As InsuranceERM announced yesterday, the Financial Reporting Council has begun a review into equity-release mortgage accounting.
The UK’s accounting watchdog has initiated a review into the statutory accounting of equity-release mortgages (ERMs), a move which may result in changes to life insurers’ profits.
Note the emphasis on statutory accounting, not to be confused with regulatory accounting, which the PRA has already corrected, at least partly. The FRC review is significant, because it may lead to a correction in the statutory reporting of ERM firm balance sheets. I raised the issue in this October 2018 letter to Stephen Haddrill (FRC chief executive). If the PRA has (partly) corrected the valuation error in the embedded option, why hasn’t the same error been corrected in the statutory balance sheet?
When I have raised the same issue with accounting people in the past, they have sometimes claimed that IFRS (statutory) equity and Solvency II capital are utterly and completely different things, apples and pears, ants and porcupines etc, and simply bear no comparison to one another, there is no problem, no issue etc etc.
This is completely false. Both accounting equity and solvency capital measures are essentially trying to measure the same thing, namely the loss-absorbing capacity of the balance sheet. You aim at measuring the fair value of assets and the fair value of debt to creditors such as senior bond holders, pensioners, depositors and the like, you subtract the value of assets from the value of debt, and the difference (whatever you call it) is a positive number that changes with the present value of assets and debt, and which if remains positive will protect the creditors of the company.
If the value of debt exceeds the value of assets, and the company is wound up, then creditors take the shortfall, which is a bad thing, particularly if they are pensioners. So the purpose of both accounting equity and solvency capital is the same, namely to measure the protection afforded to creditors.
Now it is true that IFRS equity and solvency capital are measured in different ways, but the fact that the measurement is different that doesn’t mean the thing measured is different. To illustrate this, consider the reconciliation published in Just Group’s interim report published on Wednesday, see the table on p.12 explaining the difference between the shareholders’ net equity and Solvency II ‘own funds’ i.e. capital. See the table copied below.
Looking at the table, some of the differences are small items which IFRS counts as assets, but Solvency II does not, e.g. goodwill, intangibles, and the lovely ‘ineligible items’. Of the large items, ‘risk margin’ is a number representing an asset that nobody, including the regulator, understands, but which is partly offset by the transitional measure (TMTP) which is a sort of fake asset that nobody understands either. If we therefore subtract the risk margin (£971m) from the TMTP (£1840) we are left with £869m of unexplained fake asset.
Subordinated debt is there because Solvency II considers junior creditors as basically edible, given it is the job of regulation to protect pensioners and policyholders.
We are left then with the almost completely offsetting amounts of £869m fake regulatory asset, and the legendary ‘other valuation differences’ of minus £869m in this post in August 2018. Just’s auditors have consistently refused to explain what this number actually is, but it is almost certain that it represents the amount of Matching Adjustment (a fake regulatory liability) that the firm lost last year when the PRA forced it to (partly) correct the valuation of the embedded NNEG guarantee.
I imagine most readers will be lost by now, but the whole point of Solvency II is to make the whole valuation method impenetrable even to the people who understand it. Good luck to the FRC in unravelling that lot. But in broad summary, the loss on the regulatory balance sheet represented by ‘other valuation differences’ is almost completely offset by the addition of a regulatory asset called ‘Solvency II TMTP’.
But IFRS, as far as I know, has no equivalent of TMTP. It violates any accounting standard to invent an asset which has no market value, no historic cost, which produces no income, and therefore has no value whatsoever to protect creditors. Fictitious capital cannot be ‘loss absorbing’. Yet IFRS has the exact equivalent of matching adjustment, the valuation discount rate, see p.49 of the interim report. When ERM firms lost matching adjustment benefit when the undervaluation of the guarantee had to be corrected, why didn’t the valuation discount rate fall by a corresponding amount? Doesn’t IFRS value put options in the same way that regulators value them? That is the exam question for the FRC.
But as I said above, good luck to the FRC in its unravelling operation.
| 30 June 2019 £m | |
| Shareholders’ net equity on IFRS basis | 2,133 |
| Goodwill | -34 |
| Intangibles | -127 |
| Solvency II risk margin | -971 |
| Solvency II TMTP | 1,840 |
| Other valuation differences and impact on deferred tax | -863 |
| Ineligible items | -6 |
| Subordinated debt | 589 |
| Group adjustments | 0 |
| Solvency II own funds | 2,561 |
| Solvency II SCR | -1,721 |
| Solvency II excess own funds | 840 |