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Auditing amid economic uncertainty


Published: 21 Oct 2022

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On September 23rd, Kwasi Kwarteng, who had been appointed as Chancellor of the Exchequer just 17 days earlier, held what he called a ‘fiscal event’…and quite the event it turned out to be.

Having announced a series of tax cuts to parliament - including abolishing the 45% higher rate of income tax, a further cut in the basic rate from 20% to 19%, and the cancellation of a proposed increase in corporation tax to 25% - both he and the then Prime Minister Liz Truss made it clear that they believed the measures would get Great Britain growing.

However, set against an already bleak backdrop of sky-high inflation, continually rising energy costs, and a rapidly spiralling cost of living crisis - to say nothing of the decision to decline a formal forecast of the likely impact of the measures by the Office of Budgetary Responsibility - the market was far from convinced.

On the foreign exchange markets the pound fell to its lowest ever level against the dollar, reaching a value of just $1.0327, with many fearing that it may reach parity for the first time in history. Furthermore, the cost of borrowing for the UK government rose at near unprecedented rates, with the yield on a 10-year gilt rising from 3.49% on the day of the announcement to 4.54% by the start of the following week.

In order to try and stabilise the volatility in the gilt market, which prompted mortgage providers to withdraw more than 40% of products and placed long term borrowers such as insurers under severe pressure, the Bank of England was forced to launch an emergency bond buying programme to try and offer stability.

Politically, this seemingly self-inflicted crisis spelled the end for Kwasi Kwarteng’s time as chancellor, who at just 38 days held the position for the second shortest amount of time in history, and has seen his replacement, Jeremy Hunt, reverse almost all of the measures originally proposed.

But financially, it has added even greater uncertainty to an economy, that was already forecast to enter into a recession before the fiscal event was even announced.

This huge uncertainty weighs heaviest on the UK banking and insurance sector, whose balance sheets have been put under extreme pressure as a result of the unexpected volatility, with banks forced to raise mortgage rates and insurers suffering as a result of the rise in bond yields.

But beyond the institutions themselves, the current climate of uncertainty also impacts on those who are charged with overseeing their finances and keeping an eye on their long term health in the form of financial auditors.

As risks rise, judgements will increase

As Reuben Wales, head of financial services at the ICAEW, explains, the value of a large proportion of both the assets and the liabilities held by banks and insurers balance sheets are based on estimates of how much they will be worth at certain points in the future.

This is as much the case in stable environments as unstable. However, when the state of the financial market is unstable, or uncertain, the need for such estimates and the judgements on which they are based to be accurate increases.

“That risk is heightened in the current economic environment,” explains Wales, “likely leading to an increase in judgements when preparing financial statements and less reliance on unadjusted model outputs.”

“This potentially increases the risk to the auditor of a bank or insurer, who will need to factor this into their audit planning, and it may lead to the need for additional audit work if audit quality is to be maintained.“

Getting to grips with assets and liabilities

For the insurance sector, while the current volatility and uncertainty in the financial markets presents a range of challenges, it is in a far stronger position to contend with such conditions than in the aftermath of the financial crisis of 2008.

With the implementation of the Solvency II Directive in 2016, all insurance companies are now required to hold enough capital back in order to ensure that they are able to meet all of their obligations over the course of the next year to a probability of at least 99.5%.

This solvency capital ratio (SCR) serves to drastically reduce the chances that any insurer might be at risk of becoming insolvent as a result of a devaluation of assets or a rapid deterioration in market conditions.

However, while Solvency II has served to reduce the sectors exposure to risk, the low interest rate environment seen in recent years, has prompted some insurers to increase the amount invested illiquid assets in search of higher returns. This is of particular relevance to the auditing of insurers, as forecasting the future value of illiquid assets is more challenging.

Speaking to the ICAEW, Stuart Wilson, UK Insurance Audit Leader at EY, explains: “Turbulence in the markets is challenging for all businesses, including insurers, but as long as they’ve heavily invested in liquid assets, its actually relatively straightforward to value assets on the audit side. But illiquid asset valuations will always require more judgement.”

A further challenge to auditors in the current environment, and one which is unique to the insurance sector, is the possibility that the rapid rise in inflation that has seen it increase from 4.9% to 8.6% since the start of the year will not have been fully accounted for in the premium rates charged to policyholders.

This is of even greater relevance to certain lines of business, such as motor and home insurance, where the costs associated with paying out claims has risen significantly higher than the average rate of inflation.

“The challenge faced is that they’re pricing products today based on claims that they’ll incur up to 12 months later,” explains Wilson. “Auditing this sort of unknown can be difficult, and there is more judgement than there would have been in the past when inflation rates were more stable.”

However, while accepting that issues such as this present a challenge to auditing the sector, and stressing the importance of understanding each liability to a granular level of detail, Wilson is confident that the tried and tested process will endure.

Trust the process, know the data

“The current fall in asset values is proving to be a challenge, although the audit process doesn’t change. Inflation is not a new phenomenon and auditors are well equipped to make judgements around inflation assumptions, albeit there are more judgements to make at present.”

This need to make more judgements is also mirrored in the auditing of banks. But Javier Faiz, Head of Financial Services Audit at EY, believes the profession is equally prepared to face any challenges presented by the current environment of uncertainty, with the IFRS 9 accounting framework having played a key role.

“It allows for as forward-looking a perspective within an audit as is possible, and accounts for changes to the macroeconomy in a sophisticated way,” he says. “The framework can deal with the current challenges that rising inflation are presenting and helps with the necessary judgements around scenario planning, weightings, and modelling.”

One key way in which this shift in preparedness has been driven within the auditing sector, is the increased use and involvement of quantitive model specialists, such as hedging and valuation specialists that work across specific ranges of liquid and illiquid assets.

But while both he and Wilson are confident in the professions ability to make the right judgements and deal with the current challenges, Faiz is clear that close attention must be paid in case of any uncertain events that may occur, be they formally fiscal or otherwise.

“There is always risk, so it is key that auditors are close to the companies they are auditing to ensure live issues are captured, and are across all regulatory changes as they impact.”