Brussels - Europe is bracing for two major accounting reforms in the insurance industry, but most fear that the schedules could extend to at least 2007 and possibly to 2010.One of the reforms currently in the pipeline will consist of IFRS4 Phase II, or "Insurance Phase II." This will eventually replace the Phase I version - a measure currently in place that has not radically shaken up traditional regulations.

Also in the regulatory upheaval is Solvency II, which concerns steps to harmonize capital requirements for insurance companies across the European Union's 25 countries.

"We are living in the age of the dinosaur," said Paul Sharma, of the U.K.'s financial services regulator, the Financial Services Authority. "And we look forward to an extinction!"

Sharma's comments were delivered at a recent meeting of the European Insurance Federation, or Comité Européen des Assurances, in Brussels.

Karel van Hulle, who oversees insurance at the European Commission, said that the upgrades would take time, although that did not mean that "the insurance companies in Europe are not well regulated. After all, there is also Solvency I, to which they are presently subjected."

Van Hulle said that Insurance Phase I is a provisional regime: "It is not a solution to stay. We should move on to Phase II as soon as possible."

Another speaker at the CEA meeting, Tom Jones, the vice-chairman of the London-based International Accounting Standards Board, said that he thought that a speedy solution of the outstanding issues concerning IAS 39 that particularly affect the insurance industry "seemed unlikely."

There may be debate over whether the industry in Europe has been over-regulated in some countries and under-regulated in others. However, many believe that there is no dispute that drastic reorganization and harmonization of accounting regulations is an urgent need.

A start to a program calling for more solid regulation came in 2001, with the European Commission's plans for the Solvency I Directive. However, it was soon realized that tougher measures were required, which put Solvency II on the track. A framework version of it is planned for publication next year. It could follow roughly the forthcoming Basel II Directive, its partner designed to strengthen capital requirements for European banking.

Across Europe, insurance firms traditionally have had to follow conservative rules, said Paul Rutteman, secretary general of the European Financial Advisory Group, which coordinates technical advice to the commission's accountancy regulation committee. The firms have been required to understate assets and overstate liabilities, he explained.

This situation, he clarifies, results from history, with national governments determined to protect the savings of their citizens by guarding against loss over the long term.

Rutteman explained that under the current Phase I ruling, companies record most investments at fair value but allow liabilities to continue to be booked on a cost basis.

An exception would be bonds being held to maturity, which can be booked at amortized cost. However, the overall situation gives rise to a mismatch, leading to "artificial" volatility, as assets swing in value over time while liabilities, such as the eventual payoff on a life policy, remain reasonably steady.

The aim of Phase II should be to find a system for Europe that would reflect both sides of the balance sheet, assets and liabilities, at fair value. This would prevent the mismatch seen at present, said Rutteman.

A problem blocked under Phase I was the option under which firms had falsely boosted profit by precipitously selling off assets that would normally have been held for years. Accumulated gain could be shown as instant earnings.

The formal view of the CEA is that there is a need to reflect the economics of insurance in the accounting regulations. There must be consistency between the measurement basic of insurance liability and of the assets backing those liabilities. This consistency could rely either on market-based information or on amortized cost.

Some surmise that behind some of the CEA's thinking could be the issue that it is difficult to determine the fair value of a life insurance contract as an asset. The future obligation cannot be sold on any market. Moreover, it would be virtually impossible to find assets to cover such a liability, which finally matures decades later.

Volatility vs. reality

As a rule, insurance companies try to steer away from value accounting, because of the volatility it can cause. They ordinarily seek a smooth rate of return.

In the U.S, Rutteman said, the assets of an insurance company are booked at fair value, while liabilities are booked at cost. However, adjustments are made to remove the volatility arising from the mismatch - under so-called "shadow accounting." Cost of sales is allocated over the whole period, to produce more level profitably.

However, the regulations are under survey anyway, driven in part by the interests of cohesion with international accounting standards. The IASB is pushing legislation in Europe down the route of fair value for assets and liabilities, while the U.S.-based Financial Accounting Standards Board is thinking of going down the same route.

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