New accounting rules intended to align U.S. insurers’ varied approaches to accounting for deferred acquisition costs (DAC) will negatively affect insurers’ reported equity and some of the financial metrics that the companies report, but will have no direct effect on either their credit quality or ratings, says Moody’s Investors Service in a new report.
Moody’s said the magnitude of the effect on a company’s financials will vary based on the firm’s distribution model, growth rates, and past capitalization policy.
“We expect the new rules to lead to greater consistency in financial reporting, to the benefit of investors and other users of financial statements,” said Wallace Enman, the Moody’s vice president and senior credit officer who authored the report. “Accounting rules, by themselves, however, do not affect the underlying economics of the business, or our view of an insurance company’s creditworthiness.”
According to Moody’s, adoption of the new rules could have some secondary effects, if they reveal that a firm’s previous DAC policies have been more aggressive than those of its peers, or if their impact on equity or earnings negatively affects an insurer’s bank covenants, investor demand or access to capital.
The new rules for insurance companies’ capitalization costs become effective in first quarter 2012. Firms will have the option of adopting the new rules prospectively by applying them only to future acquisition costs or retrospectively by restating previously reported numbers.
Moody’s said it expects most firms to adopt them retrospectively, which will involve recalculating DAC assets as if the new rules had been applied in prior periods, which will improve year-to-year comparability.
Applying the rules to past results will cause an immediate write-down of a portion of existing DAC, with a corresponding reduction in shareholders’ equity (net of tax). These changes will in turn alter the financial ratios and metrics that Moody’s uses to analyze insurers, although the underlying economics of the business will be unchanged.
The rating agency explained that under U.S. GAAP, insurers are permitted to capitalize certain costs incurred in the acquisition of new and renewal insurance contracts. Acquisition costs are defined as those that “vary with and are primarily related to the acquisition of insurance contracts.” Various interpretations of the phrase “vary with and are primarily related to” have led to different capitalization policies among insurers. The new rules are an attempt by the Financial Accounting Standards Board (FASB) to minimize such differences among insurers and to more specifically define — and, by extension, reduce— the costs that can be capitalized, according to Moody’s.
Called “New DAC Rules to Negatively Affect Insurer Equity and Affect Earnings,” Moody’s special comment analyzes the potential effect of the new rules on insurers’ financials, as well as the potential impact on life insurers’ metrics.
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