Office of the SuperintendentBureau du surintendant of Financial Institutions Canadades institutions financières Canada Fair Value Accounting: Volatility and Smoothing Allan Brender ETH Zurich 7 June 2004

2 The Story of a Company’s Financial Progress Investors require a standard basis for this story to have comparability among companies Hence, IOSCO pressure on IASB Establish uniform international standards for financial reporting, for all business activities

3 The Story of a Company’s Financial Progress Financial statements and reporting have uses other than to inform investors: –Regulation –Taxation –Management compensation These can lead to distortions and manipulation of the system

4 International Accounting Standards Board Establish international financial reporting standards or international GAAP Standards are for business activities –Standards for insurance contracts, not insurance companies –Some insurance company products (e.g. deferred annuities) are not insurance contracts –Some elements (e.g. equalisation reserves) will not be considered to be liabilities

5 Financial Instruments IAS 32, 39 – financial instruments (other than insurance contracts) –IAS 32: disclosure and presentation –IAS 39: recognition and measurement

6 Measurement of Value If a financial asset is held to maturity, it can be measured at amortised cost –Trading is not a consideration here IASB’s general position is that most assets and financial liabilities can be traded; market value should be the measurement standard

7 Market Value or Fair Value An active market in a particular financial asset or liability may not exist Determine fair value, the price that willing arm’s-length buyer and seller might agree to The value of certain exotic assets is determined through use of models – questionable Revision to IAS 39 : verifiable market value

8 IAS 39 Hold to maturity – value at amortised cost Available for sale – market value, but changes do not pass through profit or loss (until time of sale) Trading – value at market with changes passing through profit or loss New proposed fair value option

9 IFRS 4 – Insurance Contracts Phase 1(2005): –Continue current liability valuation –Do not net reinsurance Phase 2 (?): –Forward-looking valuation –Assumptions: best estimate plus market margin –Discounting at market rates –Recognize own credit rating (?)

10 What is Fair Value? London Life (LL) – 4 th largest Canadian life insurer Royal Bank of Canada (RBC)– largest Canadian bank Great West Life (GWL)– 3 rd largest Canadian life insurer RBC agreed to buy LL for CAD$ 2.4 billion GWL bought LL for CAD$ 2.9 billion

11 What is Fair Value? What assumptions should be used in valuation? –The market’s –The company’s How will we determine market value margins? –How will these compare to margins for adverse deviation?

12 Volatility Using fair values will introduce considerable volatility in financial reporting Asset / liability matching (ALM) can reduce volatility if it is recognized in accounting Canadian Asset Liability Method BUT accounting theory holds assets and liabilities to be independent –Not necessarily consistent with market behaviour

13 Volatility Under current version of IAS 39, volatility would be distorted Proposed fair value option –Contains an embedded derivative –Financial liability linked to assets valued at fair value –Exposure to changes in fair value is substantially offset by changes in value of another financial asset or liability

14 Smoothing: response to volatility Consider the following example: Stochastic valuation of variable annuities with minimum maturity guarantees Based upon CTE(x) = TVaR (x) = E{X  X>x}

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16 Smoothing: response to volatility Current industry proposal to formally smooth capital requirements Supporting arguments are based upon imprecision of the calculation –Do not recognize the volatility is a reflection of the market “If one is comfortable with smoothing capital volatility, then income volatility should be smoothed as well and possibly more so”

17 Protecting the Integrity of the Financial Reporting System Auditors Actuaries Analysts Regulators

Office of the SuperintendentBureau du surintendant of Financial Institutions Canadades institutions financières Canada Discussion