July 31, 2001
Comment oN JWG Draft Standard
Financial Instruments and Similar Items
The Life Insurance Association of Japan
The Life Insurance Association of Japan (“LIAJ”) is the industry organization composed of 44 member life insurance companies whose purpose is to promote development and public trust in the Japanese life insurance industry. The LIAJ sincerely appreciates the opportunity to express an official opinion in response to the JWG Draft Standard Financial Instruments and Similar Items (“JWG Draft Standard”).
The LIAJ, having great respect for the efforts of the JWG to seek better financial accounting standards, is itself striving to accomplish further improvement in the accounting system to promote the transparency and sound management of life insurance companies.
Nevertheless, the LIAJ would like to express an opinion in opposition to the language appearing in the JWG Draft Standard, namely, the proposal for “recognition of virtually all gains and losses resulting from changes in fair value in the income statement in the periods in which they arise under the measurement of virtually all financial instruments at fair value.” We feel that such a proposal is not consistent with the underlying purpose of the income statement as a vehicle for adequately displaying the business performance in a given fiscal year and is not the appropriate accounting approach for a life insurance company in view of the specificities inherent in insurance. We feel there is a need to maintain an “insurance” project to conduct further study as to the most suitable accounting standard for the business of insurance.
1. Summary of Conclusions and Proposal
(1) The LIAJ is opposed to the JWG Draft Standard proposal for “recognition of virtually all gains and losses resulting from changes in fair value in the income statement in the periods in which they arise under the measurement of virtually all financial instruments at fair value.”(2) It is important to continue to examine accounting standards that incorporate the unique aspects of insurance. The LIAJ believes that an “insurance” project should be maintained to develop proposals in this regard similar to that conducted by the IASC Insurance Steering Committee. Such a project should not limit its focus on accounting standards applicable only to insurance contracts. The LIAJ believes there is a need to conduct a thorough review of accounting standards applicable to the business of insurance as a whole. Moreover, the composition of the Insurance Steering Committee should be altered from the one dominated by accountants by including the participation of people engaged in the practice business as well as the insurance supervision representing different countries so that it can present a better balance.
(3) Absent a change in the current JWG proposal that there be no appropriate amendments to reflect the life insurance industry and that there is no need to make a distinction between life insurance companies and other business enterprises, the LIAJ opposes any application of the JWG Draft Standard in its present form to life insurance companies.
2. Background of Conclusions
(1) The following are the reasons for the opposition to the JWG Draft Standard proposal for “recognition of virtually all gains and losses resulting from changes in fair value in the income statement in the periods in which they arise under the measurement of virtually all financial instruments at fair value.”:
a. The treatment of valuation differentials resulting from changes in fair value in the same manner as gains or losses actually realized on the transactions conducted by business enterprises presents a problem from the standpoint of appropriate performance representation in a single given fiscal year.
b. If fair value changes should be reported in the income statement, the volatility of profit and loss for the period due to the fluctuation in fair value would become excessively large. This, in turn, would cause difficulty in understanding for most users of the resulting financial statements and never meet their needs. There are also problems for the business itself because the fundamental profit and loss from its regular business, the most important element of its business operations, is obscured by huge variations in fair value. Business performance is thus not properly represented in the income statement, which is contrary to the original purpose for such. This leads to a host of problems and has many negative implications for the users of the resulting financial reports.
c. From the standpoint of corporate management, the proposal would bring a very serious problem that sound and stable corporate management, which are the fundamental principles, would become difficult as the result of unstable statement of accounts for all companies. If unrealized gains and losses by the fair value changes should be recognized in the income statement, the extremely large volatility of the profit and loss for the period would lead a company to fall prey to a short term approach to management by dressing up the annual financial reports to appear better than they actually are. However, the large risk inherent in such a short term management approach and the serious problems for the soundness of the organization has manifested itself in the large amount of volatility in the stock market in the past. The accounting does not exist merely for the investors and lenders; it must provide a benchmark to enable management to carry out its duties in a healthy and efficient manner. In other words, considering the role of accounting from the frame of reference of corporate management is important.
d. Many life insurance companies are marketing participating life insurance policies with the objective of maximizing dividends provided to policyholders over the very long term. To accomplish this, assets must be invested rationally over the long term in a manner that hedges against inflation and provides a high level of profitability. To reach this objective of realizing improved investment performance over the long term, assets are maintained in areas where risk is present such as the stock market but done so within the risk parameters that are defined by the individual insurance companies. If accounting standards are introduced that require valuation differentials of fair value to be posted to the income statement, companies conducting stock investment with a long term perspective will deprive their policyholders and investors of profit opportunities that would otherwise be available. The reason for this is the fact that companies aiming to avoid any risk of large volatility in profit figures on a fiscal year basis will be forced to carry out sales of stock that are completely unnecessary.
(2) Reasons for advocating the necessity of continuing an “insurance” project to examine special accounting standards that reflect the unique aspects of insurance similar to that conducted by the IASC Insurance Steering Committee and advocating that this review be conducted in a manner that is not limited to accounting standards applicable to insurance contracts but includes a thorough review of accounting standards applicable to the business of insurance as a whole:
a. The view under the JWG Draft Standard is that it is important to incorporate the special nature of insurance and is excluding insurance contracts. Separately, the IASC Insurance Steering Committee is studying special handling of the accounting for insurance contracts. The LIAJ is of the opinion that a project similar to that conducted by the IASC Insurance Steering Committee should be maintained since it is important to continue to examine the special characteristics inherent in insurance.
b. However, for the reasons noted below, such a project should not be conducted in a manner that is limited to accounting standards applicable to insurance contracts, but should also include a thorough review of accounting standards applicable to the business of insurance as a whole.
c. Life insurance companies are engaged in more than simply acquiring and holding insurance contracts. Looking only at a single insurance policy, the related insurance risk is extremely unstable. However, insurance companies are engaged in a series of risk management processes that reduce the risk associated with individual insurance contracts by spreading both the amount and timing of such risk.
d. Spreading the amount of risk refers to pooling a large number of insurance contracts that carry the same type of risk and converting this into a stabilized risk that can be controlled by employing the statistical law of large numbers. Spreading the timing of risk refers to something other than risk management that involves balancing the cash flows for each policy or each fiscal year. Instead, it is the risk management function that aims to attain a balance of cash flow through the period of insurance coverage for a group of insurance contracts.
e. In this manner, life insurance companies are supposed to offer a risk spreading function for their policyholders in the form of the insurance contract. As it is impossible to appropriately manifest the management of insurance business, it is necessary to conduct a thorough review of what accounting standards should be applied to the insurance business which is itself engaged in spreading both the amount and timing of risk.
f. Such study as referred to above should include the following topics:
l The scope and cases where fair value measurement is appropriate, as well as the points requiring caution and change regarding fair value measurement;
l An examination of the methods to disclose fair value information, such as reporting fair value only on the balance sheet but not in the income statement, or disclosing fair value information in the notes to the financial statements; and
l The methodology and scheduling for field tests, and feedbacks of result for the accounting standards setting.
g. Currently, insurance company management is being conducted more and more on a global basis. However, insurance products that are being marketed in each country are deeply tied to the particular national and cultural traits of these countries. From this point forward, it is difficult to conceive of any major changes in this structure. For this reason, there are great many issues to resolve in order to create a set of accounting criteria that are standardized throughout the world and discussing accounting treatments for insurance products, including valuation of insurance liabilities, in the same manner as for financial instruments. Introducing fair value accounting would make drastic and definite changes to the existing infrastructure and is a problem that would give a serious impact for the life insurance industry that is inherently concerned with stable management over the long term, for a large number of interest parties such as policyholders, and for the entire insurance system that is in place in a given country. Failure to address these problems adequately and sufficiently and hasty introduction of such accounting standards without careful discussions based on the situations in each country could result in serious damage to the insurance systems of these countries. This, in turn, could pose a threat of huge loss to both policyholders and trading partners.
(3) Reasons for opposing to the present form of the JWG Draft Standard in which no appropriate amendments are proposed to reflect the business of insurance, and that no distinction is needed between life insurance companies and other business enterprises:
a. Together with an approach to balance cash flows each fiscal year, the fact that society is aging and insurance premiums are increasing year by year means that the number of people not able to obtain insurance will rise due to economic conditions. In other words, the insurance industry will not be able to fulfill its social mission of providing a sound infrastructure for financial security. In order to provide more stable coverage, premiums should be level and attempting to spread the timing of risk must be the focus of the insurance industry in today’s environment.
b. To spread the timing of risk, since insurance companies must prepare the financial resources ahead of time to deal with risks that will arise in the future, it is imperative that they create a mechanism that will allow for the gradual release of funds that have been accumulated for this purpose under a tangible schedule. Currently, insurance company accounting for each country incorporates the deferral and matching method in some form or other. This method is considered to spread the timing of risks in an accounting term.
c. Even though the assets and liabilities come within the scope of measurement in the accounting used by insurance companies, as asset-liability method was selected under the IASC framework, the essential function of the life insurance industry will not be reflected in the accounting whatsoever, if not using a deferral and matching approach for the measurement based on the spreading of timing risk. This is contrary to the principle of faithfulness. Consequently, even under the asset-liability method, it is necessary for life insurance accounting to adopt a system that incorporates a deferral and matching approach based on the spreading of timing risk.
d. With the above-mentioned mechanism for spreading risks, life insurance companies are able to offer annual guarantees of assumed rate over the long term at the time of entering the contract. For this reason, from the standpoint of soundness and protection of the policyholder, financial statements of a life insurance company, as appropriate representation of the management of the life insurance company, must show the company’s stable ability to pay claims over a long period of time. The first and foremost requirement of the financial statement of a life insurance company is to enable interested parties such as policyholders to ascertain whether the company currently has the ability to pay claims or will have in the future. This should also be the paramount requirement for the general-purpose accounting that is aimed at investors.