When reality bites

Editor's letter

What is reality is a question that has occupied philosophers since the third century BC when Plato posited his view that universals - entities whose existence is consistent throughout the universe - exist independently of, and prior to the creation of the world. The opposite position was most famously put forward two millennia later by the 18th century Irish philosopher Bishop Berkeley, whose dictum, 'Esse est percipi' (to be is to be perceived), instead states that reality is merely a perception of the mind.

A definitive answer to which of these philosophers was closer to the truth is clearly unlikely to be found within the lifetime of the readers of this magazine, or indeed before the last pound, dollar or euro, has been paid out from the pension and insurance liabilities managed by them. But the issue over what is real, and what is illusory, is of direct consequence for those attempting to manage balance sheets under the auspices of contemporary accounting standards.

At the end of July, US insurer Metlife saw a three-fold increase in its losses to $1.4 billion from the first to the second quarter. These losses included $1 billion that was due to the 'own-credit' assumptions related to the valuation of the embedded derivatives in the company's variable annuity business.

The reason for this is that under the Financial Accounting Standard's Board's (FASB) fair value directive FAS 157, insurers must include the likelihood of their own default when valuing their own liabilities. In Metlife's case, as the market perception of its credit worthiness improved and it was viewed as more likely to pay outstanding bond issues, this fed through into the profit and loss account as a writedown. The flipside of this standard is that in last year's volatile markets, as Metlife's credit spreads widened, it was able to book a decline in credit worthiness as a profit.

Proponents of this system argue that this is not the Alice in Wonderland approach to accounting that it first appears, and to do otherwise would lead to a mismatch between assets and liabilities on insurers' balance sheets, as the valuation of bonds they hold includes an allowance for likely default. But while maintaining a match between assets and liabilities is clearly a key focus for insurance risk managers, the necessity of its role in accounting for the value of companies is less obvious.

Indeed, to see US insurers' profits slashed as a direct result of the increasing market confidence in its future viability seems to belong to an alternate reality.

And it is not just the FASB whose accounting standards have come into question. In July, the US standard-setter's contemporaries at the International Accounting Standards Board (IASB) announced plans to require companies using IAS19 to bring pension losses onto the balance sheet directly, instead of leaving them on the statement of recognised income and expense (Sorie).

The logic behind the IASB's move is more obvious than the FASB's approach to valuing insurance liabilities - movements in the deficits of company pension schemes are hideously real for the corporate treasurers that have to deal with them. But this short-term volatility does not necessarily reflect the actual final cost of pension obligations. A glance at the sudden collapse in coverage ratios, and their subsequent slow recovery over the past 18 months (Netherlands' pension schemes stagger back to solvency, p10) demonstrates how wildly a scheme's funding positions can be affected without any change in the level of benefits promised.

And just as Metlife's chief financial officer dismissed his company's losses as merely "accounting noise", some have suggested that the generally accepted metric to analyse companies' balance sheets - earnings before interest, taxation, depreciation and amortization (Ebitda) may soon have pensions added to it to become Ebitdap.

If insurers and pension scheme sponsors have to explicitly state the irrelevance of accounting assumptions to the everyday facts of the business world they operate in, there is the real danger that accounting standards will only be a reality to the organisations that set them. These groups could instead do with heeding the advice from the eponymous subject of Plato's most celebrated dialogue Theaetetus, "Better a little which is well done, than a great deal imperfectly".