Transparency of financial statements

During the financial crisis, a lack of transparency about who held what risks and uncertainty over valuations knocked confidence in the financial sector. Our Chief Risk Officer Raj Singh makes the case for greater transparency in financial reporting practices.

In the wake of the turmoil, regulators and lawmakers are seeking to minimise risks of a reoccurrence of the liquidity crisis and rebuild confidence in financial markets by encouraging greater transparency in financial reporting. This should include measures such as fair value accounting, a practice that many insurers and reinsurers already apply in the form of market-consistent valuation of assets and liabilities, says Singh.

At a conference hosted by the Comite Europeen des Assurances (CEA), Raj Singh gave his view on how inaccurate or insufficient financial information could have contributed to the crisis by reducing confidence; how transparency needs to improve and why there is an argument in favour of a market-consistent approach to valuing assets even if it does run the risk of aggravating the downturns in financial markets.

Market-consistent approach

Valuing the assets and liabilities of a business is an essential measurement of any enterprise. A market-consistent approach allows companies to value their assets and liabilities for accounting purposes according to the prices they are currently fetching in the market. The advantage of market-consistent valuation is that it gives a clear, timely and economic view of the risks that are carried by companies and thus allows them to adjust their capital accordingly.

“Market consistency is not a golden bullet but it creates the essential foundation for valuing a portfolio and ensures that the important questions are answered,” said Singh. These questions include whether there is a reliable market for these assets; what market participants believe the asset is worth; what assumptions underlie these valuations; and how different it could be in the future and thus what capital might be required.

Many insurers and reinsurers in Europe already value their assets and liabilities according to market values. This approach forms the basis of advanced risk and capital management frameworks and should underpin any modern supervisory system. For insurance liabilities, which are usually not traded in liquid financial markets, market consistent valuation means that components of the insurance liabilities that can be replicated in liquid financial markets are valued at market values, and the components that cannot are marked to model. The same approach is applied to value assets. In illiquid markets, a mark-to-model approach could be used.

Risk of procyclicality?

However, some have noted that the practice of market-consistent valuation is inherently problematic in times when no market exists and it may run the risk of exacerbating the decline in asset values during a downturn by forcing all of those that hold assets which are falling in value to recognise their losses on paper at the same time. Clearly, supervisory practices must be flexible enough to avoid procyclicality and the exacerbation of an already difficult situation. A decrease in available capital due to distressed market prices for assets should not lead to immediate regulatory intervention.  

Nevertheless, the principle of market-consistent valuation for both assets and liabilities of (re)insurers should prevail, said Singh, adding that regulators should avoid the temptation to introduce accounting measures to counteract these potential procyclical effects. That would run counter to the spirit of increasing confidence in financial reporting.