Standardization Pains

by Victoria Stachowski with Alice Underwood

In March, I attended a conference in Frankfurt, Germany sponsored by the Center for Financial Studies (Institut für Kapitalmarktforschung). The conference was for European companies considering filing with the SEC, which would enable them to list their shares on stock exchanges in the United States.

The room was filled with accountants and auditors—if there was another actuary in attendance, we didn't meet. In fact, the vast majority of those present did not even work for insurance companies. Nevertheless, two themes running through the conference are relevant to those working in the multinational insurance world: (1) the creation of standardized accounting systems; and (2) the challenges of meeting specific U.S. requirements.

Creation of Standardized Systems

The fact that there is a need to create standardized accounting systems may be a surprise for actuaries working exclusively in the U.S. Yet a multinational company may use several different systems, generally based on different local statutory standards. Historically, financial statements have been designed by different groups in different countries, with each group providing a different perspective or emphasis. Even if the perspective has since changed, the format of the financial statements remains the same for historical reasons.

When business is performed only on a local scale, or the ties between operations in different countries are loose, then the multiplicity of accounting standards may cause few problems. However, as the cold wind of competition blows across the continent, management of multinationals is more interested in comparing apples to apples. At the same time, financial analysts are demanding increased transparency. So, the need for consistent accounting systems has grown.

Adopting any standardized accounting system is a real challenge. One of the speakers outlined three principles required for this adoption. Although the examples discussed at the conference were drawn from accounting-specific issues, these principles also apply to the actuarial processes and results that go into preparing financial statements:

(1) Be willing to change the culture. When an organization has been doing something one way for a long time, it's painful for the organization to start doing it another way. A good example of this in the actuarial arena is the person who signs the reserves. In many European countries this has traditionally been done by an accountant or the CFO. These individuals often do have a great deal of knowledge and experience regarding insurance reserves—and even when they don't, they may be reluctant to yield power to actuaries. It may require time, training, and possibly a directive from the parent company to get this responsibility shifted.

(2) Accept the results. A change in financial reporting techniques will almost always affect the results reported, causing great jubilation for some and bleak depression for others. For example, if a business were holding catastrophe or equalization reserves, releasing those reserves would cause calendar-year profit. If a business were holding discounted reserves, the abrupt unwinding of that discount would hurt calendar-year results.

Furthermore, the rules that help in one calendar year often hurt in the next, and vice versa. After releasing the catastrophe reserves, a catastrophe will eat into surplus. After the discount has been unwound, the next year's investment returns look stronger.

Accepting the volatility inherent in International Accounting Standards (IAS) or U.S. standards can be one of the more painful issues for companies in continental Europe. Of course, it's not always easy for American companies, either.

(3) Develop the infrastructure. Adopting a standard system is no simple procedure.

For example, insurance companies wishing to file with the SEC are supposed to supply ten-year reserve development tables. This means the data need to be collected for ten years. This also means teaching the people in the different countries what these data mean, and making sure that these definitions are applied in a consistent and correct manner. For example, what is the definition of IBNR (reserves for future catastrophes may once have been included) or reinsurance (risk transfer may not have been required in the past)? The definitions are not always consistent across borders, and different rules may have been applied historically.

Moreover, it is not simply a matter of training the local employees. There must also be local auditors for reviewing the numbers. They, too, need to understand the procedures and the meaning of the rules.

Keep in mind that these actuaries, accountants, and auditors may now have to create and maintain two or more sets of reports to comply with dual sets of rules. The parent company may have adopted an accounting standard, either for management or for group financial reporting purposes, but local legal entities still have to file reports with local regulatory authorities that conform with local statutory accounting standards.

Meeting Specific U.S. Requirements

The two main accounting systems most companies consider are U.S. GAAP (Generally Accepted Accounting Principles) and IAS. A company will choose one or the other based on its needs and goals, and based on which system it believes will best present its business. However, if the firm wishes to file on a U.S. stock exchange, it must opt for U.S. GAAP, or else file IAS and provide a reconciliation to U.S. GAAP.

U.S. GAAP, according to virtually everyone I spoke with at the conference, is the most detailed and prescriptive set of accounting rules in the world. This can be frustrating to some would-be filers with the SEC, who claim that these rules distort the picture and prevent them from telling the story they are trying to tell. Representatives from the SEC at this conference did not appear generally receptive to this complaint and emphasized the desire to protect American investors and the need for comparability between companies.

Nevertheless, there appear to be situations for which U.S. GAAP makes little sense. Tracking down all the requisite information may not be possible, and the results could be nonsense. For example, U.S. GAAP mandates that real estate held for investment be valued by applying depreciation factors to original cost. The difficulty here is that some European companies have been using the same property literally for centuries. (To be fair, the SEC appeared willing to listen when foreign companies have genuine issues.)

Of course, no one is forcing companies from European or other countries to file with the SEC. The world outside the U.S. contains many stock exchanges. However, there can be strong business reasons for filing with the SEC and being listed on a major U.S. stock listing:

(1) Easier access to the U.S. capital markets, which are the largest in the world.

(2) Greater name recognition by American customers.

(3) More flexibility in mergers and acquisitions, in that the firm's shares become a vehicle for merging with or acquiring other companies listed in the U.S.

(4) Increased ability to hire and retain U.S. employees, because firms listed on a U.S. exchange can give their American employees U.S. stock options, which are essential in some industries for retaining personnel.

The implementation of a standardized and internationally recognized accounting system—whether U.S. GAAP or IAS—is no minor undertaking for a multinational insurer. But as international consolidation in the industry continues, and as more foreign firms work towards a U.S. stock listing, this is a challenge that many insurers face. Those insurers need actuaries as well as accountants to make it happen. While the process can occasionally be painful, standardization facilitates transparency for regulators, financial analysts, investors, and, last but not least, for those managing the business.