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The Actuary The magazine of the Institute & Faculty of Actuaries

Will it last?

Uk life insurance company accounts are prepared on the modified statutory basis (MSB). The two main problems with the MSB method are:
– it is not always a realistic measure of profit; and
– no value is placed on the shareholders’ interest in with-profit funds.
These problems are overcome using embedded value techniques that value life companies on a ‘net assets plus the present value of future profits’ basis.
So that the information is clear, consistent, and comparable, the Association of British Insurers (ABI) has developed a common framework, the achieved profits methodology (APM), for embedded value reporting. The APM causes problems for the accounting profession as it values future profits. Therefore the APM has the status of ‘supplementary information’ rather than being the basis for primary financial reporting. Bancassurers consolidate the results of their life insurance subsidiaries on an embedded value basis, but not necessarily using the APM. The APM can also be viewed as a benchmark of best practice for embedded value reporting.
In December 2001 the ABI completed its work to develop an APM method, and issued its guidance document (the final version, after draft versions dating back to 1995). It is expected that companies will adopt the new guidance for the 2002 year-end, although many have implemented it already.

The APM guidance
The guidance can be summarised as:
a an active economic basis to be used, derived from market yields and excluding investment smoothing;
b demographic assumptions to be best estimates, unless including risk margins in the risk discount rate would be inappropriate, and to be assessed annually;
c cashflows to be discounted at a risk discount rate which includes a risk premium;
d allowance to be made for ‘encumbered capital’ (in the UK this could be a multiple of the required solvency margin);
e new business to be valued at point of sale, together with any profits up to the end of the year (except investment variances).
The guidance also points out areas where companies need to provide details of the methods used (for instance, the treatment of recurrent single premium policies, critical assumptions, analysis of profit, and sensitivities).
Is it applied?
I reviewed disclosures in the 2001 financial statements of the larger insurance companies and bancassurers to assess the extent to which they applied the APM guidance. The items below are a summary of the main areas.
a + c There appears to be a consensus developing in the life insurance industry on the economic basis and risk discount rate. Most companies assume an equity risk premium (defined as the gross equity return less the gross gilt return) of 2.5%. Many companies assume a risk margin (defined as the risk discount rate less the net of tax gilt return) of around 4%.
b No companies disclose their APM demographic assumptions.
d Many companies disclose clearly their allowance for encumbered capital. However, for the significant number who make no such disclosure, we must assume that no such allowance is made.
e The exact method for valuing new business is not always clear, although most companies give some commentary.
The above examples demonstrate the problems with APM. Companies can apply the guidance in a way that does not achieve clarity and comparability.

Will APM last?
This is a topical question for the life insurance industry. The EU, in its drive for harmonisation, will require all companies to report on a comparable basis with effect from 2005. For life insurance companies this has spurred the development of a new international accounting standard (IAS), expected to require a fair value (ie market value) of insurance liabilities. Such a standard would make the UK’s APM obsolete, as the embedded value in respect of a fair valued liability would be zero. IAS would replace the MSB method, and the approach could be used for solvency reporting and assessing capital requirements. If companies are required to report on an IAS basis, then they are also likely to price their contracts on that basis. In short, the outlook for APM looks bleak.
However, it is not clear that a new IAS will be in place for 2005, so there has been talk of an interim standard. An interim standard could be an embedded value approach where there are many similarities. Many insurers may push for this, as they will already have the systems in place. The UK’s APM could be used as the interim standard, but with certain modifications. In my view, there should be modifications to bring in stricter rules to achieve consistency and comparability, and much better disclosure.