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Insurance companies' profits and solvency could take a big hit from a proposed change in accounting rules, according to a recent analysis.
Pre-tax income and shareholder equity among insurers are currently inflated by the way they report the cost of selling new policies, according to a report released last week by the Financial Analysis Lab of the Georgia Institute of Technology.
The accounting rules allow insurance companies to capitalize such costs, enabling them to be spread out over the estimated life of their policies, which typically run as long as 30 years. That reduces the amounts the companies report in liabilities while increasing their income.
But proposed changes by the Financial Accounting Standards Board and its international counterpart, the International Accounting Standards Board, would force the companies to expense such costs in the year they're incurred.
The analysis found that 28 insurance companies with market capitalizations of more than $3 billion would see their pre-tax income decline by 20 percent or more. Additionally, their ratio of liabilities to shareholder equity would climb from an average of 9.9 times to 64 times if so-called "deferred acquisition costs" were expensed instead of capitalized.
As a result, lenders may demand the companies reduce their debt levels, the report warned.
"Such an increase in leverage could potentially hurt their credit ratings and put pressure on the firms to raise equity," wrote the report's authors, Charles Mulford, an accounting professor at Georgia Tech and an advisor to CFOZone, and MBA student Andrew Parkhurst.
The 28 companies in the study typically had deferred acquisition costs (DAC) of at least $1 billion and routinely capitalized and amortized amounts in excess of that number.
Principal Financial Group's 2008 net DAC balance was the highest in proportion to shareholder equity, at 109 percent, or about three times the average for the group of 32.7 percent. And its pre-tax income would fall by 67.6 percent if costs were expensed.
Prudential Financial's DAC accounted for a smaller proportion of equity, at 73.3 percent in 2008, but its pre-tax income would fall further, by 78.6 percent.
In contrast to FASB, the IASB would allow some premium revenue from contracts to be recognized at inception, that is, before it is received, so the effect on net income from any change would be mitigated.
But in either case, the report's authors noted that the increased leverage that would result from the change in accounting could violate the companies' debt covenants, increasing their debt costs, and even force them to raise equity.
"The proposed changes to the manner in which insurance companies treat acquisition costs may actually have an effect on the way insurers finance their operations," Mulford and Parkinson wrote.
The effective dates of such changes have yet to be determined, but the authors suggested that the accounting boards might want to give the industry a significant amount of time to adjust.
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