View from City Road: Capital mix-up for insurers

The insurance industry has got itself in a terrible tangle over whether it is making a profit or a loss. Three months ahead of a deadline for implementing a new European Union directive on insurance company accounts, there is no sign of an agreement on how to do it.

Consider Sun Alliance's results yesterday. The company made a dramatic loss of pounds 419m on its investments in the six months to June because of the collapse in bond and equity markets in February. But this did not have any impact at all on the profit and loss account. Was it bamboozling us?

In contrast, some insurers are adamant that such unrealised capital gains and losses should go through the profit and loss account. If Sun Alliance had reported that way - as Guardian did two weeks ago - it would have declared a pre-tax loss of pounds 237.6m instead of a profit of pounds 180.2m. Which is right?

Guardian is backed by a draft statement of practice from the Association of British Insurers. The argument is that since the industry has some of the characteristics of an investment trust, performance is best shown by the combined results of trading and investment operations.

It is certainly true that insurers are heavily dependent over the long term on good investment management performance, which has made up for their losses on underwriting over most of the past 20 years.

But in the short term capital values fluctuate wildly with the markets. Scott Nelson, Sun Alliance finance director, claimed the Guardian approach was 'economic nonsense'. It led to enormous fluctuations in profitability. Within two months, half of Sun Alliance's pounds 412m capital loss had already been recouped.

Mr Nelson believed inclusion of capital gains by Scandinavian insurers encouraged misjudgements by management, based on an illusion of profitability. Worst of all for shareholders, he saw it as an open invitation to the Inland Revenue to extend taxation to unrealised gains.

If Sun Alliance is right, the industry is more profitable than it has been for years. If Guardian carries the day, all the insurers are in the red.

The directive behind this fuss actually allows a lot of latitude, which is part of the problem. It says unrealised gains can be put through the profit and loss account in whole or part, or alternatively through the balance sheet in a revaluation. Eagle Star has compromised by charging a five-year rolling average of capital gains and losses to the P&L. That might be the basis of an agreement, though for their different reasons Guardian and Sun Alliance say they would not accept it. Either way, the ABI draft is a dead duck.

A sensible way out, surely, is to continue to report pre-tax profits as Sun Alliance does, because they show whether an insurance company is performing in its basic business, which is what most interests City analysts.

But equal prominence should be given in the announcement to unrealised capital gains and losses. Investors could then make their own judgements. Perhaps that's just too simple a solution for accountants.