Saturday, August 02, 2008

Black Box Insurers

From The Economist:

AFTER watching bank shares drop by almost a third this year, most European investors probably consider the idea of buying insurance stocks a sick joke. Banks’ balance-sheets may be difficult to understand but insurers can be mind-bogglingly complex too.

The alternative is the industry’s home-grown accounting standard, which is called Embedded Value (EV). A life company’s EV represents its shareholders’ funds plus the value of future profits it expects to generate from its existing book of business, after adjusting for risk. This is a concept most investors can get their heads around. But individual companies can pick their own assumptions on things like investment returns. Furthermore, diversified firms often report EV only for their life divisions, making it harder still to compare companies on a consistent basis. The result is that many investors view EV as just another type of black-box reporting.

The good news is that the industry is taking note. In June, a forum of Europe’s biggest insurers agreed to implement new Market Consistent Embedded Value (MCEV) rules in 2009. These require companies to make uniform assumptions about investment returns and apply the reporting standard across the entire company. In addition it will no longer be possible to book at once the profit expected from holding risky assets. Mr Crean argues that MCEV standards make it easier to see how much cash is being generated by the “back book” of existing business and how much of this is being reinvested in new business, rather than being handed to shareholders as dividends.

This is something I've never looked into, but I know Fairfax holds credit-default positions against several European insurers- a bet signifying their belief in increased credit troubles for these companies. If these companies have been allowed to book immediate profits on risky assets, that could be a source of large write-downs in this current market turmoil.

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