Topics IFRS – New accounting standards Flood risks Rising costs of bodily injury claims

Topics 2/20

  2/2004

IFRS – New accounting standards Flood risks Rising costs of bodily injury claims Münc hener Rüc k Munic h Re Gr Münchener Rück Munich Re Group

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  oup English

  Munich Re, Topics 2/2004 Editorial

  In the interests of its clients, Munich Re is constantly monitoring current and future developments. In doing so, we have to keep a close eye on many aspects, as the range of subjects that insurers have to deal with nowadays is steadily expanding. This issue of Topics demonstrates the point perfectly.

  For example, International Financial Reporting Standards, also known by the abbreviation IFRS: an area that was formerly the preserve of actuaries and accountants is gaining in importance as a competitive factor, not least because investors and clients demand fast and transparent reporting.

  But prompt action is required in other areas as well. The speed at which we have to develop solutions for new risks is increasing all the time. The articles in this issue of Topics underline our desire not just to keep pace, but to stay one step ahead at all times: whether we are talking about our joint efforts with the major rating agencies to find the right type of accounting standards for insurance contracts, our interest to learn more about the new flood model developed by experts from Norwich Union Insurance, or our proposal for a new definition of single loss events in flood insurance.

  Christian Kluge Board member responsible for Corporate Communications Munich Re, Topics 2/2004 Contents

  IFRS – New accounting standards

  The new accounting standards for the insurance industry will be introduced in two phases. However, it is primarily Phase II that will bring significant changes for insurers. The insurance industry and the rating agencies agree that we are still some way from finding a perfect solution.

  Status Fair-value accounting – Current status of the discussions

  Will the fair-value approach change the basis of insurance business?

  Page 6 Insurance There is no perfect solution

  Round-table discussion in London with experts from the rating agencies A.M. Best, Fitch, Moody’s and Standard & Poor’s

  Page 10 Opinion

  IFRS – Bridge between internal management and external reporting obligations?

  A statement by Munich Re Board member Dr. Jörg Schneider

  Page 16

  Rising costs of bodily injury claims

  Economic and insured losses from floods increased so dramatically in the 1990s that the insurance industry has been forced to optimise its risk management of extreme floods. This process includes a clearer definition of occurrence clauses and more sophisticated flood models.

  A commentary by Dr. Gerhard Berz, head of Munich Re’s Geo Risks Research Department.

  Page 28 Policyholders and insurers have to act

  A Munich Re proposal for defining flood events

  Page 26 What constitutes a flood event?

  Flood models are becoming increasingly sophisticated

  Page 20 A few metres can make all the difference

  Interview with experts from Norwich Union Insurance about its new flood model for the UK

  New maps are needed

  Page 44 Flood risks

  The costs of serious bodily injury claims in motor liability insurance have risen drastically in recent years, especially in France and the UK. New partnership models are needed as a long-term solution.

  Interview with Munich Re experts Giuseppina Albo and Margarita von Tautphoeus

  Page 43 Social law merges with private liability law

  Munich Re’s rehab project

  Page 38 Helping people find their way back in everyday life

  Advances in medical technology and changes in legal parameters are the chief causes of rising costs

  Page 36 Tracking down the cost drivers

  Interview with Willi Rothley, President of the Institute for European Traffic Law

  We must be objective and totally impartial

  Page 32 Contents Munich Re, Topics 2/2004 Munich Re, Topics 2/2004

IFRS – New accounting standards

  From 2005, listed insurance companies in the EU will have to draw up their consolidated financial statements on the basis of the International Financial Reporting Standards (IFRS), formerly known as IAS. For practical reasons, it has been decided to implement IFRS in two stages for the insurance industry, with the first changes coming into effect from 2005. However, it is the second phase of changes from 2007 that will bring really significant changes for the insurance industry.

  Today’s accountants need more than just a pocket calculator to draw up their balance sheets. The planned switch to a single set of international accounting standards poses a range of challenges for the insurance industry, especially in the field of IT.

  Status Fair-value accounting – Current status of the discussions What will IFRS mean for insurers? While the standards IAS 32/39 already stipulate the requirements on the assets side, and admittedly these are not universally popular, the regulations for liabilities have not yet been finally defined in IFRS 4.

  IFRS – New accounting standards Munich Re, Topics 2/2004

  From 2005, all listed insurance companies in the EU will have to base their group financial statements on International Financial Reporting Standards (IFRS). However, managers in medium-sized companies would also be well advised to find out all they can about IFRS. As of 2007, IFRS accounting will also be obligatory for all companies that have issued debt instruments. Another point insurers will have to bear in mind is the possible increase in capital requirements from Solvency II. According to paragraph 1, the IFRS 4 standard for insurance contracts valid as of 2005 is merely a provisional solution for the first phase and will yield only “limited improvements” until the IASB has completed the regulations for Phase II. Primarily, IFRS 4 regulates separation of insurance contracts and financial contracts, and separation of financial com- ponents and options embedded in insurance contracts. It also stipulates the principles for enhanced disclosure. Until further notice, however, it is permitted to value insurance contracts in accordance with current procedure.

  Phase II will then stipulate an all-encompassing standard. Convergence with the accounting regulations of US GAAP is also sought. The IASB for Phase II has formulated a range of “tentative conclusions” in the notes to IFRS 4. At the centre of these conclusions is a fair-value approach to insurance contracts. This idea is supported by analysts, rating agencies, professional investors and the insurance industry in some respects; in others the proposal is viewed with a fair degree of scepticism, especially as it is still un- clear what fair value will ultimately mean.

  Fair value and the insurance risk

  The IASB defines the concept of fair value via the price that another enterprise would pay the insurance company to assume all the rights and obligations from the insurance contract. With regard to obligations and in particular claims payments resulting from a contract, there is a widespread misconception that only the average loss expectancy would be taken as a basis to determine the fictitious market value. However, this method would disregard the risk of random fluctuations, the risk of error in the assumptions and the risk of change and would therefore not adequately reflect the economic reality. These values must also be considered in any assessment of market value, as is the case with premium calculations.

  In this context, the appropriate risk margin is the subject of some controversy. In principle, the assumptions used for premium calculations, including all margins, could be taken as a basis for fair value. This would abandon the idea of explicit differentiation between profit margin and risk margin. The outcome would be that no profits result directly from the conclusion of a contract, which is also in line with the IASB provisional stipulations. Rather, the profits would be realised over time, as relief from risk develops.

  Isabella Pfaller, Dr. Günter Schwarz In principle, the assumptions used for premium calculations, including all margins, could be taken as a basis for fair value.

  Status

  IFRS – New accounting standards Munich Re, Topics 2/2004

  This realisation of profits spread over the term of a contract is seen by some experts as contradicting the fundamental principle of fair value. But this is standard procedure for financial instruments as well. For example, with bonds and credits involving a risk of default, the calculated margins are naturally realised over the entire term of the agreement. Splitting the interest margin into a profit margin, which has to be entered in the accounts immediately, and a risk margin would almost certainly be regarded as artificial by the banks. Modelling on the basis of premium calculation is thus compatible with the principle of fair value. In economic terms, this would lead to a similar valuation of insurance contracts to that which is already found in the accounting practices of many countries today. This would increase acceptance and speed up the process of international con- vergence.

  Fair-value assessment and loss expectancy

  In order to accurately reflect obligations from loss events, the fair-value approach requires that claims payments are discounted and risk margins are explicitly considered in claims reserves. The current policy of non-discounting reserves today means that a safety margin is implicitly included in the reserves. However, this method ignores the sometimes considerable differences in run-off periods and the inherent uncertainty of different risks.

  The fair-value approach requires consistent valuation of the inherent risks in the loss reserves that exceed the best estimate. In order to fulfil this requirement, sophisticated stochastic models are being developed, as are other models which take account of the risk capital costs in the loss reserves. The objective of both these approaches is to achieve a differentiated determination of the reserves. Both methods incorporate product-specific differences and different degrees of portfolio diversification, which we consider essential to correctly value the obligations from a portfolio of treaties.

  Unlocking and the reliability of the calculation bases

  The calculation bases used should be reviewed regularly to monitor their suitability (unlocking). IFRS 4 and its liability- adequacy test already require a unilateral examination of reserves for negative changes. In principle, however, positive changes should also be considered for a fair-value approach. With long contract periods in particular, depend- ing on the type of treaty involved, this can mean that the underwriting reserves fluctuate significantly.

  Insofar as underwriting parameters such as mortality rates, claims distributions or disability probabilities are concerned, unlocking is only appropriate if it corresponds to the nature of the insured risks. In particular, the underlying data series should bear an appropriate relation to the contract periods. More problematical is the technical interest rate. For pro- spective calculations, such as the discounting of claims payments and present values in life insurance, it is currently being discussed whether to take the respective market in- terest rate as a basis. However, given the significant lever effect involved, even small changes in interest can have a significant impact on the reserves. The informational value of accounting figures in terms of actual economic develop- ment would be reduced because of this “artificial” volatility.

  With financial instruments such as bonds and credits involving a risk of default, the calculated margins are naturally realised over the entire term of the agreement.

  01–05 The insurance industry has to cope with almost constant change – in the fields of workers’ compensation insurance, environmental losses, terrorism risks, rising life expectancies or climate change. These changes have an impact not just on premium calculation but also on group accounting.

  Status

  IFRS – New accounting standards Munich Re, Topics 2/2004

  With short and medium development periods, this interest sensitivity could be partially compensated for by means of matching with suitable assets, provided that this valu- ation is performed analogously. This is not possible with long-term contracts, for example in life insurance, because suitable financial instruments are lacking in certain currency areas. A compromise between strict unlocking and the common interest in economically reliable figures shared by the people that draw up financial statements and those that use them would be a so-called corridor solution. This would mean that calculation bases are modified only if the parameters change beyond the range of a “normal” fluctuation.

• – The role of risk balancing in the collective and over time
• – The stochastic nature of the risk, as risks amount to more than just loss expectancy
• – Stable calculation bases for valuing uncertain future pay- ment flows

  Will fair value change the whole basis of insurers’ business?

  Some experts have expressed fears that accounting on the basis of the fair-value principle could force insurers to offer important product lines at much higher prices or even to withdraw such products from the market altogether. Others have dismissed these concerns. They believe that the basis of insurers’ business will be only marginally affected by the modified accounting procedures. If the core elements of insurance business are given sufficient consideration, then at worst such products would be in doubt, in our opinion, which one would have to view critically anyway from a value-based management point of view. What is crucial, however, is that fair-value accounting adequately reflects the economic reality of insurance busi- ness. Compared with other sectors of industry, the following factors need to be given special consideration for insurers:

  Opportunities and obligations for the insurance industry

  As definitive requirements are not yet in place, experts in the insurance industry have the opportunity to play an active role in shaping these new concepts for accounting. Munich Re is ready and eager to seize this opportunity and accept this challenge. Our specialists bring their expertise to numerous committees and bodies, particularly on the IASB advisory committee, in the CFO forum and in other national and international associations. We want to play a leading role in helping to design the new system of accounting in a way that ensures the best possible outcome for the insurance industry as a whole and we will be glad to advise and assist our clients in this process of change.

  Isabella Pfaller is head of Munich Re’s Group Accounting Division. She is also responsible for contact with the rating agencies and for questions relating to solvency in connection with accounting.

  Dr. Günter Schwarz is a consultant for actuarial questions in our Group Accounting Division. He is an expert in the accounting of underwriting matters and participates in numerous national and international committees.

  02 Environmental losses

  03 Terrorism

  Status

  IFRS – New accounting standards Munich Re, Topics 2/2004

  05 Climate change

Glossary of important terms in IFRS accounting

  IFRS

  Mismatch between assets and liabilities in a balance sheet. If no matching techniques for assets and liabilities can be used, the volatility of the results can increase unreasonably.

  IASB

  Test prescribed in IFRS 4 with the aim of checking whether the underwriting reserves are sufficient to cover future financial obligations.

  Liability-adequacy test

  Accounting approach for insurance contracts which requires ongoing adjustment of relevant assumptions concerning future payment flows and discount interest. This contrasts with the lock-in principle, under which the assumptions from the premium calculation remain fixed as long as there are no impending losses.

  Unlocking

  With fair-value measurement, the risk that the market anticipates for the acceptance of insurance business must be considered with an appropriate loading. Conventional accounting usually considers the margin implicitly.

  Risk margin

  Fundamental principle of IFRS, which stipulates valuation of assets and li- abilities at market value. If no market value is available, internal valuation models have to be developed which simulate the market value in ac- cordance with the principle of an exchange between knowledgeable, willing partners in an arm’s length transaction.

  Fair-value accounting

  Asset-liability mismatch

  International Financial Reporting Standards, which will become compulsory for all listed companies in the EU as of 2005.

  Provisional position of the IASB on the development of the insurance standard in Phase II. This position is of an official nature and can be found in the “Basis for Conclusions” for IFRS 4. Munich Re, Topics 2/2004

  The International Accounting Stand- ards Board based in London, whose objective is the achievement of uniform international accounting standards. The 14 members come from nine countries.

  Fundamental principle of the IFRS, which focuses on measurement of assets and debts. This contrasts with the “deferral and matching principle”, which focuses on the period-related allocation of payment flows on in- vestment income and expenses.

  Asset-liability management

  Abbreviation for US Generally Accept- ed Accounting Principles. For many companies US GAAP regulations form the basis of international accounting for insurance contracts.

  IFRS 4 will be used for the transitional phase. IFRS 4 permits continued use of current accounting practices, with a few notable exceptions. The actual starting date and content of Phase II are still under discussion. The changeover to the new system was originally scheduled for 2007. However, it is now unlikely to come into effect before 2009.

  IFRS for insurance contracts

  Accounting standards of the IASB for valuing financial instruments, in par- ticular the accounting of investments.

  IAS 32/39

  Tentative conclusions

  IFRS – New accounting standards Insurance There is no perfect solution In spite of various difficulties, the planned changes to the accounting regulations for insurers are certain to increase transparency. This was the unanimous view of experts from the different rating agencies in an interview with Topics. Moreover, they also think it is unlikely that the new regulations will have any significant impact on the ratings of insurance companies.

  Round-table discussion with Lynn Exton (Moody’s), Rob Jones (Standard & Poor’s), Andrew Murray (Fitch) and Carlos Wong-Fupuy (A.M. Best). Interviewer: Isabella Pfaller, Munich Re Isabella Pfaller: Work on an internationally binding account- in my opinion. However, implementing such reform is a

ing standard for insurance companies in accordance with major job. I agree with Lynn that national implementation

  

IFRS is already at a very advanced stage. The changes that will be carried out with different degrees of rigour in differ-

concern the insurance industry will come into effect in 2005 ent countries. For example, a UK auditor has a very different

with commencement of Phase I. Will the new regulations concept of what constitutes true and fair in accounting

affect rating agencies’ risk assessment? compared to a Continental auditing firm. An international

Andrew Murray: The most important single change in Phase I accounting standard therefore also needs a standard

  concerns disclosure in the extended notes. As we do not auditing system to go with it. Having said this, I would not expect this to produce too many surprises, our ratings should go as far as to say that I consider the fair-value principle to not be affected. be entirely suitable as a framework for IFRS.

  Carlos Wong-Fupuy: Some changes from the transitional

  Phase I are helpful and are obviously included in our Pfaller: So you are quite critical of fair value? Do you there- analyses. However, I do not think it will change the way we

  fore think it should be questioned and challenged in order see things. to see if it is entirely suitable for the insurance industry?

  

Rob Jones: It is a pity really that the IFRS standards are Jones: The planned fair-value approach is a bit of a strait-

  being introduced in two phases. All in all, it is a rather piece- jacket. The industry may just have to live with it and come up meal approach to achieving the objective of a standardised with a framework which can fit the objectives of fair value. accounting system. However, we do not expect it to have The efforts by the CFO forum are very helpful in this respect. any major effect on our risk assessment. They are a step in the right direction and are certainly a lot more helpful than the antagonistic attitude of the IASB and

  Pfaller: the insurance industry towards each other.

  Phase II will bring much more extensive changes and an all-embracing accounting standard for insurers. What expectations and fears do you have for Phase II? Lynn Exton: We hope that standardised accounting will

  create greater transparency. One problem is that it is an extremely complex undertaking. I can imagine that the whole thing will be approached differently in different countries. Experience from the banking sector with Basel II has shown just how long it can take before a common basis is found. However, the efforts to achieve convergence between IFRS and the US GAAP regulations will further improve transparency and help promote consistency of reporting on a global basis.

  01 Andrew Murray, Fitch Jones: The whole process is very healthy. In insurance we

  02 Lynn Exton, Moody’s

  currently have to deal with all sorts of different accounting

  03 Rob Jones, Standard & Poor’s

  systems, especially in life. Reform is therefore long overdue

  04 Carlos Wong-Fupuy, A.M. Best

  01

  02

  04

  03

  Insurance

  effect on products. If the new system of accounting better reflects the risks involved in products, it can help promote better management of risks.

  parency. From the rating agencies’ point of view, it is essential to be able to see where and to what extent the principle of prudence is applied, which is not always easy as things are at the moment. Essentially, it does not matter whether the margins are embedded in the reserves or in the capital, although this could obviously affect taxation.

  Pfaller: A principle of the new accounting regulations prohibits excessive prudence in valuation. But what is overprudence? Would the rating agencies be in favour of a more prudent approach? Murray: Overprudence is primarily a question of trans-

  requirements than accounting and product design. I think it is very difficult to separate the two things.

  Exton: But that is more because of a change in capital

  the demand and supply side, for example with financial reinsurance. If the accounting benefits from such contracts with the cedant change, then those kinds of product will also have to evolve and change. On the supply side, companies might be less willing to write certain lines of business if there is a significant shift in the way profitability is shown in the financial statements. However, the benefits of the change in accounting will be that profitability and risks will be presented more clearly in the statement.

  Murray: I think there will be some kind of impact on both

  Pfaller: There is some discussion that the new standards could see a lot of products disappear from the market altogether. What is your view on this? Wong-Fupuy: Such developments could have a very positive

  IFRS – New accounting standards Munich Re, Topics 2/2004 Murray: It would be a pipe dream to believe we could have a perfect accounting solution that will satisfy everyone.

  produce significant long-term benefits, especially in terms of internal management.

  Murray: I agree. This is just a one-off burden that can

  have to be weighed against real added value. By that I chiefly mean the indirect effects of fair-value accounting, such as improved risk management and the adjusted economic capital model.

  Pfaller: Another issue is the high cost of implementation. Exton: There is no denying the costs, that is true. But these

  advantages from Phase II, not only in terms of convergence with US GAAP and common standards but also with regard to a new accounting concept. It will help to manage risks, which in my view is fundamental. This will certainly neces- sitate the matching of assets and liabilities and may have long-term effects on management, strategies and pricing. On the operational side we obviously anticipate difficulties in terms of implementation and particularly in terms of trying to find a fair value for liabilities. This is a hot topic for actuaries and it will take several years to agree.

  Wong-Fupuy: I fully agree with my colleagues. We expect

  I think we all accept that. At the end of the day, there will have to be a compromise between the different users of financial statements, those that draw them up and those that use them.

  So you are quite critical of fair value? Do you therefore think it should be questioned and challenged in order to see if it is entirely suitable for the insurance industry? Isabella Pfaller

  Insurance

  Rob Jones

  The oldest rating agency is Standard & Poor’s. The company was founded in 1860 and was taken over by McGraw-Hill in 1966. S&P employs 1,250 analysts in 20 countries worldwide. In addition to its credit ratings, Standard & Poor’s develops and publishes various stock market indices.

  Standard & Poor’s

  Moody’s can look back on a history dating back over 100 years. The company was founded in 1900 and published its first ratings in 1909. The company is based in New York and is now represented in 18 countries worldwide and employs some 1,000 analysts.

  Moody’s Investors Service

  The Fitch Publishing Company was established in 1913. The rating agency grew significantly in the 1990s following a series of mergers. Fitch became part of the French Fimalac Group after it merged with IBCA. Fitch Ratings has around 50 branch offices and employs some 700 analysts from 80 countries.

  Fitch Ratings

  A.M. Best was founded in 1899 in New York and specialises in ratings for primary insurers and reinsurers. In keeping with the process of globalisation in the insurance industry, A.M. Best opened offices in London in 1997 and in Hong Kong in 2000. The company employs some 400 analysts.

  I do not think that we would be doing our job properly if there was a huge swing in ratings because of IFRS.

  IFRS – New accounting standards Munich Re, Topics 2/2004 Wong-Fupuy: I think this depends on how you define the

An overview of the major rating agencies The assessment of companies by independent rating agencies has steadily grown in importance for institutional investors in recent years. Here is a brief summary of the four most important rating agencies: A.M. Best

  shares is a clear reflection of the general mistrust of balance sheets. And anything that will improve transparency has to be a good thing, such as sensitivity analyses which show how equity market development or interest rate changes affect key figures in the financial statements, as is currently provided for in Phase I.

  Jones: I think the current volatility of insurance company

  interest for accounting issues. Very few people used to be interested in such topics at our annual management meetings. This has changed because accounting questions are now being discussed by capital market experts. Analysts nowadays have to grapple with and understand the finer points of actuarial science.

  Exton: It is quite remarkable to see the recent increase in

  stand insurers’ financial statements. In practice, there are unfortunately very few people who read the statements, but those that do can certainly benefit from the enhanced information.

  Pfaller: The fair-value principle could lead to a rather complicated actuarial approach and make already complex accounting even more incomprehensible to shareholders. Might this not result in a competitive disadvantage for insurers on the capital market or will investors rely on the assessments made by the analysts who understand the greater transparency? Jones: It is already very difficult for the public to under-

  objectives you are pursuing. Insurance supervision usually needs to ensure strong capitalisation and is much less concerned with financial performance and results. Rating agencies need to keep a close eye on both aspects and also assess how the business profile and financial performance can support that in the future. Pfaller: More transparency would also mean that the different risk margins, which can be seen between French and German companies for example, would have to converge. This will lead to higher reserves somewhere and lower reserves somewhere else. Could that affect ratings? Jones: I do not think that we would be doing our job

  properly if there was a huge swing in ratings because of IFRS. The danger is to be found more in external influences. It is possible that the stock market may value insurance business differently than it did in the past on the basis of

  IFRS. In this case, there could be some changes in ratings. Changes in the way profits are shown could also see the tax authorities chasing the additional profit.

  Exton: We could certainly see the odd change here and

  there. But I do not think the top 20 companies would be affected. But you should never say never, I suppose.

  Pfaller: How do you see the unlocking of assumptions for prospective calculations, for example with interest rates? Wong-Fupuy: I think the unlocking of assumptions is

  important within the fair-value framework. For example, changes in the market interest rate would have to be reflected in the discount rate applied to reserves. In this way, companies can be encouraged to achieve a good level of matching between assets and liabilities.

  Pfaller: But we do not always have 30-year bonds as an instrument for matching in each currency. Jones: I don’t feel that assumptions should necessarily be

  changed for every little movement in the market. US GAAP, for example, only provides for changes if the assumptions are no longer appropriate over a longer period of time.

  Insurance

  IFRS – New accounting standards Munich Re, Topics 2/2004 If the new system of accounting better reflects the risks involved in products, it can help promote better management of risks.

  Carlos Wong-Fupuy From our point of view, it is essential to be able to see where and to what extent the principle of prudence is applied, which is not always easy as things are at the moment.

  Andrew Murray Munich Re, Topics 2/2004 Insurance

  IFRS – New accounting standards Very few people used to be interested in such topics at our annual management meetings. This has changed because accounting questions are now being discussed by capital market experts.

  Lynn Exton Pfaller: That would mean that strict unlocking is aban- Pfaller: Is it important that we stick to the timetable for doned and corridor solutions are introduced. Would that

  IFRS? Or would it be better to postpone implementation be acceptable? to allow more time for its development and to ensure Exton: Yes, that would be an adequate concept. If there has better quality?

  been a shift of more than 100 basis points, for example, Wong-Fupuy: The most important thing is to get it right then one would have to react accordingly in terms of the from the very beginning. From a rating point of view, the discount rate. new accounting regulations are not going to change the

  

Wong-Fupuy: You would have to see similar treatment on economic situation of a company. It is mainly a question of

  the asset side and an abandonment of the strict fair-value better transparency. If that takes a little longer, it will be concept. worth it.

  Jones: Ultimately, it is not so important how strict the Lynn Exton is Vice-President of Moody’s Investors Services Limited in

  criteria for unlocking assumptions are. It is all about dis-

  London, where she is responsible for financial institutions and coordination

  closure and sufficient transparency of the accounting of new financing instruments in Europe. bases. In this way, it is easy to see the effects of changes

  Rob Jones is Director of the Financial Services Division at Standard & Poor’s in London.

  in certain parameters.

  Andrew Murray is an analyst at the Fitch rating agency in London, where Wong-Fupuy: What really matters is being able to see the his area of responsibility is the insurance industry.

  sensitivities of the accounting bases.

  Carlos Wong-Fupuy is a financial analyst and actuary at A.M. Best in London.

  Pfaller: The fair-value approach also requires evaluation of options and guarantees. What mathematical concept could be used for this purpose? Murray: It is very important that IFRS includes the value

  of options and guarantees. Actuaries have to determine this value on the basis of stochastic models. This may mean that companies will offer two versions of a particular product – either with or without a guarantee. Customers will then have to decide whether they want to pay the price for such a guarantee.

  Wong-Fupuy: As an actuary myself, I fully support the

  stochastic approach. Both insurers and supervisors are familiar with these models. There are obviously also various other formulas and complex analytical processes but these are very difficult to understand. Munich Re, Topics 2/2004

  IFRS – New accounting standards Opinion

  IFRS – Bridge between internal management and external reporting obligations? Efficiency of accounting will be of crucial importance to the long-term success of each and every company.

  Dr. Jörg Schneider

  Global insurers currently face a variety of different reporting Prerequisites for acceptance of the new system requirements in a highly disjointed accounting world. The scope and complexity of these regulations lead to absurd It is very likely that strong fair-value elements will be in- difficulties and complications for all concerned. For example, corporated in Phase II of the IFRS standard for insurance parent companies in Continental Europe usually report contracts. However, while market-value measurement of for the entire group on the basis of IFRS and also have to financial instruments is generally favoured, market valuation prepare additional complex reconciliations in order to meet of assets and liabilities resulting from insurance contracts supervisory and rating-related requirements. At the same is quite rightly viewed with a certain amount of caution. time, the individual companies have to observe numerous Insurance companies and addressees of balance sheets other national regulations concerning trade, supervision and will only accept a standard for valuing insurance contracts tax laws. This almost Babylonian confusion can exasperate on the basis of fair value if it meets the following require- even the most accomplished accounting experts. The Munich ments: Re Group therefore welcomes the further development of IFRS as an important step towards a uniform and globally – The standard must be supported by a thorough under- recognised accounting standard. standing of the business model of the insurance industry, i.e. the new regulations must adequately reflect the

  

Presenting financial instruments at market value principle of a balance of risks within a portfolio and over

  time. The “risk” factor, the whole crux of our business, The fundamental advantage of IFRS is in its market-value must be considered in the balance sheet via adequate approach. Currently, many national accounting systems valuation methods. place utmost emphasis on protecting creditors and measur- ing dividend payments, by representing assets at historical – The new standard must not cause an inappropriate acquisition cost. IFRS is different: IAS 39 (revised 2003), al- increase in the volatility of the results shown for each ready used by the Munich Re Group in its financial statement accounting period. Otherwise, the costs of equity of the of the same year, stipulates that most financial instruments entire industry would increase as a result of risk aversion should be shown at market value. This market-value approach on the part of investors. Of course, accounting should makes it possible to base internal value-based management and must indicate the extent to which investments are on the figures for external accounting – provided they matched with the structure of the liabilities. are derived from sufficiently reliable calculation bases such as securities traded on the stock exchange. The Munich Re – Finally, the valuation methods must more or less accurately Group already takes advantage of this opportunity for reflect the economic reality and be describable in terms its internal management by making only a few business- of the underlying assumptions, but at the same they must related adjustments to the IFRS result. This includes also be comprehensible to non-experts and be verifiable the smoothing of major losses and investment results. by people outside a company. Munich Re, Topics 2/2004 Opinion

  IFRS – New accounting standards This almost Babylonian con- fusion can exasperate even the most accomplished accounting experts.

  Dr. Jörg Schneider

  There is still much work to be done in terms of develop- Accounting as a quality feature for investors and clients ment and above all in convincing people of the benefits of the new system before a set of rules can be adopted as a Accounting can no longer be seen merely as a necessary binding standard. Thanks to its membership in numerous chore. Prompt and transparent external reporting is a crucial committees and bodies, particularly through its active quality feature for investors, and even clients, who are participation in various working groups, Munich Re is doing becoming better informed and more demanding in their its utmost to help achieve practical regulations. Given the in- expectations. The more strongly accounting reflects factors evitable complexity of any new standard, generous transi- on the basis of their economic substance, the more it will tional provisions are necessary to ensure that the time- and become a sustainable value-creating element of internal cost-intensive conversion of the accounting systems can management. Ultimately, accounting can help open up be achieved without too much upheaval. extended financing and growth options for insurance companies. The performance of accounting systems and methods is therefore a decisive factor in determining a

  The changeover will require a lot of hard and detailed work company’s ability to compete.

  In order to take advantage of this opportunity to intermesh Dr. Jörg Schneider is a member of the Munich Re Board of Management. external reporting requirements with internal management

  He is responsible for the areas of accounting, controlling, taxes, integrated

  and to prepare for the requirements resulting from fair- risk management and investor relations. value accounting of insurance contracts, it is not just the major players that should be considering converting their accounting procedures as soon as is feasible. Admittedly, it will be some time before enough companies use IFRS for their accounting to make the system a de facto standard for everyone. That said, however, the new EU Regulation 1606/2002 of 19 July 2002 prescribes IFRS for the group accounts of all listed companies from 1 January 2005.

  From January 2007 this will then be extended to all com- panies that have issued debt instruments traded on the stock exchange. IFRS will offer companies the opportunity to deploy additional financing options such as participation certificates or subordinated bonds. Given the possibility of higher capital requirements for many insurers under Solvency II, managers of medium-sized companies should also start to learn about IFRS. After all, conversion to IFRS, which will be further developed in the future, involves a lot of hard and detailed work. Munich Re, Topics 2/2004 Munich Re, Topics 2/2004

Flood risks

  It is not just far-flung places like Mozambique, Australia or Bangladesh that face catastrophic floods these days. Just think of the summer floods in August 2002 on the Elbe, Vltava and Danube or of the 2000 floods in central England which caused enormous damage. Reason enough for the insurance industry to further optimise its risk management of extreme flood events.

  Christmas 1993: Many a famous Parisian spent the festive season with wet feet. The Seine floods also severely disrupted shipping on the river, as the high waters made many of Paris’s 27 bridges unpassable.

  Thomas Börtzler: Norwich Union has launched a unique flood model in the UK. What initiated the project in the first place? Laurence Loughnane: The UK floods in 2000 cost the

  insurance industry at least £1bn, with Norwich Union, the UK’s biggest insurer, paying out £200m in claims. We found that the data available to insurers was not accurate enough to judge the risk of flooding very well. In particular no height maps had been used in the creation of the flood models.

  Jill Boulton: The original idea to improve the flood models

  came from Willis, the reinsurance brokers. They had created a pilot flood model for the Thames and had tried to interest the insurance industry over the previous two years, but it seemed like hard work and very difficult to achieve. After our experience with the 2000 floods Norwich Union decided we must give it a go.

  Börtzler: What was the first step after signing the contract with Willis in November 2001? Loughnane: The first step was to create an accurate height

  map of the UK. That is when Intermap Technologies, the world’s leading radar specialists, came on board. We originally decided to leave Scotland out and concentrate on England and Wales because this is where most people live and the flood risk is highest, although we have now acquired Scotland too. Once the surveying was under way, the data from the flights had to be processed and made into maps.

  Börtzler: How long did creating the map take? Loughnane: A lot longer than we thought: a year and a

  half all in all. The biggest problem was getting permission to fly over the south-east. We were flying over the rest of the country at 28,000 feet to get a vertical accuracy of plus or minus one metre, but in the south-east we went down to 20,000 feet. That gave us a vertical accuracy of plus or minus half a metre. And you naturally need permission to fly over airports, military airbases and radar stations at such a low altitude.

  Boulton: Processing the data to obtain a uniform map also

  proved problematical. The planes fly roughly 240 kilometres in one direction and cover a swath about ten kilometres wide, depending on their altitude. These segments have to overlap by about three kilometres so that we can fit them together. The problem with this “zip” method was that the segments did not match at first: the zip sort of got stuck.

  Loughnane: Quality control also took up a lot of time. The

  maps were delivered in square tiles of 10 by 10 kilometres, 1,812 in all, and had to be checked one by one. The next stage was to develop flood models together with the con- sulting hydrologists Jeremy Benn Associates. The country was divided into 85 river catchments, each representing a river system. By the end of the year we will have com- pleted the whole of England and Wales.

  Status New maps are needed “Our flood model covers every single house.” Jill Boulton, responsible for Geographic Information Systems (GIS) at Britain’s Norwich Union Insurance and her colleague Laurence Loughnane, underwriting manager, in an interview with Topics.

  Thomas Börtzler talks to Laurence Loughnane and Jill Boulton Flood risks Munich Re, Topics 2/2004

  In the south-east we went down to 20,000 feet. That gave us a vertical accuracy of plus or minus half a metre.

  Laurence Loughnane

  The company Intermap Technologies flew over the UK in such a Lear Jet to generate the data for the maps.