“Insurers’ Biggest Writedowns May Be Yet to Come: Jonathan Weil
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Commentary by Jonathan Weil

Aug. 20 (Bloomberg) — How many legs would a calf have if we called its tail a leg?

Four, of course. Calling a tail a leg wouldn’t make it a leg, as Abraham Lincoln famously said.

Nor does calling an expense an asset make it an asset. This brings us to the odd accounting rules for the insurance industry, including Lincoln National Corp., which uses Honest Abe as its corporate mascot.

Look at the asset side of Lincoln National’s balance sheet, and you’ll see a $10.5 billion item called “deferred acquisition costs,” without which the company’s shareholder equity of $9.1 billion would disappear. The figure also is larger than the company’s stock-market value, now at $7 billion.

These costs are just that — costs. They include sales commissions and other expenses related to acquiring and renewing customers’ insurance-policy contracts. At most companies, such costs would have to be recorded as expenses when they are incurred, hitting earnings immediately.

Because it’s an insurance company selling policies that may last a long time, however, Lincoln is allowed to put them on its books as an asset and write them down slowly — over periods as long as 30 years in some cases — under a decades-old set of accounting rules written exclusively for the industry.

Rule Overhaul

Those days may be numbered, under a unanimous decision in May by the U.S. Financial Accounting Standards Board that has received little attention in the press. The board is scheduled to release a proposal during the fourth quarter to overhaul its rules for insurance contracts. If all goes according to plan, insurers no longer would be allowed to defer policy-acquisition costs and treat them as assets.

One question the board hasn’t addressed yet is what to do with the deferred acquisition costs, or DAC, already on companies’ books. While there’s been no decision on that point, it stands to reason that insurers probably would have to write them off, reducing shareholder equity. The board already has decided such costs aren’t an asset and should be expensed. If that holds, it wouldn’t make sense to let companies keep their existing DAC intact.

The impact of such a change would be huge. A few examples: As of June 30, Hartford Financial Services Group Inc. showed DAC of $11.8 billion, which represented 88 percent of its shareholder equity, or assets minus liabilities. By comparison, the company’s stock-market value is just $7.3 billion.

MetLife, Prudential

MetLife Inc. showed $20.3 billion of DAC, equivalent to 74 percent of its equity. Prudential Financial Inc.’s DAC was $14.5 billion, or 78 percent of equity. Aflac Inc. said its DAC was worth $8.1 billion as of June 30, which was more than its $6.4 billion of equity. Genworth Financial Inc. listed its DAC at $7.6 billion, or 76 percent of net assets. That was more than double the company’s $3.4 billion stock-market value.

The rules on insurance companies’ sales costs are a holdover from the days when the so-called matching principle was more widely accepted among accountants and investors.

At life insurers, for example, it’s common to pay upfront commissions equivalent to a year’s worth of policy premiums. By stretching the recognition of expenses over the policy’s life, the idea is that companies should match their revenues and the expenses it took to generate them in the same time period.

The problem with this approach is that deferred acquisition costs do not meet the board’s standard definition of an asset. That’s because companies don’t control them once they have paid them. The money is already out the door. There’s no guarantee that customers will keep renewing their policies.

No Recognition

Even the industry’s normally friendly state regulators don’t recognize DAC as an asset for the purpose of measuring capital, under statutory accounting principles adopted by the National Association of Insurance Commissioners.

To be sure, the FASB’s decisions to date are preliminary. How to treat acquisition costs is one of many issues the board is tackling as part of its broader insurance project. Others include the question of how to measure insurers’ liabilities for obligations to policy holders.

Meanwhile, the London-based International Accounting Standards Board is working on its own insurance project and has said it would take a more accommodating approach to policy- acquisition costs.

Insurers would be required to expense them immediately. However, the IASB has said it would let companies record enough premium revenue upfront to offset the costs. That way, they wouldn’t have to recognize any losses at the outset. So far, the U.S. board has rejected the IASB’s method.

Congress Wild Card

The wild card in all this is Congress. Last spring, the insurance industry joined banks and credit unions in getting U.S. House members to pressure the FASB to change its rules on debt securities, including those backed by toxic subprime mortgages, so that companies could keep large writedowns out of their earnings. Because the FASB caved before, it’s a safe bet the industry would go that route again.

With so much riding on the outcome, we should expect nothing less. What’s at stake isn’t the real value of the industry’s assets, but investors’ perceptions of how much they’re worth.

Honest Abe wouldn’t be fooled.

(Jonathan Weil is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: Jonathan Weil in New York at jweil6@bloomberg.net

Last Updated: August 19, 2009 21:00 EDT “