Reliance on Risk Management
Many life insurance firms may not really be aware of the degree to which they are exposed to risk.
When these firms write a life insurance policy, they are immediately exposed to a significant amount of gross risk. Looking at the entire liability book, the risk is immense. Many multiples of capital.
I am not talking about the fact that face amounts of insurance far exceed premiums. What I am trying to point out is that there is a very large amount of risk created by accepting premiums with the guarantee of certain surrender values. (There is somewhat more mortality risk there than many insurers may realize, but it is not significant on a gross basis compared to the interest rate risk on the cash values.)
Insurers tend to forget about this because there is a very longstanding practice of offsetting that risk by investing funds (called the assets) of the life insurer.
The folks who are insisting on market value accounting for insurance liabilities are trying to point out this fact of life.
In many markets, the insurer will then take investment risk – credit or market – with the investments and finally they will do something further that deeply offends the market value folks.
They will split some of the money that they are paid in risk premium with their policyholder/customer.
This practice can probably be traced back to the time when the predominant form of life insurance was mutual life insurance. Under that structure, the policyholder is thought to share the risk of the insurance company, and it therefore makes sense that they would share in the risk premium.
Non-mutual firms found that they could not compete with this because most customers did not understand that they had the choice of one level of return within their insurance policy at a certain level of risk and a lower level of return with a lower amount of risk. The customers usually just saw the net return. Risk was not communicated well. Usually risk was communicated very vaguely while return seemed to be really tangibly conveyed.
So what the market value folks are trying to accomplish is to overcome hundreds of years of confusion about the actual level of risk of an insurer.
You see, risk premiums are usually collected in advance of losses. If an insurer is paying some fraction of its risk premiums to its customers, and it does not have a loss sharing mechanism as is fundamental to a mutual insurance scheme, then it is acting similarly to a leveraged hedge fund.
The resources of the insurer to absorb losses is the capital, but the exposure to losses extends to a much larger pool of insured funds.
So the market valuing of insurance liabilities is really a risk recognition exercize. It is trying to make a point, that point being that the practices of insurers have evolved to become much riskier than what they had been in the past. And the mark to market system would force insurers to acknowledge that additional risk at the point at which they decide to tak on the risk.
Now, it appears that IFRS accounting is heading a different direction. The IASB seems to be backing away from a full mark to market system for assets. This will wreck havoc on the balance sheets and income statements of the insurers who will be marking their liabilities but not their assets to market.
Sort of like the mess that has existed in the other direction for some time not, were insurers in many situations have been marking assets, but not liabilities to market.
Insurance has a reputation for totally opaque financial reporting. It seems that this reputation will continue to be well deserved.
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