Equity and Liabilities – A Discussion of IAS 32 and a Critique of the Classification

Abstract

It is a traditional convention in accounting to distinguish between two classes of claims, liabilities and equity. The International Accounting Standards Board and the Financial Accounting Standards Board have been using a dichotomous classification approach, adhering to this convention. However, over the recent years, this approach has been put under stress. First, there is an ever-growing variety of hybrid financial instruments, some of which designed to exploit this classification approach (accounting arbitrage). Second, the adoption of IFRS in Europe and elsewhere has brought scenarios to light in which the classification approach does not result in decision-useful information. These issues arise when IFRS are applied by entities in legal forms other than a private or public limited company. This essay discusses IAS 32 in the light of the historic origins of the dichotomous classification approach, the recent standard-setting activities and a review of the empirical research. This essay suggests that a reconsideration of the traditional dichotomous classification might be a way forward.     

Fair Value: Your Value or Mine? An Observation on the Ambiguity of the Fair Value Notion Illustrated by the Credit Crunch

Current International Financial Reporting Standards (IFRSs) define fair value as a transaction price. In imperfect markets, buyer's and seller's marginal prices, at which they are rationally willing to transact, differ. The transaction price can be any amount within the range between those prices. However, scenarios are conceivable in which no such range exists because the seller's marginal price exceeds the buyer's. In this scenario, no arm's length transactions between knowledgeable, willing parties are possible. Such a scenario can be likely characterised by low liquidity and/or high information asymmetry and seems to be broadly consistent with what is recently referred to as the ‘credit crunch’. Under this scenario, the IFRS definition of fair value is not readily applicable. Two views are possible: under view 1, fair value refers to the potential buyer's marginal price. Although fair value does always exist conceptually, it negates the notion of two rationally acting parties. View 2 acknowledges that no arm's length transaction is possible, resulting in the fair value notion not being applicable. If these two views are applied to the IFRS definition of an active market, view 1 results in markets that are always active. Only view 2 allows distinguishing between active and inactive markets.     

Author’s Reply: Market Value Of Insurance Liabilities: Reconciling the Actuarial Appraisal and Option Pricing Methods - Discussion by Thomas S. Y. Ho; Joe Koltisko; Thomas J. Merfeld; Marsha Wallace

Adverse selection death spirals in health insurance are dramatic and, so far, exotic economic events. The possibility of death spirals has garnered recent policy and popular attention because the pricing regulations in the Affordable Care Act (ACA) of 2010 make health plans more vulnerable to them (though some other aspects of the ACA limit them). Most death spirals tracked in the literature have involved selection against a group health plan that was dropped quickly by the employer. In this article, we empirically document a death spiral in individual health insurance that was apparently triggered by a block closure in 1981 and developed slowly because the insurer partially subsidized the block. We show that premiums rose dramatically from around the time of the block closure to at least 2009 (the last year of available data). By 2009, some, but very few, policyholders remained in the block, and premiums were roughly seven times that of a yardstick we developed. The history of this slow-moving event is directly relevant to current policy discussions because of both adverse selection in general and the particular problems induced by closing a block.     

Authors’ Reply: Economic Valuation Models for Insurers - Discussion by Jacques F. Carriere

Abstract

This article employs a longitudinal form of the Grade of Membership (GoM) model to specify and estimate a multivariate model of the trajectories of morbidity, disability, and mortality among longitudinally followed elderly respondents to the National Long-Term Care Survey (NLTCS) of 1984, 1989, 1994, and 1999. A distinct trajectory was constructed for each individual respondent to the survey. The trajectories described the progressive declines over time in physical and cognitive functioning among a nationally representative sample of the U.S. elderly population.

The model was structured to represent simultaneously the essential features of the fixed frailty model of Vaupel, Manton, and Stallard and Strehler and Mildvan’s model of linearly declining vitality. Unlike those models, however, the longitudinal GoM model was designed for easy and direct application to existing longitudinal data sets.

The measurement space in the NLTCS application included from one to four sets of repeated measures for each survey respondent on 95 independent variables characterizing the nature and intensity of limitations in activities of daily living (ADLs), instrumental activities of daily living (IADLs), physical functioning, and cognitive functioning, as well as indicators of behavioral characteristics, medical conditions, subjective health, age, race, sex, institutional status, and survival status.

The application showed that the model can be fitted to existing data and that the results were interpretable as generalizations of fixed frailty with linearly declining vitality.