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Fair Value Accounting: Volatility and Smoothing. Allan Brender ETH Zurich 7 June 2004. The Story of a Company’s Financial Progress. Investors require a standard basis for this story to have comparability among companies Hence, IOSCO pressure on IASB

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Fair Value Accounting:Volatility and Smoothing

Allan Brender

ETH Zurich

7 June 2004


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The Story of a Company’s Financial Progress

  • Investors require a standard basis for this story to have comparability among companies

  • Hence, IOSCO pressure on IASB

  • Establish uniform international standards for financial reporting, for all business activities


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The Story of a Company’s Financial Progress

  • Financial statements and reporting have uses other than to inform investors:

    • Regulation

    • Taxation

    • Management compensation

  • These can lead to distortions and manipulation of the system


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International Accounting Standards Board

  • Establish international financial reporting standards or international GAAP

  • Standards are for business activities

    • Standards for insurance contracts, not insurance companies

    • Some insurance company products (e.g. deferred annuities) are not insurance contracts

    • Some elements (e.g. equalisation reserves) will not be considered to be liabilities


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Financial Instruments

  • IAS 32, 39 – financial instruments (other than insurance contracts)

    • IAS 32: disclosure and presentation

    • IAS 39: recognition and measurement


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Measurement of Value

  • If a financial asset is held to maturity, it can be measured at amortised cost

    • Trading is not a consideration here

  • IASB’s general position is that most assets and financial liabilities can be traded; market value should be the measurement standard


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Market Value or Fair Value

  • An active market in a particular financial asset or liability may not exist

  • Determine fair value, the price that willing arm’s-length buyer and seller might agree to

  • The value of certain exotic assets is determined through use of models – questionable

  • Revision to IAS 39 : verifiable market value


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IAS 39

  • Hold to maturity – value at amortised cost

  • Available for sale – market value, but changes do not pass through profit or loss (until time of sale)

  • Trading – value at market with changes passing through profit or loss

  • New proposed fair value option


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IFRS 4 – Insurance Contracts

  • Phase 1(2005):

    • Continue current liability valuation

    • Do not net reinsurance

  • Phase 2 (?):

    • Forward-looking valuation

    • Assumptions: best estimate plus market margin

    • Discounting at market rates

    • Recognize own credit rating (?)


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What is Fair Value?

  • London Life (LL) – 4th largest Canadian life insurer

  • Royal Bank of Canada (RBC)– largest Canadian bank

  • Great West Life (GWL)– 3rd largest Canadian life insurer

  • RBC agreed to buy LL for CAD$ 2.4 billion

  • GWL bought LL for CAD$ 2.9 billion


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What is Fair Value?

  • What assumptions should be used in valuation?

    • The market’s

    • The company’s

  • How will we determine market value margins?

    • How will these compare to margins for adverse deviation?


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Volatility

  • Using fair values will introduce considerable volatility in financial reporting

  • Asset / liability matching (ALM) can reduce volatility if it is recognized in accounting

  • Canadian Asset Liability Method

  • BUT accounting theory holds assets and liabilities to be independent

    • Not necessarily consistent with market behaviour


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Volatility

  • Under current version of IAS 39, volatility would be distorted

  • Proposed fair value option

    • Contains an embedded derivative

    • Financial liability linked to assets valued at fair value

    • Exposure to changes in fair value is substantially offset by changes in value of another financial asset or liability


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Smoothing: response to volatility

Consider the following example:

  • Stochastic valuation of variable annuities with minimum maturity guarantees

  • Based upon CTE(x) = TVaR (x) = E{X X>x}


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Smoothing: response to volatility

  • Current industry proposal to formally smooth capital requirements

  • Supporting arguments are based upon imprecision of the calculation

    • Do not recognize the volatility is a reflection of the market

  • “If one is comfortable with smoothing capital volatility, then income volatility should be smoothed as well and possibly more so”


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Protecting the Integrity of the Financial Reporting System

  • Auditors

  • Actuaries

  • Analysts

  • Regulators


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Discussion

www.osfi-bsif.gc.ca