Does it hit the mark?

Accounting’s boring, right? Well, maybe but, for insurers, it has just got very important.

Under rules called mark to market, or fair value, financial institutions have to value their assets at today’s market price for regulatory purposes – and in the current economic climate, that means they are losing billions, on paper at least.

Solvency II, the new European regulatory regime due to come into force next year, is underpinned by the mark-to-market principle, so the problem is about to get bigger. Led by the ABI, a number of insurers have seized the chance to speak out against mark to market and lobby for change under Solvency II. But will they be successful – and what’s the alternative?

At the Global Financial Leadership Forum last November, Stephen Haddrill, director-general of the ABI, said: “In the UK we have confidence in prudential regulation. There is, however, one area that concerns us – fair value. To be clear, we do support fair value for accounting purposes. But not in all circumstances for regulating capital. There does come a point as markets crash when fair value becomes pro-cyclical. Regulators need to judge when such rules must be suspended.”

Insurers are against fair-value accounting for this reason too. “I’ve never been in favour of mark-to-market accounting – the current market turmoil shows us the drawbacks,” says Jean Drouffe, finance director of AXA.

“Mark to market is good when you have a market. But sometimes, as it is at the moment, you don’t have a market for the assets. You don’t have transactions as people don’t buy or sell and therefore it does not represent a real value for assets. Then it’s dangerous to use this measure.”

The flaws of mark-to-market accounting have also cast doubt over the otherwise popular Solvency II. Under the incoming European regime, an insurer’s assets will also have to be given a market valuation at any point in time, and its capital adequacy will be assessed on the basis of this valuation. Philippe Maso, chief executive of AXA Insurance, said this was not fair because valuations could be artificially low at times of market turmoil and insurers would need to hold more money to meet potential claims or risk being declared insolvent.

Insurers have been lobbying the MEPs steering the Solvency II legislation through Brussels to revisit mark to market in the light of the credit crunch. However, with the legislation bogged down in squabbles between European member states, they have yet to meet with success.

So far, it’s the banks that have been the most vocal about the flaws of the accounting method. Last spring, the Institute of International Finance (IFF), an alliance of more than 300 companies, chaired by Josef Ackermann, chairman of Deutsche Bank, called for the rules to be relaxed so companies could value assets using historical measures rather than current market prices.

But not everyone agrees that this is the answer. Goldman Sachs quit the IFF after it criticised fair value. Lucas van Praag, a spokesman for Goldman Sachs, said: “We believe that in times of market stress it is particularly important to be rigorous about the value of your assets and liabilities.” Van Praag also labelled the IFF’s plan to change the standards as an attempt to adopt “Alice in Wonderland accounting”.

Is there a better idea?

The alternative to fair-value accounting is to use a cost-based approach. “This is where the firm looks at what it paid for something and then makes a reasonable judgment about its impairment over time,” explains Steve O’Sullivan, head of Accenture’s finance risk and regulatory practice in the UK.

“But on the basis that it’s going to hold it to maturity, the actual market value doesn’t actually matter. So, for example, if you buy a bond with a five-year maturity and hold it to maturity, all the prices in between don’t really bother you. But if it halves in value along the way and you have to account for that, clearly that gives some concern.”

Drouffe says you have to take into account market movements on instruments such as corporate bonds, but he is largely supportive of the cost-based approach. “Something which is closer to historical value for certain class of assets should be used. If it’s just market hiccups, I don’t think we should take that into consideration in our accounts.”

But there is a reason why fair-value accounting is in place, insists O’Sullivan. “If companies end up deciding, they may be prone to optimism rather than the enforced rigour of the market.”

So is fair value “fair”? The problem is that no system is perfect, says O’Sullivan. “Fair value clearly makes some assumptions about liquidity but these aren’t always true.”

John Charles, principal in the Tillinghast insurance consulting business of Towers Perrin, points out how markets can give a false impression: “More or less all share values have fallen drastically over the past six months. That can’t truly reflect the underlying values of those companies and the amount of their future dividend stream.”

He adds that, even in good times, the system has flaws. “There was a period when corporate bonds showed hardly any spread between the gilts at all. In other words, the market was saying there is no possibility of these bonds defaulting, which any sensible person would have realised is equally untrue.”

Because assets are constantly falling, the problem – particularly since the virtual meltdown of mortgage-backed securities – is that banks and other financial institutions are stuck in a constant loop. O’Sullivan explains: “The securities come under stress, the firms are forced to mark to market, which means they need to hold more capital because these securities have declined in value, which invariably means they have to sell some securities, which means the price tends to fall, which means they have to hold more reserves. As you can see, it all ends up in this death spiral.”

This situation has led to billion-dollar losses, says Charles of Towers Perrin, particularly for banks and insurers that have ended up holding toxic assets. “No one wants to buy them, so the price is considerably less than what the economic value might be. It doesn’t mean they [banks or insurers] have increased their exposures; it’s simply that the market price is falling.”

Insurers argue that mark-to-market accounting is especially unfair for them. Many tend to hold assets for long periods, so it’s unreasonable to value assets at their current price if there is no reason for the company to liquidate them there and then.

O’Sullivan says insurers would like to work on a more actuarial view, one that takes a reasonable view of what is happening in the market but is not necessarily subject to the short-term volatility of that market. “It’s a problem for insurers as they don’t want to account for, in a really brutal way, changes to their portfolio, particularly in stressed markets,” says O’Sullivan.

While the debate around fair value rages on, both camps accept that there is no system available that could legitimately replace it. “The alternatives are by no means better,” says Charles.

O’Sullivan adds: “If fair value stops reckless behaviour that’s a good thing, but if it also stops reasonable behaviour that’s not good. But there are unintended consequences that need to be highlighted and carefully managed.”