Academic journal article Risk Management and Insurance Review

Implications of Ifrs for the European Insurance Industry-Insights from Capital Market Theory

Academic journal article Risk Management and Insurance Review

Implications of Ifrs for the European Insurance Industry-Insights from Capital Market Theory

Article excerpt

ABSTRACT

The European insurance Industry is currently undergoing a substantial change in financial reporting requirements. Beginning in 2005, compliance with the International Financial Reporting Standards (IFRS) has been required in the European Union. Substantial sections of the IFRS-leading to a market-oriented valuation of insurance contracts-are still under construction and will be introduced in the next few years. To date, assessment of the potential impact of the new IFRS accounting and reporting system is largely found in trade literature, and in insurance industry business leader and expert commentator statements. The tenor of opinion is that the IFRS will create a serious challenge for the European insurance industry. To evaluate the impact of IFRS more scientifically, this article applies-where indicated-capital market theory and the concept of information efficiency. The article suggests that concerns about the effects of IFRS are exaggerated, and reveals that the main area of IFRS impact on the European insurance industry is likely to be on insurance product design.

INTRODUCTION

The 2002 IAS Regulation (Regulation (EC) No. 1606/2002) required European Union insurers whose securities are traded on a regulated EU market to use the International Financial Reporting Standards (IFRS) for financial reporting starting in 2005. The sections of the IFRS specifically devoted to insurance contracts will be substantially revised in the next few years, leading to a market-oriented valuation of these contracts. How the IFRS and, in particular, their focus on market-oriented "fair values" will affect the European, perhaps in the future also the United States,1 insurance industry is not clear. The ongoing discussion of possible implications is largely based on trade literature, insurance industry business leader comments, and ad hoc hypotheses. Some prominent statements in the recent discussion include the following (see, e.g., PricewaterhouseCoopers, 2002; Swiss Re, 2004; Dickinson and Liedtke, 2004):

- Fair value accounting will lead to a significant increase in the volatility of an insurer's equity and earnings. Therefore, the cost of equity capital will increase substantially.

- Insurer efforts to reduce this volatility will lead to economically suboptimal asset allocation and hedging decisions.

- Investment risks will be shifted to policyholders.

- The duration of life insurance products will be reduced substantially.

- The tendency of IFRS to recognize profits earlier will induce a change in dividend policy.

Some of the current hypotheses even contradict each other. For example, many commentators claim that the IFRS will increase transparency due to more, or better, comparable information across companies and countries (see, e.g., PricewaterhouseCoopers, 2002; Swiss Re, 2004). However, it seems possible that because of the reliance of the IFRS on numerous management-set assumptions, e.g., on interest rate or mortality developments when calculating fair values of insurance contracts, transparency will be reduced and the reliability of insurers' financial statements brought into question (see Dickinson and liedtke, 2004; Swiss Re, 2004).

The statements set out above indicate that IFRS may create serious challenges for the insurance industry.2 Therefore, it is important to analyze the consequences of introducing IFRS. The problem, however, is that there has never before been a comparable change in the insurance accounting and reporting world and, thus, there has been no chance to empirically evaluate the hypotheses presented. While Dickinson and Liedtke (2004) did a comprehensive survey of insurance business leaders to ascertain their opinions about this problem, our article looks at the issues of IFRS specifically by using capital market theory and the concept of information efficiency to evaluate the aforementioned hypotheses. We further consider empirical analyses not directly related to the insurance context in order to assess the validity and consistency of the hypotheses. …

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