Journal :: With-Profits Accounting Standards

Published: December 19, 2005
Author: Graham Dragon
Category: Back Office
Permalink: With-Profits Accounting Standards

This article was written by Graham Dragon of Adviser Breakthrough Solution, and was originally published on the 10th of November 2005 by Financial Adviser. ? Copyright Financial Times Business Limited - 2005.

If you advise on with-profits funds you will be aware that since May 2004 the FSA has required more transparency in

with-profits funds, with the publication of the Providers? Principles and Practices of Financial Management. There has, however, been a further significant development since that date ? the publication of Financial Reporting Standard 27 (FRS 27). This standard has similar objectives ? a greater disclosure in the accounts of the potential liabilities of the fund and in some cases a more conservative accounting treatment. The combination of both the FSA requirement and a new accounting standard for with-profits means that intermediaries should perhaps be more circumspect and diligent when reviewing with-profit recommendations to clients. More information than ever before will be available, and we need to ensure we have absorbed it before finalising a recommendation.

One of the recommendations of the Penrose Report into the circumstances surrounding the Equitable Life affair was that the

accounting for with-profits should disclose a realistic position of the with-profits fund in a clear and simple way. FRS 27, published nine months after that Report, was a knee-jerk reaction to this recommendation. As such, the Accounting Standards Board recognises that the Standard has not addressed all the relevant issues, but believes it nevertheless ensures future financial reports of life assurance companies will be significantly improved as a result.

FRS 27 applies to accounts with periods ending after 22nd December 2005, so if we were relying only on the requirement of companies to adhere to standard accounting practices it would be some time before we started to see the results in practice.

There are also two major categories of insurance company that are not required to apply FRS 27:

• Smaller companies
• Companies that apply International Accounting Standards

Probably most of the larger insurance institutions will be applying the International Standards. It does not seem to me, therefore, that there would be many insurance companies in the void between these two categories and that would therefore have to apply the standard. So at first glance it would almost appear the standard is meaningless. There is little point in having a ?standard? that virtually nobody is required to follow!

However, all the major insurers and bancassurers have formally agreed to adopt the standard for accounting periods ending December 2004 and onwards. This is despite the fact that most are not required to adopt it even when it comes into force

fully from the end of this year. It is therefore only the smaller insurance companies who are likely to continue publishing accounts that do not comply with the standard and that may not address at least some of the issues raised in the Penrose report.

FRS 27 has focused on improved reporting of the financial position rather than of financial performance. What the company
has, rather than what it has done. The main areas addressed by FRS 27 are:

• Proper disclosure of the capital of the insurer, including the extent to which different parts of the business have access to that capital;
• Proper recognition of the liabilities represented by the implied obligation to pay future bonuses;
• Clearer and more transparent valuation assumptions;
• A change in the measurement of embedded values ? this relates to a different method of analysing financial position and tends to be used in the main by bancassurers.

Particular problems arise with disclosure of potential future liabilities from as yet undeclared bonuses. How do you determine what that liability is likely to be when the management have the discretion whether or not to declare a bonus? In the past the answer has been that there is no real liability yet and therefore nothing to disclose. Policyholders expect bonuses to be declared, of course, and would eventually leave in droves if they felt that no bonuses would ever be declared again. There is, therefore, a ?real? liability there, albeit hidden and difficult to measure.

FRS 27 now requires a disclosure of this rather nebulous liability. In one method of calculating it, the ?prospective valuation method?, the company is required to take account not only of the likely future bonuses it will declare, but also the premiums policyholders would need to pay in order to benefit from those bonuses, the administrative costs associated with those premiums, and the likely investment returns. Then all those numbers have to be ?discounted? back to the present day in order to take account of inflation. Certainly not a simple exercise! And also not very precise. What bonuses will the Directors declare? How many policyholders will lapse their premiums? What investment returns will be obtained? And what will be the rate of inflation? By the time all those unknowns have entered the equation, the value given to future liabilities seems rather suspect, but both the FSA and FRS 27 still requires the company to report on this.

Reading between the lines of the Accounting Standards Board report to HM Treasury last July, it is likely to be many years before there are really satisfactory standards in place for life assurance financial reporting. The Board sincerely believes that, with the combination of the FSA ?Providers? Principles and Practices of Financial Management? and FRS 27, policyholders can now place much greater reliance on the reports from insurers on their with-profits funds. But the Board also recognises that things are far from perfect.

The Accounting Standards Board feels clearer and better reporting is required generally, not just in respect of with-profits funds. However, it is particularly in the area of with-profits that policyholders need greater protection and more advance warning when things start to go wrong.

Advisers should continue to take very great care when recommending investment into with-profits funds. Despite all the noise there has been from both the regulator and the accountancy profession since the problems of Equitable Life first surfaced, it will be a long time, if ever, before we can rely on an insurance company?s financial reporting when assessing the risk of a with-profits investment.

There has been a great deal of argument about the pros and cons of with-profits versus Unit Linked funds. I do not intend to be drawn into that argument here. This is an issue over which each financial adviser must make his or her own decisions ? and many will continue to take a balanced view, considering with-profits funds suitable for certain types of client and not for others.

What is clear from the Accounting Standards Board report to the Treasury on this new accounting standard, however, is that we all need to continue taking great care when selecting with-profits funds for our clients. In the past it was possible for an insurance company to obfuscate and obscure many of the weaknesses in their with-profits funds, and therefore it may have been reasonable for an adviser to argue that he or she could not have recognised those weaknesses. Now, however, this argument is unlikely to hold up. The writing will now be on the wall for all who can read it to see. The trouble is, it will be written in a language that many will find incomprehensible (try reading FRS 27 yourself if you do not believe me).

The recent report by AKG Actuaries and Consultants, which showed that intermediaries seem to have taken little notice of the Providers? Principles and Practices of Financial Management, seems to underline this conclusion. It is certainly not easy trying to get to grips with some of the language used. The report to the Treasury was scattered with terms like ?fungibility?, ?stochastic modelling?, and ?embedded value disclosures?. The commercial lawyers amongst you will be familiar with the first term, and actuaries will be quite comfortable with the others, but advisers who have not studied the theoretical basis of with-profits in depth may well find themselves straying outside their comfort zone when confronted with language like this.

The FSA, the Ombudsman, and even the courts will, however, no doubt take the view that if you are recommending with-profits investments you cannot at the same time claim ignorance of the language in which the reports relating to those investments are written. Whilst we may not be able to rely fully on an insurance company?s reporting, it is another thing entirely to ignore it altogether. So if you intend to continue recommending with-profit investments, perhaps now is the time to get to grips with the terminology and learn how to read between the lines of the FRS 27 compliant reports we will shortly be seeing.

Graham Dragon ATT
Adviser Breakthrough Solution

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