by Tom Doran, April 2001

National Underwriter

Quick question:  Who (or what) are FASB and GAAP and what do they have to do with the insurance brokerage M&A world?  If your best guess involves a clouded recollection that Fasbee Gap opened at a Rolling Stones concert you attended in 1975, you're wrong.   FASB, or the Financial Accounting Standards Board, is actually a fun-loving group of accounting professionals responsible for establishing the rules of the accounting game, better known as GAAP (U.S. Generally Accepted Accounting Principles).  Late in 2000, FASB issued a proposal for a change in GAAP's treatment of how business combinations are accounted for that has set the M&A world aquiver.
 
Currently, GAAP allows for two ways to account for business combinations:  purchase and pooling.  Under the purchase method, the buyer creates a goodwill entry on the balance sheet to account for the difference between the price paid and the seller's book value.  For businesses whose values are made up primarily of intangible assets, like insurance agencies or software companies, this requires buyers to book large amounts of goodwill after a deal is done.  The buyer is then required to amortize, or write off, this goodwill for a period not to exceed 40 years.  Typically, acquired goodwill is amortized over 10-20 years.  This is for book purposes only - this amortization has no impact whatsoever on the acquirer's actual cash flow.  It does, however, depress reported earnings. 

For example, assume ABC Bank acquires XYZ Insurance Agency for $25,000,000 and XYZ Insurance's book value totals $1,500,000.  Under purchase accounting, ABC books $23,500,000 in goodwill.  If this goodwill is amortized over 20 years, ABC's reported earnings are tagged to the tune of $1,175,000 a year, while actual cash flows remain unchanged.  For buyers sensitive to transactions that create sizable drains on earnings due to amortization, the purchase accounting method proves to be about as popular as a class-action lawsuit.  Many financial institutions refuse to consider any insurance agency purchase that proves dilutive to earnings as a result of amortization, regardless of the underlying cash flows.

The pooling method allows for the combination of the buyer and the seller's balance sheet (a pooling of interests) and results in no new goodwill to book and amortize.  Under pooling, a transaction results in no reduction to reported earnings on the part of the buyer due to goodwill amortization.  Most public buyers love the pooling method.  Unfortunately, pooling transactions must meet a long list of strict conditions, so the pooling method can be difficult to use.

Although it is generally acknowledged that the current purchase accounting methodology is flawed, goodwill amortization is not all bad.  Goodwill and book amortization are unavoidable reminders of the actual costs of acquisitions, which are very real.  Under the pooling method, in which no goodwill is booked to indicate an acquisition's price, the costs and financial impact of acquisitions are much easier to obscure. 

Several years ago, FASB suggested that the pooling method be eliminated completely.  This proposal created a uproar in the M&A world, where FASB was accused of being "out of touch" with the realities of the "new economy," where intangible assets far outweigh "old economy" tangible assets, such as steel, physical plants and factories, in their contribution to enterprise value. 

Well, it turns out FASB wants to be "in touch" after all, so it has proposed an elimination of the pooling method.  Under FASB's proposal, business combinations would be accounted for with the purchase method, but goodwill and other intangible assets acquired would no longer be written off, subject to certain restrictions.  The proposed change would be retroactive, meaning companies currently amortizing intangible assets for book purposes on past acquisitions would no longer have to do so.   If these charges against earnings are eliminated, some analysts expect reported earnings to increase by as much as 5.5% in the banking community.  For banks with substantial acquired goodwill on the books, the increase in earnings would be even greater. 

Before you add FASB to your Christmas card list, recognize that there are material vagaries in the current proposal that may ultimately result in a less favorable environment in which to do deals.

First of all, an "impairment" rule has been proposed wherein any acquired intangibles that become impaired must be amortized.  If a case can be made that an intangible asset's book value exceeds its fair value, the asset would be written down to the point where the book and fair values are in equilibrium.  All acquisitions would be subject to an impairment review within a year of the closing date. In addition, certain "triggering events" may also result in an impairment review.  These include unexpected revenue shortfalls, cash flow losses, the loss of key employees, the loss of key accounts, and the like.  Unlike current amortization expenses, which constitute economic vapor, impairment amortization expenses would have some real teeth to them and would likely create justifiable concern on the part of the investment community. 

Secondly, FASB's proposal requires that all intangible assets acquired be separately identified and the purchase price allocated accordingly.  Under the proposal, intangible assets are to be considered separate from goodwill "if either (a) control over the future economic benefits of the asset results from contractual or other legal rights, or (b) the intangible asset is capable of being separated or divided and sold, transferred, licensed, rented, or exchanged."  Insurance expirations, the primary asset of any insurance agent or broker, would fall into this second category, so purchased insurance expirations would likely be accounted for separately from goodwill.

Here's the rub.  Intangible assets other than goodwill would then be classified as either indefinite or finite in life span.  If indefinite in their life span, intangible assets would be treated like goodwill, where amortization charges result only from impairment.  If, however, intangible assets are deemed to have a finite life span, they would be amortized over their useful lifetime.  This might result in an even shorter amortization period than under the current rules.  Reported earnings might be even lower than they would be under the current set of rules.  Any poor souls sensitive to reported earnings would end up worse off than if no change had taken place at all.

Now for the $64,000 question:  are purchased expirations an asset with an indefinite or a definite life span?  Some would argue that insurance expirations represent an asset with a clearly indefinite life span.  The price paid for insurance expirations reflects both the earnings expectations associated with expirations currently in place and those to be added to the fold in the future.  This argument holds that the earnings engine purchased (existing expirations) makes all future earnings possible.

Others might argue that the portion of the purchase price paid for earnings resulting from yet-unwritten expirations should be allocated to goodwill, since post-transaction expirations would originate out of the goodwill of the acquiring entity.   This perspective views a purchased book of business as simply a static list of accounts that should fade completely from sight in something far less than 40 years. Therefore, the portion of the purchase price allocated to the existing list of expirations would be amortized over a reasonable estimate of its useful life. 

One FASB member has been quoted as having said, "I think most intangible assets would have a defined life" and "The customer list has a finite life."  If this is a sign of things to come, it is likely that the eventual GAAP ruling will still result in sizable amortization charges for insurance agency deals.

It is expected that FASB will issue its final purchase accounting ruling as early as July 1.  One thing is clear - the early cheers regarding the elimination of intangible amortization were premature.  Until the final details of the actual ruling are known, the FASB proposal is unlikely to have any significant impact on transaction flow. 

If the ultimate ruling essentially excludes purchased insurance expirations from the amortization ax, the impact could be significant.  If this happens, expect to see earnings-sensitive financial institutions further accelerating their foray into the insurance arena.  This newfound earnings liberation would likely empower a large group of smaller community banks, hindered to date by the dilutive effects of amortization, to begin acquiring insurance agencies of a significant size.  Publicly traded insurance brokers currently tempering their acquisition appetites to manage reported earnings would be much freer to pursue their quarry.  

This being a supply & demand world, a new and energized supply of buyers should create additional demand for quality acquisition targets, thus providing continued support for already strong agency pricing, if not pushing price levels even higher.  For privately held agents, who already operate in a cash flow world, these proposed accounting changes should have little impact other than perhaps increasing the competition for acquisitions even more.
 
Tom Doran (tom@reaganconsulting.com) is a Principal with Reagan Consulting, an Atlanta-based management consulting firm that serves the insurance distribution system.  Visit Reagan Consulting at www.reaganconsulting.com.