Potential Drawbacks of Price-based Accounting in the Insurance Sector

This paper analyzes the relevance of cost-based accounting in financial markets, focusing on the drawbacks associated with a move from cost- to price-based accounting. While the benefits of such a move are well known, much less attention has been given to the potential hidden costs. We explore such hidden costs looking at both companies and investors. From the point of view of insurance companies, we consider issues like the potential increase in earnings volatility and changes in the cost of capital. From the point of view of the final investor, we consider liquidity and expected returns, stressing the role of behavioral models. Our conclusion is that cost-based accounting is a useful addition to financial markets. It may stabilize short-run financial results and may improve the situation of investors with short horizons and loss aversion. It is certainly true that cost-based financial products are not fully transparent and leave to the asset manager large discretion in the determination of short-run returns. However, we believe that cancellation of cost-based financial products is not the right reaction to these drawbacks. Rather, we believe that regulation and monitoring is the best answer. The Geneva Papers (2007) 32, 163–177. doi:10.1057/palgrave.gpp.2510123