen & Jørgensen (2002), Andreatta & Corradin (2003), Balotta,
Haberman, & Wang (2003), Haberman, Balotta, & Wang (2003), Tanskanen &
Lukkarinen (2003), and Steffensen (2004).12 Steffensen (2000) and Steffensen (2002)
offer frameworks which to some extent cover both product types. Both unit-linked
and participating contracts have been offered with guaranteed annuity options
(GAOs) included. GAOs are interesting because the world’s oldest life insurer,
Britain’s Equitable Life, nearly collapsed in 2000 as a result of insufficient risk
management of this particular form of liability. GAOs have been studied in for
example Milewski & Promislow (2001), Boyle & Hardy (2003), Haberman & Balotta
(2003), and in Pelsser (2003). See also Hansen (2003) for a comprehensive treatment
of various aspects in relation to both of the above-mentioned product types.
Participating L&P products have been in high demand partly because of their
application of return smoothing mechanisms to market returns. However, this product
class has also been criticized for lack of transparency regarding the bonus process.
There are typically no formal rules governing the bonus distribution, which again
makes fair valuation via financial valuation models problematic. In Denmark, the
market has recently seen a new product which entails an explicit and mathematically
well-defined return smoothing mechanism, thus meeting part of the criticism against
traditional participating L&P contracts. See Guillen, Jørgensen, & Perch-Nielsen
(2004) for an analysis of this product.
5. A FIRST STEP IN IMPLEMENTING FAIR VALUE ACCOUNTING
CASE OF DENMARK
/
THE
Sometimes I sing and dance ’round my house in my underwear. Doesn’t make me Madonna.
Never will.
/
‘‘Cynthia’’ (Joan Cusack) in Working Girl , 20th Century Fox (1988).
Among international L&P practitioners and market participants, it is widely held
that Denmark has been a leader in Europe with respect to implementing fair value
based accounting and solvency monitoring rules in the L&P industry. This section
12
See e.g. Linnemann (2003a,b, 2004) for actuarial approaches to market based valuation of participating
life insurance contracts.
384 P. L. Jørgensen
Scand. Actuarial J.
will therefore briefly review and comment on the recent initiatives that have been
taken in Denmark.
The Danish fair value transition process was initiated in the Fall of 1998 when
the Minister of Economic Affairs appointed a Market Value Committee to
consider methods for valuation of L&P liabilities which were commensurate with
planned requirements to have L&P companies report all assets at ‘‘market
value’’.13 It was an explicitly stated purpose of the proposed transition to fair
value based financial reporting to provide more realistic and reliable information
to market participants about the financial solidity and risk exposure of Danish
L&P companies.
The Market Value Committee finished its work in 2001 and its recommendations immediately led the Danish Financial Supervisory Authority (Danish FSA)
to issue in December of 2001 a new executive order regarding L&P companies’
annual financial reports. According to this new executive order, L&P companies
must report all assets at market value beginning 1st January, 2002. Since the mid
1990s stocks and real estate investments had already to a large extent been
reported at market value, but the significant bond holdings were typically still
reported at a book value determined via a smoothing method referred to as
mathematical price appreciation . Moreover, the executive order required companies
to start reporting liabilities at market value as of 1st January, 2003. It was allowed
(but not required) to initiate market value reporting of liabilities already from 1st
January, 2002.
The Danish FSA’s executive order required a new decomposition of the liability
side of L&P companies’ balance sheets. The technical provisions was previously a
single entry on the liability side. It was estimated on a policy-by-policy basis using
the policies’ different technical bases at issuance and there was no attempt to
separately identify and include the value of the right to receive bonus. The former
rules merely required listing of the aggregated non-distributed profits in an entry
called bonus smoothing reserves. Now, according to the new executive order, the
technical provisions must be split into three parts for each of which a market
value must be reported. Two of the three new components relate to the individual
bonus potential of the policies, cf. Figure 1 and the discussion below.14 The bonus
smoothing reserves entry carried over to the new rules, but was renamed as
collective bonus potential .
Disregarding administrative and standard actuarial charges and costs, and
focusing here only on the financial elements of the three new entries, their market
values must be estimated as explained below (see also Figure 2).
13
The Danish L&P sector has not (yet) adopted the fair value terminology explained in Section 3. Values
of liabilities for which there is no active market and thus have to be estimated (using for example financial
modeling techniques) are also referred to as ‘‘market values’’, and the remainder of this section therefore
uses this term.
14
The figures list the most significant liability side entries, but the lists are not exhaustive.
5
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On accounting standards and fair valuation of L&P liabilities
385
Fig. 1. Old and new liability side decomposition.
The market value of the guaranteed benefits is calculated as the difference between
the present value of the contractually specified guaranteed benefits (A /B ) and the
present value of the policies’ remaining future premiums (C). This entry is thus the
market value of the policies’ remaining promised net cash flows. For a single policy
with a relatively low rate of return guarantee, the value of the guaranteed benefits can
be negative.
Fig. 2. Cash flow illustration.
386 P. L. Jørgensen
Scand. Actuarial J.
In addition to promised net benefits, policies have a bonus potential the value of
which is to be determined. The market value of the individual bonus potential is split
in two. First, the market value of the bonus potential on future premiums is calculated
as the maximum of zero and the difference between the present value of the
remaining future premiums (C) and the present value of the part of the total
guaranteed benefits that are specifically related to future premiums (B ). Second, the
market value of the bonus potential on paid-up policy benefits 15 is calculated as the
maximum of zero and the difference between the value of the retrospective reserve
(D, sometimes referred to as the value of the policy holders’ deposits as in ‘‘Bremerrapporten’’ (2003)) and the present value of the part of the guaranteed benefits that
are specifically related to the paid-up policy (A ). Figure 2 illustrates the strings of
cash flows that must be considered as part of these calculations. All of the abovementioned present value calculations must be performed using either an estimated
term structure of zero coupon interest rates (cf. the previous section) or a simplified
‘‘market interest rate’’, which is determined and published daily by the Danish
FSA.16 In any case, the approach is entirely deterministic.17
The new market value based decomposition of the L&P companies’ liability side
clearly makes a lot of sense. The biggest improvement over previous practice / which
sometimes involved discounting liability cash flows with the expected return on the
investment assets (!) / is that companies are now forced to use a market interest rate
for discounting future cash flows although the Danish FSA’s reference rate can be
criticized cf. the discussion in the previous section of this paper. The new
decomposition is also potentially useful as it provides at least partial information
on the extent to which liabilities are influenced by issued options and guarantees. In
fact, the new liability decomposition has some similarity with fair value decompositions suggested in academic studies by e.g. Briys & de Varenne (1997), Grosen &
Jørgensen (2000), and Grosen & Jørgensen (2002). These papers identify a riskless
bond element as part of the policy holders’ claims, which is comparable / and in
simplified cases exactly identical / to the guaranteed benefits -entry in the Danish
FSA’s new rules. Put differently, the guaranteed benefits -entry can be taken to
represent the market value of policies that are stripped of all of their options
15
According to Danish insurance legislation, policy holders can terminate the payment of premiums and
still be entitled to receive the proportion of promised benefits that have already been earned by the previous
premiums. A policy continuing in this way is termed a paid-up policy.
16
This interest rate is determined on the basis of an after-tax duration weighted average of the yields of
three different government bonds. A swap-spread is then added(!). This spread currently amounts to about
10 /20 basis points, but historical values have exceeded 50 basis points. For further details of the
calculation principle, the reader is referred to The Danish Financial Supervisory Authority (2001).
17
The term structure of zero-coupon interest rates tends to lie above the Danish FSA’s reference rate in the
long end of the maturity spectrum and below the reference rate in the short end. Casual empiricism
suggests that ‘‘young’’ pension funds with relatively long liabilities tend to choose zero-coupon interest
rates for discounting their projected cash flows, whereas mature pension funds and life insurance
companies with relatively shorter liabilities tend to use the Danish FSA’s reference rate. This indicates that
L&P companies tend to choose the discounting methodology that minimizes the estimated value of
liabilities.
5
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On accounting standards and fair valuation of L&P liabilities
387
including, for example, the option to surrender, the right to receive bonus, and the
option to continue as a paid-up policy. The market value of these options should
then / and can to some extent / be related to the bonus potentials of the new Danish
market value rules. However, the fundamental difference between the theoretical
studies and the Danish FSA’s executive order is their approach to determining the
market value of the embedded options. For example, in the above-mentioned
theoretical papers, the market value of the policy holders’ right to receive a fair share
of the surplus is modeled as a well-specified bonus option and valued using noarbitrage based financial valuation techniques, cf. the previous section.18 In contrast,
in the Danish FSA’s executive order, the market value of the embedded options (the
bonus potential) is basically determined as two deterministic residual terms
(a retrospective and a prospective term) so that by convenient construction the
sum of the three technical provision terms will typically precisely equal the value of
the retrospective reserve. In other words, it is ensured that the bonus potentials will
never be generators of solvency problems.
In relation to the issue of solvency it should be noted that at about the same time
as the introduction of ‘‘market value’’ accounting in Denmark the Danish FSA also
introduced a new risk-based supervision system known popularly as the ‘‘traffic
lights’’ system. The introduction of this system was necessary in order to
accommodate the L&P companies’ strongly expressed desire to be allowed to invest
a larger share of their assets in the stock market. From 2001 onwards, L&P
companies were thus allowed to invest up to 70% of their assets in stocks depending
on their risk tolerance as evaluated by the traffic lights system.19
In summary, the traffic lights system requires Danish L&P companies to provide
semi-annual reports on the effect on key solvency variables of (hypothetical) changes
in a number of market variables. A company will be in ‘‘red light’’ if / following a 12%
decline in stock prices, a 0.7% increase or decrease (whatever is worst) in the interest
rate level, and an 8% decrease in real estate investment values / the company’s base
capital is below a certain critical level which is currently defined as the solvency
margin requirement minus 3% of the technical provision. A company in red light will
be monitored closely by the Danish FSA and typically be asked for more frequent
(monthly) solvency reports. A company will receive ‘‘yellow light’’ status if base
capital at the above-mentioned critical level cannot be established following a 30%
decrease in stock prices, a 1% increase or decrease (whatever is worst) in the interest
rate level, and a 12% decrease in real estate investment values. Companies in yellow
light will be asked for more frequent (quarterly) solvency reports.
18
Rules for sharing the investment (and insurance) surplus should follow the contribution principle and
guidelines are formulated in a separate executive order issued by the Danish FSA. These guidelines have
had to be revised and updated several times in connection with the issuance of the new market value
reporting requirements, see The Danish Financial Supervisory Authority (2004).
19
Prior to 1997 the maximum allowable portfolio weight in stocks was 40%. It was raised to 50% between
1997 and 2000.
388 P. L. Jørgensen
Scand. Actuarial J.
Since the traffic lights system was introduced simultaneously with the new market
value reporting requirements, it has thus been possible to create a simple yet
meaningful solvency monitoring system based on an integrated view of companies’
asset and liability sides and on risk measures in economic terms.
The new Danish market value regulation can be criticized on a number of grounds.
As already mentioned, policy holders’ call option to participate in the upside of
investment returns is not accounted for in a way that is consistent with fair valuation
of contingent claims in general and options in particular. Instead the value of the
bonus potentials are determined as residuals in a calculation which is anchored in the
value of the retrospective reserve. Whether this term itself deserves the market value
predicate can indeed be questioned. Some other critical points relate to the fact that
the new regulation effectively allows companies to include the part of the technical
provision labeled bonus potential on paid-up policy benefits as part of their buffer
capital. This rule should cause some concern. First, it seems problematic particularly
in the presence of (cohorts of) policies with guaranteed surrender values. Second, it is
likely to further encourage risk-taking on the asset side and to weaken the incentive
to perform proper asset-liability management. Third and as pointed out by Grosen
(2003), this rule has also already had the odd effect of making Danish L&P
companies appear more financially solid after the year 2002 (the first year with
market value based financial reporting) than after the year 2001, despite severe losses
on equity investments and further increases in guaranteed liability values (due to a
further fall in interest rates) during the year 2002. Grosen (2003) also points out that
severe redistributions of wealth between policy holders with different levels of
guaranteed returns are a likely consequence of this rule in combination with the way
in which the new executive order on the contribution principle is currently
interpreted.20
We conclude that although significant progress has clearly been made in Danish
financial reporting regulation, there is still room for improvements. We could also say
that a classical comparison still applies: The financial reports of Danish L&P
companies are like bikinis: What they reveal is interesting, but what they conceal is
vital! Fortunately, the deficiencies of current rules are to some extent recognized by the
Danish FSA, which have announced that further changes of the market value based
reporting requirements must be expected as new standards from the IASB are issued.21
6. DISCUSSION AND CONCLUDING REMARKS
All truth passes through three stages. First, it is ridiculed. Second, it is violently opposed. Third,
it is accepted as self-evident.
/
20
Arthur Schopenhauer (1788 /1860).
Readers familiar with the Danish language can consult The Danish Financial Supervisory Authority
(2002) for illustrative numerical examples of how the values of the different entries on the balance sheet
evolve in different investment scenarios under the new Danish market value regulation.
21
See e.g. The Danish Financial Supervisory Authority (2002).
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In order to function properly and efficiently as a capital allocating mechanism, the
world’s capital market must be continuously fed with timely, reliable, and relevant
information. For L&P companies in particular, the current value of assets and
liabilities represent information of the highest relevance to all stakeholders. It should
therefore be brought to the market in a form which is as accurately reflecting
economic realities as possible. It is this basic insight which has been underlying the
work of the IASB (and the former IASC) and which has led the European
Commission to put forward its requirement that from 2005 onwards all EU listed
companies must prepare their consolidated financial statements in accordance with
IAS and IFRS standards. The L&P companies’ compliance with IASs and IFRSs
mainly implies that income statements and balance sheets will have to be prepared
based on fair values rather than book values of assets and liabilities.
The proposed transition to a fair value based accounting system represents a
wonderful opportunity for the L&P industry to present itself in a way which is more
transparent and economically meaningful, and it should potentially improve crosscompany and cross-country comparisons immensely. The prospect of a new fair value
based accounting regime has nevertheless been violently opposed by some. The
critical voices have in almost all cases been raised by company representatives and
there are some obvious reasons for this.
First, a natural implication of the adoption of the fair value concept in preparing
balance sheets will be that reported asset and liability values will become more
volatile than under a historical cost based reporting system. Moreover, net movements will go through the earnings statement and thus affect reported equity values.
To the extent that assets and liabilities are poorly matched then, under fair value
reporting, the equity value will also become more volatile and this will, ceteris
paribus, in turn increase the probability that a pension fund or a life insurance
company must declare insolvency. This has been referred to as constituting an
‘‘artificial’’ and intolerable ‘‘volatility problem’’ by critics of fair value accounting,
and some even go as far as to claiming that fair value accounting in insurance may
hurt overall financial stability. The purpose of expressing such strong views is of
course to impress regulators and persuade them to back off on the proposed
reforms.22 The financial economist, however, interprets the criticism as a rather
arrogant unwillingness of fund managers to have their investment performance
evaluated and displayed in company profits for everyone to see and compare. For an
in-depth understanding of this issue the reader should note again the stated premise
for the increased volatility of profits and equity value: The ‘‘volatility problem’’ will
arise only if assets are not sufficiently matched with liabilities. The opposition against
fair value reporting can therefore also be interpreted as resistance against regulators
intent to remove company management’s option to hide risky investment bets for
pension savers’ money and to enforce a regulatory system which would imply a more
22
French critics in particular seem to have had some success with their lobbyism recently, see The
Economist (2003).
390 P. L. Jørgensen
Scand. Actuarial J.
responsible investment practice. Fair value based accounting and new solvency rules
thus entail an implicit requirement that assets and liabilities be better matched in the
future than have been the case in the past. This makes a lot of sense.
One might wonder from where many investment managers’ reluctancy to fully
match assets and liabilities originates and whether it is in any way logical. One very
plausible explanation in this respect could be a strong belief in the ‘‘equity premium’’
on the part of investment managers of L&P companies. The ‘‘equity premium’’ refers
to the fact that on an expectations basis risky stocks earn a higher return than
bonds.23 Investment managers commonly propose and discuss investment strategies
that are designed to ‘‘capture the equity premium’’ through ‘‘time diversification’’. It
is somehow believed that if a well-diversified portfolio of stocks is managed
appropriately and held for a long enough time, then the equity premium will be
realized with little or no uncertainty. If this was true, it could clearly be optimal to
disregard short-run solvency concerns and the fact that L&P liabilities are typically
predominantly bond-like, and nevertheless invest heavily in the stock market. That
many pension advisors share this view of markets is perhaps further supported by the
fact that recent years have seen an explosion in unit linked pension and life savings
contracts at the expense of traditional participating/with-profits contracts. To the
extent that holders of traditional policies can be persuaded to switch into unit linked
policies, this may have the nice side-benefit of alleviating equity-fixated investment
managers’ and companies’ problems with the asset-liability mismatch. However, most
finance scholars reject the above-mentioned perception of the relationship between
risk, return, and time in the equity markets, and they will be happy to remind anyone
that the equity premium is a reward for risk / not a free lunch.24
There is another obvious explanation for some parts’ expressed opposition against
the new fair value based accounting standards and solvency rules for insurance.
Apparently the financial position of many L&P companies throughout Europe and
the US is not good. According to recent estimates, European life insurers currently
face a combined capital shortfall of about 100bn EUR when measured against
Solvency II capital requirements, which are based on fair value principles.25 The
funding deficit in corporate America’s pension funds is a staggering 350bn USD.26 In
this light the resistance against the new accounting standards can be seen simply as
an attempt to buy the companies more time to come up with the missing money.
23
See e.g. Dimson, Marsh, & Staunton (2002).
This view was shared by UK based Boots’ pension fund which / in a spectacular and highly publicized
strategic move / switched its entire 2.3bn GBP investment fund from equities into long-dated Sterling fixed
rate bonds in order to obtain a better match between assets and liabilities. The head of corporate finance at
Boots, John Ralfe, subsequently reached fame partly because of what was considered a truly controversial
attitude to pension fund management, and partly because of the exceptionally fine timing of the switch,
which was completed just prior to ‘‘9 /11’’ and the subsequent burst of the stock market ‘‘bubble’’ in 2001,
see e.g. The Boots Company (2001) and Nicholson (2004).
25
See Mercer Oliver Wyman (2004) and The Economist (2004a).
26
See The Economist (2004b) and Watson-Wyatt (2003).
24
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Interestingly, the US deficit mentioned above is shouldered by the Pension Benefit
Guaranty Corporation (PBGC) and to mitigate its problems the US Senate has just
recently (April 2004) signed a pension relief bill essentially allowing the L&P industry
to significantly increase the discount rate used for calculating the present value of the
promised benefits (see e.g. The Economist (2004d) and Global Pensions (2004)). Such
a move is obviously inconsistent with strict enforcement of and compliance with fair
value based accounting. It ignores the sound economic principles and incentives on
which the concept of fair value relies, and it is unlikely to serve the interest of pension
savers in the long run.
People who oppose the transition to fair value based accounting principles and
praise the antiquated historical cost based accounting methods should re-think their
position. They might also take into consideration that according to a recent survey of
negative press coverage, the field of accountancy ranks a distant 45th out of 45
leading UK business sectors (Wild, 2002). Bad accounting, and admittedly also
outright illegal actions, has played a central role again and again in recent corporate
scandals where stakeholders have lost money partly because available financial
accounting information was unreliable, inaccurate and/or arrived too late.
The introduction of fair value accounting in the L&P industry would represent a
significant improvement over current state of affairs in many countries. Booking
asset and liability values at fair value would not only expose traditional smoothing
practice for the lie that it is, it would also make income statements and balance sheets
much more transparent, comparable, and reliable. By more accurately reflecting
economic realities, financial reports will serve better as part of an early warning
system when things start to go wrong, and should also potentially play a role in
disciplining managers when their overconfidence is about to get out of hand. In this
way fair value accounting should be considered by all as a valuable tool that should
enhance rather than weaken financial stability of the L&P industry as well as more
generally of the entire financial sector.
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Manuscript received June 28, 2004
Address for correspondence:
Peter Løchte Jørgensen
Department of Management
University of Aarhus
University Park 322
DK-8000 Aarhus C
Denmark
Tel.: /45 89 42 15 44
Fax: /45 86 13 51 32
E-mail: [email protected]
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