An annuity anomaly: Record sales, red ink

The insurance industry booked record annuity sales last year – and, says one expert, may have hidden buckets of red ink with questionable accounting practices.

The culprit: last year’s plunging stock market.

Most insurers model their sales expenses and fees on the assumption that variable-annuity accounts will appreciate at 8% to 10% annually, slightly less than the 11.3% compound annual growth rate of the Standard & Poor’s 500 stock index over the past 75 years.

If you consider the broad stock market’s 9% drop, variable-annuity sales from the last half of 1999 through last year were unprofitable for the industry and are unlikely to ever generate a profit, says Robert Saltzman, chief executive of Jackson National Life Insurance Co. in Lansing, Mich.

“If you predicated your pricing on 8% to 10% positive investment performance, and you start off with a minus 8% to 15% – or worse if there was a large Nasdaq component to the investments – you’re way in the hole,” Mr. Saltzman says.

But Michael Weinstein, a senior vice president and insurance analyst at Putnam Investments in Boston, believes companies are still writing profitable business, though margins are significantly less than they were two years ago.

He figures return on equity has fallen to 14% to 15%, from 18% to 20%.

“When people run aggressive sales promotions, it could be as low as 9%,” Mr. Weinstein says.

Tight spot

Nonetheless, the situation is likely to put increasing pressure on profits, which could hurt stock prices and nail investors, especially if the market performs poorly again this year.

That, in turn, could force a round of consolidations among smaller industry players caught in the squeeze.

But Mr. Saltzman contends that some insurers may be trying to forestall the inevitable by using questionable accounting practices to mask declining profitability.

Publicly traded insurers must report their earnings to investors and the Securities and Exchange Commission using generally accepted accounting principles. GAAP rules measure earnings by attempting to match revenues to expenses.

For example, under GAAP, the costs associated with selling a variable-annuity contract – such as agent commissions and wholesaler costs – are spread over the policy’s expected lifetime.

The amortized expenses are referred to as “deferred acquisition costs,” an intangible asset that insurers hold on their balance sheet.

Mr. Saltzman says some insurers he declined to name appear to be using unrealistically long assumptions.

Stretching the amortization period boosts near-term earnings, because a smaller portion of the costs is charged against annuity fee revenues. Many insurers amortize annuity sales costs over 15 to 20 years.

Companies also use widely varying standards to determine how much of a contract’s sales costs should remain unexpensed after the contract’s five- to seven-year period expires for surrender charges.

Mr. Saltzman says that that can range anywhere from 30% to 60% of annuity sales costs. That’s significant because redemptions usually spike up after surrender charge periods end.

“If an insurer can show their auditors they have experience that shows that level of persistence, then the auditors would probably let them do it,” says Mr. Weinstein. “I don’t think it would make many investors comfortable to know that was the case.”

Though no firm data exist, account persistency is turning out to be materially less than some insurers may have assumed in their pricing, especially with the popularity of bonus annuities, Mr. Saltzman says.

For example, many insurers routinely encourage their annuity customers to switch to in-house bonus offerings to avoid outside raids from competitors. The internal switches add another layer of commission expenses onto the original policy.

“Many people think if you pay more than half the commission paid on a new sale, for an internal exchange, you are probably [better off letting the business go],” says Mr. Saltzman.

Companies appear to be willing to swallow a loss on internal exchanges rather than risk investor concern over a shrinking asset base.

But don’t expect insurers to voluntarily confess to that accounting maneuver anytime soon, says Mr. Saltzman.

Annuity sellers can put off taking charges against their earnings by offsetting their current losses with higher than expected profits on annuities sold in the last half of the 1990s, which enjoyed robust returns.

If the market remains flat, insurers may be forced to take significant write-offs against deferred sales costs.

“It will play out very slowly,” predicts Mr. Saltzman. “You can assume your way to profitability through DAC assumptions only so long.”

Increased scrutiny by Wall Street analysts would also help foster more-realistic accounting assumptions.

But “analysts focus too easily on sales and market share growth because they think it is a leading indicator to profitability,” says Mr. Saltzman.

“I’m not sure these sales are all that profitable and the sooner analysts figure this out, the healthier it will be for the industry,” he says.

The American Institute of Certified Public Accountants is studying the treatment of sales inducements and sales expenses associated with internal replacements. The group expects to issue final guidelines by yearend.

Variable-annuity sales reached $1.4 trillion last year, up 12% over 1999, according to the Variable Annuity Research and Data Service of Marietta, Ga.

But if last year’s fourth quarter was similar to the first nine months of 2000, then for every $100 in sales that annuity companies took in last year, $68 went out through redemptions. In contrast, $39 went out the door for every $100 in sales in 1996.

“Given the market, I’d argue that the sales that were made in 2000, and the later part of 1999, are likely to be unprofitable for their lifetime, which is probably a very sobering fact if anyone focuses on it.”