Two Fatal Flaws in Fair Value

The credit crunch has revealed how tough it is put a price on downside risk when there's no one around to buy it, say top insurance managers.

The subprime crisis has exposed two major deficiencies in how fair-value accounting has been implemented, senior insurance executives say: the “myth” that all securities have a market and a tendency to overlook downside risk.

The current credit crunch has revealed that many financial services companies have been operating as if some of the securities they sold could always be converted to cash, says William Panning, an executive vice president with Willis Re, a reinsurance brokerage. “The whole development of derivative securities was premised on a false notion — that underlying assets can always be priced,” he said at a session of the annual Risk and Insurance Management Society conference in San Diego on Monday. “This year has totally disabused us of that notion.”

The widespread illiquidity besetting seemingly liquid securities has put a dent in the idea promoted by advocates of fair-value accounting that a market could be reasonably assumed for any kind of security, he suggested. Under current conditions, for instance, auction rate securities, considered by some to be tantamount to cash, have failed to find bidders. According to a hierarchy set up under the Financial Accounting Standards Board’s new fair-value accounting rules, however, companies with unmarketable assets or liabilities must value them as if they had a market.

Another speaker, Kevin Kelley, chairman and chief executive of Lexington Insurance Company, an AIG subsidiary, suggested that had financial services companies been able to gauge the true fair value of some of the securities they were marketing, there might never have been a subprime crisis. “I don’t think you know a risk until you know the accounting of a risk gone bad,” he said. “If you knew the fair value of a credit swap gone bad, you might not be in that business.”

Indeed, the recent breakdowns in securitization and risk management were big topics of discussion at this large gathering of corporate risk and insurance professionals. Keynote speaker Lauralee Martin, CFO and chief operating officer of Jones Lang LaSalle, a real estate services company, saw in the subprime fiasco a failure to use the standard risk management scheme of identifying, assessing, monitoring, and pricing risk exposures. “I continue to be shocked that all the risk disciplines and processes could not have been followed,” the finance chief said.

The big problem with securitized risk taking is that the risk takers can’t really estimate the value of their liabilities, according to Kelley. He drew a sharp contrast between counterparties assuming risks on securitizations and property-casualty companies assuming risks on natural catastrophes. After Hurricane Katrina, “within three weeks, everybody had a pretty good idea of what that loss [was] and who had what part of that loss,” the insurer said.

In comparison, loss estimates tied to the subprime crisis are still fluctuating wildly eight months after it began to emerge, he said, noting that “nobody knows the size of the loss, and you don’t know the strength of the counterparty.” A big reason for the uncertainty is the requirement that securities must be accounted for in fair-value terms, he contended.

Kelley also complained that fair-value accounting will force insurance companies to take big, unnecessary writedowns. “At AIG, we have the capacity to hold on to the assets before we have to market them,” he said, suggesting that mark-to-market reporting doesn’t apply to the circumstances of large, well-capitalized insurance companies.

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