Many life insurance companies will be taking deferred acquisition cost (DAC) charges when they release earnings this quarter. This may cause an investor panic and a major selloff in the group.
Deferred acquisition costs represent the costs that an insurer spends to acquire a customer when it issues a policy. Those costs are capitalized on the balance sheet as an asset and then expensed over the life of the policy as the premium is earned. When a company establishes this account it must make assumptions about investment returns, mortality, policy lapses and expenses. If actual experience differs materially from these assumptions used, then the company must "unlock" its deferred acquisition costs to reflect reality.
If a company has lower investment returns than what was modeled into its assumptions, then it must accelerate the recognition of the deferred acquisition costs, and take a charge to reflect it. Since this is an asset account, it reduces book value. (To learn more, read Testing Balance Sheet Strength.)
Two Breeds of DAC
There are two types of unlocking of deferred acquisition costs: prospective and retrospective. Retrospective unlocking refers to a change in the previous profit estimates to the actual profits in the current quarter, while prospective unlocking is based on an annual review by a company, where they adjust assumptions used in models to estimate future profits.
This fall in the equity markets has cut actual investment returns, which forces the retrospective unlocking, and some companies may adjust models this quarter, which will trigger the prospective unlocking.
Several companies have already announced deferred acquisition cost charges this quarter. Prudential Financial (NYSE:PRU) announced on October 9, 2008, that it was taking a pre-tax charge of $380 million or 68 cents per share related to its individual annuity business. MetLife (NYSE:MET) also took a deferred acquisition cost charge of $105 million or 14 cents per share.
Fixed Income Decline
This is not the only issue facing insurers, as they also hold large investment portfolios of fixed income securities that are used to pay off claims. These portfolios have declined in value the last three months and insurers must recognize the decline in value as well.
Hartford Insurance Group (NYSE:HIG) was one insurer taking a large loss on its investment portfolio. The company announced in early October that the net realized loss would range from $7.05-7.25 per share, or $2.1 billion to $2.2 billion. Its next earnings report is expected after market close October 29, 2008.
Lincoln Financial Group (NYSE:LNC) also wrote down the value of its portfolio with net realized losses on investments and derivatives in a range of $140-160 million, or 55-60 cents per diluted share. Even more worrisome was a net unrealized loss of $1.8-2.0 billion. Total revenue reported for the three months ending June 30, 2008 was $2.58 billion which was down 3.4% from the same period in 2007. Net income was down 66.8% in the most recent quarter from $376 million in 2007 to $125 million in 2008. On an earnings per share basis that's a drop to 48 cents per share from $1.37 per share. Current quarter results are expected October 28, 2008.
Standard and Poor's also recognized the issues impacting the life insurance industry and revised its outlook to' negative' from 'stable', citing "expectations of higher-than-normal credit losses, lower fee-based revenue and a reduced financial flexibility".
Investors should brace themselves. The latest issue to hurt the life insurance sector will be the acceleration of deferred acquisition costs as a result of lower investment return assumption - both real and future.