An accounting change too far

This time though it is not the accountants who are in the driving seat and it is not banks and pension funds in the firing line. The coming change under discussion is the proposal that the life assurance companies should from late next year use new standards to replace — or rather enhance — their embedded value approach to calculating profit with something called MCEV, market consistent embedded value.

The motive is honourable enough. The accounts of life offices are like the ­Schleswig Holstein question beloved of 19th-century historians, which was said to be understood by only three people — one dead, one mad, and one who had forgotten. The core problem is that life assurance is a long-term business, and it is only when the contract matures after 25 years that the company can genuinely say how profitable it has been. To overcome this, various accounting techniques have been ­developed to assess and recognise implied profit throughout the life of the contract. Unfortunately, the resultant accounts are complex, the jargon impenetrable and the permitted ­variations so considerable that even the best analysts find it difficult to compare one life assurer with another.

Thus for the best of intentions the chief financial officers' forum — a club of the senior financial executives from European firms — decided they should overlay this with a new measure which in essence grafts fair value accounting on to what they do at present by marking all the long-term assets to market.
This might have seemed a good idea at the time, but as implementation looms next spring a lot of British companies are getting cold feet. Not surprising, since it will have a devastating effect on declared profitability.

In the words of one finance director, a company will in essence declare 24 years of losses on a life contract then a colossal profit in year 25. This is because everything in the balance sheet which relies on an equity return is going to have to be discounted at the very much lower risk-free rate — until it matures and is found after all to have made a substantially greater amount.

It hits companies differently, depending on the mix of equities and bonds in their portfolios, and, ­crucially, on the mix between conventional policies and unit-linked — the latter being held at market price already. That can make it even more ­mystifying — Prudential will suffer here yet not in Asia.

Arguably, therefore, it will be even more confusing than what we have now — and it certainly seems to have wrong-footed even the best of the analysts, who having done the sums themselves, have come out with wildly differing results.

In the bearish corner sits Andrew Crean at Citigroup. He claims that four of the five UK life players will see an adverse impact on embedded value and new business profits — with falls, or at least the perception of falls, of 20% plus in the latter. But Crean's estimates vary significantly with those of Greig Paterson at KBW, who has a fall of only 5% in new business profits.

And just as the sector averages diverge, so do the estimates for individual businesses, all of which raises doubts about the ability of the analysts to agree on balance sheet values of these businesses under MCEV prin­ciples. This is hardly the time to start raising additional, unnecessary doubts about insurers' balance sheets.

It is tempting to blame the accountants, but as this does not come from them it counts as supplementary disclosure rather than a new accounting standard. The net effect is the same. All will have to comply: those who don't will be accused of hiding something — unless they all refuse to comply. They should be encouraged down this course. Comparability is indeed a problem, but this is quite the wrong answer.