At the Actuaries Institute Financial Services Forum, in May, I’m running a Panel discussion entitled Is MOS Accounting Responsible for the Woes of the Retail Life Industry? This post gives some background to the question and why it seemed a good topic for a panel discussion.
What are the woes of the Retail Life Industry?
I posted earlier this year about the issues affecting the Australian life industry as a whole. Annualised profit as a percentage of premium (after tax) has dropped from just over 15% in early 2009 to 2.0% in the year to December 2013. The whole Australian life insurance business (excluding reinsurance that went off shore) made a profit of $249m in 2013, a margin of 2.0% on a revenue of $12.7 billion income. That’s unlikely to be an adequate return on capital.
Retail insurance made more than 100% of the profits noted above; making a profit of $684m in 2013, a profit margin of 8% on $8.3 billion of income. Compared to the Wholesale (group) side, that is quite good, but it is a massive drop in profitability from a few years before. In the year to March 2009 (the first 12 months for which APRA statistics are available) $4.5 billion of income earned retail life insurers a profit of $857m, at a profit margin of 19%.
So why are the returns so bad now?
There are a few main drivers of profitability in retail insurance:
- Commission and other acquisition expense levels – most retail life insurance has high acquisition costs – either high up front commission rates (some over 100% of the first year’s premium) or other marketing costs, such as advertising. Over the life of the policy, the higher the up front costs, the lower the profits. And that leads to our next driver:
- Retention – the longer a contract stays paying premiums, the more chance the company has of recovering those high acquisition costs, and then making profits. Life insurance contracts with attached advice generally only break even over 5-7 years of the life of the contract.
- Claim rates – Around half the premium of a retail life insurance contract goes into paying claims, over the life of the policy, which means that higher claims will lower profitability; in particular
- Duration of claims – the longer an income claim stays disabled, the higher the total payments made to claimants.
Most of these issues are affecting the industry; some parts of it more than others, depending on the way in which insurance contracts were sold, and in some cases, exactly what types of claim can be made on the policy.
So far, all of this seems straightforward. The complexity comes when considering the long term nature of the contract. Because the cost of selling the contract is so high, a life insurer can only be profitable if contracts stay around for a while. That’s why retention is such a key driver. It is also why life insurance accounting is very complex; to try and capture the long term nature of the profitability in a balanced way.
MoS Accounting (Australian GAAP)
Back in 1995, Australia introduced its own method of accounting for these contracts – called Margin on Services (MoS). There is no international accounting standard for insurance contracts, and most methods in use at that time were unsatisfactory for a variety of reasons.
Very briefly, the intent of MoS accounting is to spread the profits of the contract over the expected life of a contract. Providing it is expected to make a profit, the company sets up an asset of the total up-front costs (often called DAC – deferred acquisition costs) at the point of sale. This means that there is no profit or loss at the point of sale. Over the life of the contract, the asset is gradually written off using a complex formula intended to spread the profits as a proportion of the “profit carrier” – generally premiums or claims.
So providing the assumptions made at the outset about the contract (retention, claims, expenses etc) are correct, the profit will emerge smoothly over the life of the contract.
Of course, as every actuary knows, the only certainty is that the assumptions will be incorrect. This presentation from NZ is the only analysis I have seen of experience gains and losses (where the outcome for a particular year was higher or lower than assumption).
So when experience suggests that assumptions should be changed, the pattern of future profits is changed. There is no change to past profits. So if the actuary forms the view that retention is worse than originally thought, or that claims are going to be higher in future, future profits will be reduced. There will be no impact on this year’s P&L (except the impact that came from the claims or retention being worse than expected this year). The only exception to this is if there are no profits left; if the profit is expected to be loss making, this must be recognised immediately.
Issues with MoS accounting
Any issues arising with MoS accounting are the interaction of the reported profits with the management and shareholder response. Ultimately the purpose of accounting for profits and losses is to help understand the health of a business. With an insurance business, there is enough complexity that no single measure will be perfect.
That said, what kind of issues emerge with MoS Accounting?
- Deferral of acquisition expenses – as outlined above, the costs incurred in acquiring new business are deferred, and gradually taken as expenses over the life of the contract. This means that if you use the profit line as the main way in which to measure the performance of your business, these costs will show up many years after they are incurred, and well after any action can be taken.
- Smoothing of assumption changes over the future – if the experience of the portfolio is gradually worsening, that worsening experience is spread over the future life of that portfolio. It doesn’t emerge immediately, until suddenly, it does, if there is loss recognition.
- Spreading of claims cost over future years – this is a special case of the smoothing of assumption changes. For many companies, a change in the assumptions about the duration of income claims (even existing ones) will be spread over the future life of the portfolio.
- No recognition of cost of capital – There is risk involved in insurance. Companies hold capital to guard against the risk of not having adequate assets to pay claims when they occur. Profit accounting does not allow for the cost of holding this capital (which is not an issue unique to insurance).
Does profit reporting drive behaviour?
One of the key questions in all of this is how much profit reporting drives behaviour. Some of the underlying issues in a portfolio that might be obscured by this method of accounting could include:
- Acquisition expenses that are uneconomic for the business being sold
- Overly optimistic assumptions at the point of sale
- Reductions in expected value of business (from changes in views of retention or claims behaviour), even to the point of not making an adequate return on capital, that don’t lead to actual losses
- Profitability of business being highly sensitive to different choices of assumptions
Some of these issues may emerge in a portfolio regardless of how much information managers and shareholders have, and how they report their profits. But if the profit reporting is all they have, will it change how they manage the portfolio?
Please feel free to comment below. As is the case with any industry going through a rough patch, there is no single cause, rather a raft of them. But with changes in accounting policy likely to occur in this industry in the next few years, it would be good to tease out issues with our current approach.