Posted by: Daryl & Wendy Ashby | October 22, 2010

Tough Times for Insurance Companies

International Financial Reporting Standards (IFRS) is a new accounting standard coming into force in January 2011 (except for the U.S.; think of IFRS as the metric system of measurement for accountants; it works for everyone but the Americans). Only geeky accounting folk are excited about the introduction of IFRS. But for investors, it may have a large impact.

As I posted earlier, the insurance stocks as a whole is experiencing a downturn which is more structural in nature than company specific. IFRS will only make the situation worse in the short term. As reported in Advisor Magazine, the board which governs how IFRS is applied is proposing new valuation rules starting 2013 which would require insurers to value their assets on an almost risk free discount rate for present value policy liabilities (i.e. payouts of policies).

In plain English, the accountants are asking the insurance companies to value their policies as if they would all be paid in full and making them set aside money for this contingency (or liabilities on the balance sheet are being increased and more assets are required to balance off liabilities). The problem is the more capital being used to meet present policy liabilities, the less policies insurance companies can offer or less capital can be used to expand into new products/markets.

Alternatively, insurance companies have to offer shorter-term policies (since liabilities are more knowable in the short term) which typically means more assets have to be set aside to pay out those policies whereas in long term policies the insurer does not have to worry about paying out the policy so soon and be less risk adverse with their investing of insurance premiums (which is how Manulife got caught short).

(… the best analogy is imagine the government required all new homeowners to set aside money to replace the roof. Typically, if the roof does not need to be fixed for 10 years, the amount of money set aside in year 1 would be quite modest. But now the government imposes a IFRS roof fixing regime where you have to set aside money to fix the roof as if it was year 9, and you have to catch up from year 1-8, even if you only bought the house and you have 10 years before the roof needs replacing. Setting aside this money, which cannot be touched, puts a big dent on your balance sheet and cash flow. This is the insurer’s problem in a nutshell).

IFRS is also impacting other sectors. The Globe ran an interesting column on how IFRS will affect Shoppers Drug Mart and perhaps cut same store sales figures (a key metric in retail). IFRS is one of those creeping issues few investors are concerned with but it may create some short term distortions to quarterly financial reports

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