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Safety Nets For the Future.

Adverse-development policies help smooth mergers and acquisitions by protecting the buyer from the risks of the seller's past.

The insurance industry is experiencing the longest soft market in its history, which has encouraged a new wave of consolidation. A significant by-product of this consolidation is the purchase of adverse-development covers, which are designed to protect the future earnings of the newly merged companies from any surprises from the past.

The property/casualty acquisitions announced in 1998 and 1999 were valued at more than $100 billion. In the reinsurance arena, it appears that size does matter. The average surplus for the top 10 U.S. reinsurers (excluding Berkshire Hathaway's National Indemnity, which skews the figures because of its size) has surpassed $2 billion, based on 1998 data. Including National Indemnity, average surplus was more than $4.5 billion. With Swiss Re America's pending acquisition of Underwriters Re, the surplus benchmark will move up another notch.

Most of these acquisitions are being consummated with adverse-development covers. These covers serve to make the seller more attractive, because the buyer has a higher degree of confidence in the potential return on investment. The primary reason for purchasing an adverse-development cover is to protect GAAP earnings and share price. Adverse-development covers offer these additional benefits:

* They protect statutory earnings and surplus.

* They minimize the financial-statement impact of adverse development on reserves, such as those held for asbestos and environmental liabilities, construction defect liabilities, other mass torts and asset write-downs such as reinsurance recoverables.

* They protect financial-strength ratings, access to capital and the cost of capital.

Accounting Rules

Accounting standards that pertain to reserve guarantees conflicted until a task force resolved the differences. The Financial Accounting Standards Board, in its standard on short- and long-duration reinsurance contracts (FASB Standard No. 113), provides for retroactive accounting of reserve guarantees that were funded through a reinsurance agreement. The Accounting Principles Board's opinion on business combinations (APB Opinion No. 16) provides for prospective accounting of such guarantees. The Emerging Issues Task Force of the Financial Accounting Standards Board noted that the purchaser may reflect the credit as income for the receivable due from the seller under a reserve guarantee.

Under the Emerging Issues Task Force announcement (EITF D-54), generally accepted accounting principles will allow the purchaser of an insurance enterprise to account for an adverse-development cover as prospective reinsurance under certain conditions. The prospective accounting treatment is limited to business combinations that are accounted for as a purchase under the Accounting Principles Board's opinion. Furthermore, the adverse-development cover must be purchased by the seller in lieu of a guarantee and be placed contemporaneously with the sale. The task force opinion does not apply to spinoffs, initial public offerings, demutualizations or acquisitions accounted for as a pooling of interest.

Statutory accounting procedures allow the benefits of an adverse-development cover to be reflected as "other income" on the income statement and as "special surplus from retroactive reinsurance" on the balance sheet. The special surplus is restricted from paying dividends, but it is given full credit in the National Association of Insurance Commissioners' risk-based capital formula and in other statutory solvency measures. Thus, the purchaser of an insurance enterprise is able to protect both GAAP and statutory income and surplus from any adverse contingencies associated with an acquisition. Depending on the structure of the adverse-development cover, its net cost might decrease the book value of the company being acquired. But most insurance company executives are willing to accept the slight increase in the goodwill amortization to avoid the chance of a much bigger negative surprise to earnings.

Belts and Suspenders

Regardless of how complete and thorough the due diligence of an acquisition may be or how adequate the acquired insurance company reserves may appear, surprises happen in the insurance industry. Berkshire Hathaway's $275 million surprise charge for Cologne Re after acquiring General Reinsurance Corp. illustrates what can happen in even the best acquisition scenario.

An adverse-development cover is an integral part of a successful acquisition strategy. The acquired company may be able to clean up its balance sheet before the sale by increasing reserves to the high end of the range, writing off uncollectible reinsurance recoverables or other similar charges. But these measures address only the known items.

An insurance executive might view an adverse-development cover as a "belts and suspenders" approach to an acquisition. The one-time window of opportunity to reinsure past exposures and obtain prospective GAAP earnings protection is compelling. And since the adverse-development cover leverages off the entire reserve base, certain economies of scale are realizable that are not available under normal circumstances. For instance, the coverage afforded by the adverse-development cover may be broadened to include other balance-sheet items, such as other legal liabilities that are not reinsurable on a stand-alone basis. Also, certain incidental tax efficiencies might result from the transaction that serve to make the cost/benefit relationship of the transaction favorable for the buyer and seller of the insurance company.

Other Considerations

Aside from the tax implications, parties in an acquisition also need to evaluate considerations concerning the U.S. Securities and Exchange Commission. It is critical to include the independent auditors from both sides of the acquisition to ensure that sufficient risk is being transferred to the reinsurers. Even though the retroactive accounting aspects of the Financial Accounting Standards Board's statement on reinsurance might not apply to an adverse-development cover, its risk-transfer requirements still apply. The auditors also will want to ensure that the nature of the coverage is properly disclosed and that earnings are not distorted.

Putting It to Use

Suppose ABC Co. is selling XYZ Insurance Co. to Growing Insurance Co. Growing Insurance has required, as a condition of the purchase, that ABC provide a $100 million guarantee for the held reserves of XYZ or fund such guarantee through an adverse-development cover from a highly rated reinsurer. The $100 million represents 10% of XYZ's $1 billion reserve base. The reserves primarily consist of casualty losses that pay, on average, in eight years. The last losses are expected to pay 20 years after the date of sale.

ABC arranges an adverse-development cover with AAA Reinsurer. The analysis of the contingent $100 million of coverage indicates that if losses develop adversely, such losses above the held reserves are not expected to pay until 10 years after the sale, with an average settlement of 15 years. The evaluation of reserves indicates that the held reserves are near the high end of the range. There is a 5% probability that the $100 million of contingent coverage will be fully utilized. Based on the analysis, AAA Reinsurer is willing to provide such coverage for $25 million of consideration on a guaranteed-cost basis (that is, with no profit sharing).

ABC finds these terms desirable. The guarantee enhances the sale price of XYZ, and the adverse-development cover helps bring finality to ABC's venture into the insurance business. Growing Insurance's interests also are served by the adverse-development cover, because future earnings are protected from any surprises from XYZ's past. The $25 million pretax cost of the adverse-development cover may result in a $16.25 million post-tax decrease in book value and a comparable increase in goodwill. In essence, the cost of the adverse-development cover will be amortized, for example, over 20 years at less than $1 million per year.

A Growing Trend

The consolidation in the insurance industry is expected to accelerate. The premiums over book value desired by sellers will necessitate adverse-development covers to further justify such sale prices. The buyers of insurance companies will demand adverse-development covers to protect the future returns on such acquisitions. The one-time window of opportunity to protect future income from surprises from the past and obtain prospective GAAP accounting treatment is an opportunity on which many insurance executives are capitalizing.

Hugo Kostelni is vice president with Pegasus Advisors Inc., a reinsurance intermediary and consultant in Avon, Conn.
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Article Details
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Title Annotation:reinsurance, adverse development
Comment:Safety Nets For the Future.(reinsurance, adverse development)
Author:Kostelni, Hugo
Publication:Best's Review
Article Type:Brief Article
Geographic Code:1USA
Date:Jun 1, 2000
Previous Article:Lessons from Unicover.
Next Article:Islands in the Sun.

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