Deferred Acquisition Costs for Life Insurance Companies

[wstguest]

I am trying to value diversified insurance companies using market multiples. When you have the "amortization of deferred policy acquisition costs" for life insurers, should I treat it as a cash expense, not as a non-cash amortization charge it ostensibly is?

This issues arises becuz we're comparing health insurers vs. life insurers. Back in 1986, many health insurers also had life insurance exposure. So this supposedly noncash chrage (deferred policy acquisition cost amortization), which is predominantly broker commissions for the unearned premiums of acquired life insurance policies, gets added back and increases the EBITDA base. (I know that we should use equity multiples -- i.e., PTI or BV but we're forced to use EBITDA along with those).

My thinking here is that this item should be treated as an expense because this large non-cash item articially lowers the EBITDA trading multiples when treated as a noncash charge. Subtracing this amount from the EBITDA base makes the multiples to be much more reasonable. Also, doing so makes the EBITDA multiples (i.e., enterprise value to EBITDA) to be similar to the PTI multiples (i.e., MV to PTI). Have you ever normalized the EBITDA base for a mixed insurer with life insurance exposure this way?

For example:

EV = 80
EBITDA = 20
EBITDA multiple = 4x

Amortization of deferred policy acquisition costs = 10
EBITDA adjusted by treating this amortization as an expense = 20-10 = 10
Adjusted EBITDA multiple = 8x

Will normalizing this way eliminate the distortions caused by this noncash item? Thanks.

[wstexpert]

the DAC as its called arises bc life insurers pay commissions
upfront to brokers which obviously due to accrual accounting,
matching principle must be amortized.

Thus GAAP "underwriting income" is higher than Statutory
underwriting income. Since for purposes of GAAP "EBITDA" and
general profitability, this non-cash DAC is a legitimate
expense, do not add back. Think of it as prepaid rent or
something. When you prepay rent to landlord its a cash outflow
like paying commissions but doesn't hit GAAP I/S but when you
recognize both expenses it lowers GAAP I/S. You would never add
back that prepaid rent to EBITDA so don't here.

This is why life insurers need so much capital in the early
years bc statutory capital & surplus is lowered bc you don't
have that cash anymore to back claims.

[wstguest]

Thanks, that's what I thought. Now, if I wanna use the BV multiple, it seems that I need to adjust the BV by the "deferred policy acquisition costs" and/or the "value of insurance purchased," since the amounts are sitting on the balance sheet as an asset. It would only seem to make sense to make this adjustment. My question then is, should the "value of insurance purchased" also be adjusted? It would seem that only a portion need to be taken out, since DPAC is only for the unearned premium portion? I would rather make 1 big adjustment.

TA = 10
TL = 5
BV = 5
DPAC = 2
Value of Insurance Purchased = 1

So adjusted TA = 10 - 2 - 1 = 7. 7 - TL (5) = 2 = adjusted BV? Or is it 5-2 = 3 is new BV, sans Val of Ins Purchased?