Securities Commission - Discussion on Life Insurance and Law Practices

PART II - LIFE INDUSTRY LAW AND PRACTICES

Main Contents
Glossary
Part I - Background
Part II - Life Industry Law and Practices
Part III - Public Policy Discussion
Appendices

FINANCIAL REPORTING BY LIFE INSURANCE COMPANIES

Our experience of New Zealand life insurance practice
A financial reporting standard for life insurance business
Life insurance financial reporting in Australia and the United Kingdom
Comment

Our experience of New Zealand life insurance industry practice

9.1
Life insurance companies are "issuers" for the purposes of the FRA. As such they are required to deliver to the Registrar of Companies for registration financial statements which comply with the requirements of that Act, including compliance with applicable financial reporting standards and generally accepted accounting practice. However, as noted earlier (see para 4.17), there is no applicable financial reporting standard for life insurance business and there are number of approaches to life insurance accounting which may be regarded as generally accepted accounting practice. Life companies are also, by Release No 4 issued by the ASRB in August 1994, excused from the application of six SSAPs to their financial statements (see para 4.18).

9.2
We have reviewed each year the financial statements of nearly every life insurance company operating in New Zealand. In our view these financial statements have had many shortcomings. The enactment of the FRA did not significantly remedy these shortcomings because there has been no approved financial reporting standard for life insurance companies available to deal with the peculiarities of life insurance business.

9.3
Among the matters we noted were:

many financial statements of life insurers did not show a "profit" figure in the conventional sense. In these cases it was impossible to determine the outcome of the company's trading for the year from its published financial statements. Companies which reported on the basis of the schedules to the Life Act provided only a "revenue account" and a balance sheet. The "income" or "surplus" figure in the revenue statement took no account of the change in the company's liabilities over the period.⁵² Some Life Act "revenue statements" did not include comparative figures for the previous year;

where financial statements showed something akin to a profit figure it was sometimes not possible to tell the extent to which this profit had been derived from the year's trading and the extent it had been increased or reduced by transfers to or from reserves;

there was inconsistent treatment of unrealised profits and losses on revaluation of investments. Some companies put these changes through the profit and loss or revenue account while others took them directly to reserves;

it was generally not possible to ascertain the level of a company's capital or solvency "buffer" i.e. its shareholders' funds plus the difference between the company's liability to its policyholders and its disclosed level of life insurance funds, because generally a company's actuarially computed liability to its policyholders was not disclosed. This liability was usually not the same as the "life insurance fund" disclosed as a source of funds in the company's financial statements because:

the actual liability to policyholders was less than the stated amount of the life insurance fund; and/or

the liability to policyholders in the valuation (sixth schedule) balance sheet included contingency and other reserves not disclosed in the financial statements; and/or

sometimes investment revaluation reserves disclosed in the company's statement of financial position (separately from what was described as the "Life Fund", but among "Life Assurance Funds") were actually required to cover the company's liability to its policyholders;

a few financial statements disclosed the actuarial liability to policyholders as a memorandum item so that the extent of any "hidden reserve" could be calculated;

there was no distinction in the financial statements between assets attributed to policyholders and those attributed to shareholders;

there was no disclosure of the basis upon which profits had been divided between shareholders and with-profits policyholders, where this had occurred;

there was often no disclosure of the basis on which the company's liabilities to policyholders had been determined;

there was no analysis of the risk concentration of the company's investment exposures broken down, for example, by percentage of total assets;

there was no breakdown of the life insurer's policy liabilities by maturity so that it was not possible to ascertain either the extent to which the life insurer was using the issue of short-term life policies as a means of financing its day to day operations or the extent of any matching or mis-matching of the maturity of its assets and liabilities;

there was generally no statement attributed to the company's actuary as to his or her responsibility for measuring the value of the company's liabilities, his or her assessment of the company's ability to meet its liabilities as they fall due, or his or her assessment of the fairness of the procedures used for setting the distribution of profits as between shareholders and policyholders.

A financial reporting standard for life insurance business

9.4
It has been partly as a result of our awareness of life insurance industry accounting practices that we have been encouraging the Institute of Chartered Accountants of New Zealand ("the Institute") (formerly the New Zealand Society of Accountants ("the NZSA")) to introduce a financial reporting standard for life insurance companies.

9.5
We have been conscious that, with the obligation from October 1997 onwards for life insurance companies to issue prospectuses and investment statements, there should be a satisfactory financial reporting standard for life insurance in place in New Zealand.

9.6 We welcomed the publication of ED-79, Financial Reporting of Life Insurance Business, by the NZSA in July 1996 and we look forward to the exposure draft becoming an approved financial reporting standard as soon as possible.

9.7
It follows from our earlier comments that in our view the new financial reporting standard needs to provide for:

a consistent approach to the valuation of liabilities and the calculation of profit taken by all companies;

a conceptually sound "profit attributable to shareholders" figure reported for all proprietary life insurers;

disclosure of actuarially computed solvency reserves, with an explanation of the meaning and status of those reserves;

disclosure of any difference between the reported level of "life insurance funds" and the calculated actuarial liability to policyholders ;

some analysis of the exposure concentrations, along the lines incorporated in the financial reporting standard for financial institutions (in bands related to percentages of total assets);

appropriate disaggregation of the life insurer's policy liabilities by broad order of liquidity;

disclosure of the basis on which profits have been divided between with-profits policyholders and shareholders;

description of those assets assigned to shareholders and those assigned to policyholders and a description of the principles of segregation, where allocation of assets is asserted;

a statement from the company's actuary as to his or her responsibility for the calculation of the company's liabilities to its policyholders, assessment of the company's ability to meet its obligations as they fall due, and procedures for ensuring the fairness of the distribution of profits between shareholders and with-profits policyholders.

9.8 The ED already addresses a number, but not all, of these issues.

9.9 The Institute has a process underway for considering submissions on the exposure draft, ED-79. It can be expected that the form of the standard will change as a result of the Institute's normal consultation process. Moreover the Institute has committed itself to moving forward with its counterpart organisations in Australia. It is our expectation from discussions in Australia that progress achieved on this joint basis is likely to be slow.

Life insurance financial reporting in Australia and the United Kingdom

9.10 ED-79 is an exposure draft of what is intended to be a joint Australia-New Zealand financial reporting standard for life insurance business. However in Australia the Commissioner, through his rule-making powers, has prescribed financial reporting obligations for life companies, including use of the "margin on services" method of accounting for determining life insurance policy obligations and thus profits. This method is, with some variations, the same as that included in the current draft Australia/New Zealand financial reporting standard. Australian life insurance companies are currently publishing their financial statements on the basis of the Commissioner's rules.

9.11 In the United Kingdom there is no approved financial reporting standard for life insurance business. Companies generally report on a solvency basis. However some life insurers have used, as a supplementary basis of financial reporting, the "achieved profits" method. This is a method put forward by the Association of British Insurers but is one which does not, we understand, have wide acceptance in the UK. (Several companies have used the achieved profits method to report their results in New Zealand.)

Comment

9.12 In general terms we have supported the approach taken in the exposure draft, including its adoption of the "margin on services" method of measuring life insurance company liabilities.

9.13 We do not propose to discuss the various alternative methods of profit determination for life insurance companies in this paper in any detail.⁵³

9.14 We are aware that there are criticisms of the margin on services method of accounting for life insurance profits, particularly as to the predictive value of its reported profit. Mr Richardson-Hay, for example, with respect to the "margin on services" method, said in his paper, "It has a number of fundamental flaws, which make it unusable for any other purpose except as an accounting tool. It will generate a profit figure that may be considered meaningless and misleading. ... If adopted in New Zealand will it replace the current unacceptable system with a meaningless system? ...".

9.15 We think this criticism is too harsh. We understand that the method, despite its shortcomings, is generally accepted by the actuarial profession in Australia, where there is now some experience with using it. Moreover the policy of the FRA is to provide harmonisation of financial reporting standards with Australia and this should be an important consideration particularly as it will facilitate comparisons of the results of companies in the Australasian region.

9.16
The solvency method is generally regarded as too conservative to give a fair recognition of the profitability of a portfolio of life insurance policies. This view is supported by recent experience where the prices paid for life insurance businesses being acquired greatly exceeded the book value of the shareholders' and policyholders' funds.

9.17 We consider there is an urgent need for the adoption of a new financial reporting standard for life insurance business in New Zealand. The regulatory environment under which life companies operate in Australia is fundamentally different from that in place in New Zealand. Because Australian life insurance companies are now reporting publicly under financial reporting rules imposed by the Commissioner there is less urgency in Australia for the introduction of a new financial reporting standard. The basic philosophy in New Zealand is disclosure of information and market scrutiny. That process of scrutiny is hamstrung at present by a lack of coherent financial information.

Footnotes

For example, a company which had received $1,000,000 in net premium during the year, had paid out claims and expenses of $500,000, and had had an increase in liabilities to policyholders over the year of $400,000, would show in its Life Act revenue account a "surplus" of $500,000 for the year ($1,000,000 - $500,000). However its sixth schedule return would show a profit, calculated on the solvency basis, of $100,000 ($1,000,000 - $500,000 - $400,000) after the deduction of the increase in liabilities over the year.
The main methods are the "solvency" or traditional method, the "margin on services" method, and the "achieved profits" method. The differences relate to timing of profit recognition over the period of a life insurance contract. For example, under the solvency method, costs tend to be recognised earlier, as they are incurred, and profits are recognised later, when realised. The achieved profits methods puts emphasis on the work done by the insurer, thus bringing revenue forward to cover the high up-front expenses involved with selling the policies. The margin on services method puts emphasis on the services provided by the insurer, thus spreading the profits more evenly over the life of the policy.

Main Contents
Glossary
Part I - Background
Part II - Life Industry Law and Practices
Part III - Public Policy Discussion
Appendices
INDEX || BACK || FORWARD

Our experience of New Zealand life insurance industry practice
9.1	Life insurance companies are "issuers" for the purposes of the FRA. As such they are required to deliver to the Registrar of Companies for registration financial statements which comply with the requirements of that Act, including compliance with applicable financial reporting standards and generally accepted accounting practice. However, as noted earlier (see para 4.17), there is no applicable financial reporting standard for life insurance business and there are number of approaches to life insurance accounting which may be regarded as generally accepted accounting practice. Life companies are also, by Release No 4 issued by the ASRB in August 1994, excused from the application of six SSAPs to their financial statements (see para 4.18).
9.2	We have reviewed each year the financial statements of nearly every life insurance company operating in New Zealand. In our view these financial statements have had many shortcomings. The enactment of the FRA did not significantly remedy these shortcomings because there has been no approved financial reporting standard for life insurance companies available to deal with the peculiarities of life insurance business.
9.3	Among the matters we noted were: many financial statements of life insurers did not show a "profit" figure in the conventional sense. In these cases it was impossible to determine the outcome of the company's trading for the year from its published financial statements. Companies which reported on the basis of the schedules to the Life Act provided only a "revenue account" and a balance sheet. The "income" or "surplus" figure in the revenue statement took no account of the change in the company's liabilities over the period.⁵² Some Life Act "revenue statements" did not include comparative figures for the previous year; where financial statements showed something akin to a profit figure it was sometimes not possible to tell the extent to which this profit had been derived from the year's trading and the extent it had been increased or reduced by transfers to or from reserves; there was inconsistent treatment of unrealised profits and losses on revaluation of investments. Some companies put these changes through the profit and loss or revenue account while others took them directly to reserves; it was generally not possible to ascertain the level of a company's capital or solvency "buffer" i.e. its shareholders' funds plus the difference between the company's liability to its policyholders and its disclosed level of life insurance funds, because generally a company's actuarially computed liability to its policyholders was not disclosed. This liability was usually not the same as the "life insurance fund" disclosed as a source of funds in the company's financial statements because: the actual liability to policyholders was less than the stated amount of the life insurance fund; and/or the liability to policyholders in the valuation (sixth schedule) balance sheet included contingency and other reserves not disclosed in the financial statements; and/or sometimes investment revaluation reserves disclosed in the company's statement of financial position (separately from what was described as the "Life Fund", but among "Life Assurance Funds") were actually required to cover the company's liability to its policyholders; a few financial statements disclosed the actuarial liability to policyholders as a memorandum item so that the extent of any "hidden reserve" could be calculated; there was no distinction in the financial statements between assets attributed to policyholders and those attributed to shareholders; there was no disclosure of the basis upon which profits had been divided between shareholders and with-profits policyholders, where this had occurred; there was often no disclosure of the basis on which the company's liabilities to policyholders had been determined; there was no analysis of the risk concentration of the company's investment exposures broken down, for example, by percentage of total assets; there was no breakdown of the life insurer's policy liabilities by maturity so that it was not possible to ascertain either the extent to which the life insurer was using the issue of short-term life policies as a means of financing its day to day operations or the extent of any matching or mis-matching of the maturity of its assets and liabilities; there was generally no statement attributed to the company's actuary as to his or her responsibility for measuring the value of the company's liabilities, his or her assessment of the company's ability to meet its liabilities as they fall due, or his or her assessment of the fairness of the procedures used for setting the distribution of profits as between shareholders and policyholders.
A financial reporting standard for life insurance business
9.4	It has been partly as a result of our awareness of life insurance industry accounting practices that we have been encouraging the Institute of Chartered Accountants of New Zealand ("the Institute") (formerly the New Zealand Society of Accountants ("the NZSA")) to introduce a financial reporting standard for life insurance companies.
9.5	We have been conscious that, with the obligation from October 1997 onwards for life insurance companies to issue prospectuses and investment statements, there should be a satisfactory financial reporting standard for life insurance in place in New Zealand.
9.6	We welcomed the publication of ED-79, Financial Reporting of Life Insurance Business, by the NZSA in July 1996 and we look forward to the exposure draft becoming an approved financial reporting standard as soon as possible.
9.7	It follows from our earlier comments that in our view the new financial reporting standard needs to provide for: a consistent approach to the valuation of liabilities and the calculation of profit taken by all companies; a conceptually sound "profit attributable to shareholders" figure reported for all proprietary life insurers; disclosure of actuarially computed solvency reserves, with an explanation of the meaning and status of those reserves; disclosure of any difference between the reported level of "life insurance funds" and the calculated actuarial liability to policyholders ; some analysis of the exposure concentrations, along the lines incorporated in the financial reporting standard for financial institutions (in bands related to percentages of total assets); appropriate disaggregation of the life insurer's policy liabilities by broad order of liquidity; disclosure of the basis on which profits have been divided between with-profits policyholders and shareholders; description of those assets assigned to shareholders and those assigned to policyholders and a description of the principles of segregation, where allocation of assets is asserted; a statement from the company's actuary as to his or her responsibility for the calculation of the company's liabilities to its policyholders, assessment of the company's ability to meet its obligations as they fall due, and procedures for ensuring the fairness of the distribution of profits between shareholders and with-profits policyholders.
9.8	The ED already addresses a number, but not all, of these issues.
9.9	The Institute has a process underway for considering submissions on the exposure draft, ED-79. It can be expected that the form of the standard will change as a result of the Institute's normal consultation process. Moreover the Institute has committed itself to moving forward with its counterpart organisations in Australia. It is our expectation from discussions in Australia that progress achieved on this joint basis is likely to be slow.
Life insurance financial reporting in Australia and the United Kingdom
9.10	ED-79 is an exposure draft of what is intended to be a joint Australia-New Zealand financial reporting standard for life insurance business. However in Australia the Commissioner, through his rule-making powers, has prescribed financial reporting obligations for life companies, including use of the "margin on services" method of accounting for determining life insurance policy obligations and thus profits. This method is, with some variations, the same as that included in the current draft Australia/New Zealand financial reporting standard. Australian life insurance companies are currently publishing their financial statements on the basis of the Commissioner's rules.
9.11	In the United Kingdom there is no approved financial reporting standard for life insurance business. Companies generally report on a solvency basis. However some life insurers have used, as a supplementary basis of financial reporting, the "achieved profits" method. This is a method put forward by the Association of British Insurers but is one which does not, we understand, have wide acceptance in the UK. (Several companies have used the achieved profits method to report their results in New Zealand.)
Comment
9.12	In general terms we have supported the approach taken in the exposure draft, including its adoption of the "margin on services" method of measuring life insurance company liabilities.
9.13	We do not propose to discuss the various alternative methods of profit determination for life insurance companies in this paper in any detail.⁵³
9.14	We are aware that there are criticisms of the margin on services method of accounting for life insurance profits, particularly as to the predictive value of its reported profit. Mr Richardson-Hay, for example, with respect to the "margin on services" method, said in his paper, "It has a number of fundamental flaws, which make it unusable for any other purpose except as an accounting tool. It will generate a profit figure that may be considered meaningless and misleading. ... If adopted in New Zealand will it replace the current unacceptable system with a meaningless system? ...".
9.15	We think this criticism is too harsh. We understand that the method, despite its shortcomings, is generally accepted by the actuarial profession in Australia, where there is now some experience with using it. Moreover the policy of the FRA is to provide harmonisation of financial reporting standards with Australia and this should be an important consideration particularly as it will facilitate comparisons of the results of companies in the Australasian region.
9.16	The solvency method is generally regarded as too conservative to give a fair recognition of the profitability of a portfolio of life insurance policies. This view is supported by recent experience where the prices paid for life insurance businesses being acquired greatly exceeded the book value of the shareholders' and policyholders' funds.
9.17	We consider there is an urgent need for the adoption of a new financial reporting standard for life insurance business in New Zealand. The regulatory environment under which life companies operate in Australia is fundamentally different from that in place in New Zealand. Because Australian life insurance companies are now reporting publicly under financial reporting rules imposed by the Commissioner there is less urgency in Australia for the introduction of a new financial reporting standard. The basic philosophy in New Zealand is disclosure of information and market scrutiny. That process of scrutiny is hamstrung at present by a lack of coherent financial information.