Life insurance primer

United StatesInsurance - Life

6 February 2003

Edward A. Spehar, CFAFirst Vice President

(1) 212 [email protected]

Rashmi H. PatelAssistant Vice President

(1) 212 [email protected]

Primer V

Scaling the Wall of Life

Merrill Lynch Global Securities Research & Economics GroupGlobal Fundamental Equity Research Department

RC#60203716

Investors should assume that Merrill Lynch isseeking or will seek investment banking or otherbusiness relationships with the companies inthis report.

Refer to important disclosures at the end of this report.

Primer V – 6 February 2003

2 Refer to important disclosures at the end of this report.

Bigger and Hopefully BetterIn the fifth edition of our Primer, we have added to ormodified our discussions on a number of topics. Onpages 26-27, we expanded our discussion on deferredacquisition costs (DAC) by looking at the relationship inthe individual annuity line between DAC amortizationand gross profits. On pages 66-97, we have added anew section on assessing normalized ROE for the lifeindustry. In our opinion, it is no longer reasonable toassume that latest twelve-month earnings are a proxyfor normalized results. The volatility of equity sensitivebusinesses, the varying exposures to credit risk and thereturn improvement stories for demutualizedcompanies suggest that more work is required. Thebottom line is forget 15%, we think normalized netROE for our coverage universe is 12%. We havebeefed up the discussion on the importance of ratingagencies on pages 129-130. We believe that theagencies are the force behind the level of capital heldby the industry. Given the recent developments relatedto guaranteed minimum death benefits (GMDB), wehave added a discussion on variable annuity productguarantees (p.173-174). Just when you thought we weredone with DAC, we decided to expand the sectiondevoted to the topic (163-169) with a discussion of thedifference between recoverability and unlocking. Finally,we added a new section on life reinsurance on pages 176-181. We did our best to provide some basics on the topic,but suffice to say, if you can figure out reinsurance, youprobably have a shot at developing the unified fieldtheory that eluded Einstein.

� What’s an Analyst to Do?

We originally decided to write a primer because someoneneeded to take a stab at explaining how to use lifeinsurance company financial statements to both identifyand interpret existing trends and to project future results.Unfortunately, this is not an easy task, and we apologizeup front for dragging the reader through some fairlycomplex accounting detail. We are sympathetic, especiallyconsidering that some of the more esoteric concepts are ofdubious value to someone whose focus is picking stocksthat go up, and perhaps even to the builder of lifeinsurance company earnings models.

However, we believe that we have included someinteresting ideas on how to approach the analysis of thegroup, the key drivers of earnings and returns, what towatch out for in the numbers (both positive and negative),useful “rules of thumb”, etc. In addition, we have put fortha reasonably comprehensive discussion of deferredacquisition costs and reserves, both key accounting areasthat are critical to understanding how GAAP profitsemerge for a life insurance company.

� Misunderstanding Hurts Valuation

Difficulty in understanding the industry’s accountingpractices likely is a valuation factor for life insurance

stocks. Complex accounting treatments for a giveninsurance product, as well as vast differences inmethodologies from one product class to another, presentchallenges for those who analyze life insurers’ financialresults. The existence of various profit drivers within thesame industry is an impediment to both understanding howa life insurer makes money and comparability fromcompany to company. Although life insurers provide moreinformation on profit drivers today than they did in thepast, insurers still do not fully disclose information thatwould help investors understand the profit dynamics andrisks inherent in the products that are sold, in our opinion.

� Mix Shift hasn’t Made it Easier

The life insurance industry has moved away from amortality and morbidity risk assuming focus toward asavings orientation, where profits increasingly aredetermined by investment spreads and fee income. Theshift in the industry’s business mix meaningfullycomplicates the financial analysis of life insurancecompanies, in our view. As recently as the mid 1980s itwas easier to understand life insurers’ financial results andmake company-to-company comparisons because the keyprofit drivers were premium income, policy benefits andexpenses.

Today, pure risk products are substantially less importantto the bottom line, and it is no longer reasonable to assumethat ordinary life is entirely a margin-on-premium business(because of the mix shift to investment-oriented products).Also, the increasingly important asset accumulationproduct lines are return-on-asset businesses withsubstantially different margin characteristics depending onwhether the top-line contribution is from an investmentspread or fee income.

� Don’t Give Up Hope

There is no question that it is difficult to decipher lifeinsurance company financial results, but we believe that it ispossible to make sense out of the numbers. We detail ourideas on this topic in the first six sections of this report, witha heavy emphasis on the level of and trend in return onequity (both net and operating). In sections seven throughnine, we discuss top-line issues (a little preview, growth ismodest and when it isn’t, that is probably a reason to beconcerned). In the latter sections, we explain GAAPaccounting concepts, a discussion that could cause at leastsome consternation among our readers. Our advice – do notpanic. Analysts and investors need to remember that,despite all of the complexity and uncertainty behind thenumbers, there is an inherent level of stability to lifeinsurance company earnings. Although there has been anincrease in earnings volatility because of exposure to theequity market (variable product lines) and credit losses,most traditional life companies continue to display areasonably high level of earnings predictability. Also, evenfor variable companies, estimate revisions have been lesspronounced than revisions to expectations for S&P 500earnings.


Refer to important disclosures at the end of this report. 3

CONTENTS

� Section Page

Executive Summary 2

It Isn’t Easy 1. 5

Making the Most of What’sAvailable 2. 21

Product Type Drives ModelingApproach 3. 35

Why We Pay So Much Attentionto ROE 4. 43

Focus on Operating, but Don’tForget Net 5. 57

Tackling Normalized ROE 6. 66

Understanding Sales andPremium 7. 98

The Potential Perils of Top-LineGrowth 8. 103

Think Single Digit Top Line 9. 109

A Comprehensive Approach toValuation 10. 114

Some Basics 11. 123

A Highly Regulated Industry 12. 126

Two Main Product Categories 13. 131

Understanding Distribution 14. 133

Two Accounting Systems –SAP and GAAP 15. 144

Accounting for Assets 16. 147



� Section Page

Understanding DAC 17. 163

Accounting for Reserves 18. 170

Income Statement 19. 175

How to Think About LifeReinsurance 20. 176

Accounting for Life InsuranceAcquisitions 21. 182

Modeling Blocks of Policies 22. 187

Appendix A:Life Insurer Accounting Survey

23.196

Appendix B:Life Insurance Products 24. 197

Bibliography 25. 203



1. It Isn’t EasyDifficulty in understanding the industry’s accounting practices likely is a factor forthe valuation of life insurance stocks. Complex accounting treatments for a giveninsurance product, as well as vast differences in methodologies from one productclass to another, present challenges for those who analyze life insurers’ financialresults. The existence of various profit drivers within the same industry (asevident from the diversity of modeling approaches presented in our quarterly LifeInsurance Model Book) is an impediment to both understanding how a life insurermakes money and comparability from company to company. The fundamentaldifferences in profit drivers by product suggest that consolidated financialstatements required under Generally Accepted Accounting Principles (GAAP) areof limited usefulness. Therefore, most insurance analysts spend their time focusedon the business segment financial information that is included in statisticalsupplements to the GAAP financials. While this detail gets us closer tounderstanding the derivation of a company’s profits, it does not solve thecomparability problem because insurers present supplemental financialinformation in a variety of formats. FAS 131, which was adopted no later than thefourth quarter of 1998, requires companies to present segment data that reflecthow the business is managed. In practice, this has meant generally modestchanges in the presentation of information, and, therefore, the usefulness of lifeinsurer financial statements has not changed as a result of FAS 131.

Lack of Clarity Hurts Valuation

Although life insurance companies seem to provide more information on profitdrivers today than they did five years ago, insurers still do not fully discloseinformation that would help investors understand the profit dynamics and the risksinherent in the products that are sold, in our opinion. (We use the term “life insurer”to refer to companies that sell life insurance, annuity and health insurance products,unless we explicitly state otherwise.) A few years ago as part of the preparation ofthis report, we sent an accounting survey to 27 publicly traded life insurancecompanies (Appendix A). The survey included specific questions on the key driversof profitability, the targeted returns by product line and the risks inherent in thebusiness. Of the 27 companies that received the survey, only six responded; and ofthe six that responded, the answers to the questions were often general in nature.For example, when asked about specific margin targets by product (as a percentageof assets, premiums or revenues), five of the six respondents provided only general,overall return on equity goals, and one company disclosed partial margin detail. Allof the life insurance companies surveyed with market capitalizations of greater than$5 billion chose not to respond.

In our opinion, accounting complexity and less-than-full disclosure are partiallyresponsible for the discount valuation awarded the group. Even though lifeinsurance earnings are relatively predictable and the Beta for the life group fromthe Capital Asset Pricing Model (CAPM) is approximately in line with the market,the valuation multiples awarded these stocks typically are at a discount toindustrial companies with similar growth prospects and returns on investment.Currently, despite the expectation that operating earnings per share growth for thelife insurance group will be a little better than 10% in 2003, the shares are tradingat about 50% of the market multiple (Figure 1). During the last five and ten years,the price-to-earnings multiple for the Merrill Lynch Life Insurance Index hasaveraged less than two-thirds of the S&P 500 multiple, and the group has not soldat a market multiple since mid 1985.

Financial disclosure typicallyvaries significantly from

company to company

Important analyticalinformation is not always

readily available

Discount valuation partiallyexplained by accounting

complexity & disclosure issues



Figure 1: Merrill Lynch Life Insurance Index – Relative Price-to-Earnings Multiple onExpectations, 1982-2002

0.30

0.40

0.50

0.60

0.70

0.80

0.90

1.00

1.10

12/8

112

/82

12/8

312

/84

12/8

512

/86

12/8

712

/88

12/8

912

/90

12/9

112

/92

12/9

312

/94

12/9

512

/96

12/9

712

/98

12/9

912

/00

12/0

112

/02

Note: Price-to-earnings multiple is based on current-year estimates from January through June and on following-yearestimates from July through December.Sources: Compustat Monthly PDE Database and I/B/E/S.

Although lack of transparency in the financial statements is a factor, we would beremiss to suggest that it is the sole reason for the group’s modest historical relativevaluation. From an economic standpoint, the life insurance group does not seemto deserve a premium valuation because growth prospects are fairly modest. (Wediscuss our more cautious view of growth in detail in Section 9.) In our opinion,policy reserve growth is one of the best overall indicators of the underlying top-line growth trend, especially given that revenue and premium growth trends aredifficult to discern as a result of changes in statutory accounting in 2001 (Figure2). Total policy reserve growth has slowed from an 8% to 10% annual rate overthe past ten and twenty-year periods to a 7% annual rate from 1996 to 2001. Theannuity business, which had been a key driver of overall industry asset growth, hasalso slowed from almost a 12% annual rate during the past twenty years to a 6%annual rate from 1996 to 2001 (Figure 3).

Figure 2: Life Insurance Industry Policy Reserve Growth

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

1981-2001 1991-2001 1996-2001

Life Health Individual Annuities Group Annuities Total

Note: Codification of statutory accounting in 2001 has led to comparability issues. We have adjusted the data to makethe year/year comparisons meaningful.Sources: American Council of Life Insurance (ACLI) and Merrill Lynch estimates.

The industry’s growth prospectsare modest, which also helps

explain relatively low valuation



Figure 3: Total Annuity (Individual and Group) Policy Reserve Growth

0%

2%

4%

6%

8%

10%

12%

14%

1981-2001 1991-2001 1996-2001

Note: Codification of statutory accounting in 2001 has led to comparability issues. We have adjusted the data to makethe year/year comparisons meaningful.Sources: ACLI and Merrill Lynch estimates.

No Longer a Simple Risk Business

The life insurance industry has moved away from a mortality and morbidity risk-assuming focus toward a savings orientation, where profits increasingly aredetermined by investment spreads and, in more recent years, fee income. Thesavings products sold by the industry often are referred to as asset-accumulationproducts, receive favorable tax treatment (tax deferral on the inside buildup), andcan either involve fixed or variable contracts. The mix shift to asset-accumulationproducts can be explained by, at least in part, individuals’ increasing concernabout living too long rather than dying too soon and the 1986 Tax Reform Act’selimination of most other tax-preferenced investments.

The significant change in the life insurance industry’s business mix since the mid-1980s is illustrated by Figures 4 and 5. Annuities (a pure savings product)accounted for 21% of the stock life insurance industry’s statutory operating profitsin 2001, which was a dramatic increase from only 2% of profits in 1986, plus webelieve that annuity earnings were below trend in 2001. During the past five yearson a cumulative basis, annuities accounted for almost 40% of total statutoryoperating earnings for stockholder owned life companies. The importance of assetaccumulation products to the life insurance industry is perhaps more dramaticallyillustrated by the differential between the growth rate of the annuity line and theperformance of all other lines of business combined. Since 1986, annuity earningshave compounded at a 26% annual rate compared to 5% annual growth for allother lines combined and 2001 annuity earnings were at a depressed level. Westill believe that demand for accumulation products will outpace other productlines because the 45 to 64 year old age group (or pre-retirement savers) willexhibit one of the fastest population growth rates during the next 10 years (Table1). However, we believe that the differential between annuities and other lines oflife insurance will be less pronounced than has been the case since the mid 1980s.

The business has shifted towardasset accumulation products…



Figure 4: Stock Life Insurance Industry Profit Mix, 1986

Supplementary Contracts

0.5%

Other Accident & Health10.6%

Credit 8%

All Other12.1%

Industrial6.5%

Group Accident & Health10.2%

Group Life8.6%

Annuities1.8%

Ordinary Life42.2%

Note: Data is on a statutory basis.Source: A.M. Best’s Aggregates and Averages.

Figure 5: Stock Life Insurance Industry Profit Mix, 2001

Ordinary Life40.8%

Annuities20.7%

Group Life7.7%

Group Accident & Health2.5%

Industrial3.1%

All Other11.9%

Credit Insurance5.6%

Other Accident & Health6.7%

Supplementary Contracts

1.1% CAGR ’86-’01 CAGR ’96-’01Total Industry 7% -1%Total Annuity 26% -12%Total Ind. w/o Annuity 5% 4%

Note: Data is on a statutory basis. Codification of statutory accounting in 2001 has led to comparability issues on ayear/year basis, especially with regard to revenues and expenses.Source: A.M. Best’s Aggregates and Averages.

Table 1: Population Projections, 2000-2025

Compound Annual Growth2000A 2005 2010 2025 2000-2005 2000-2010 2000-2025

Under 5 19,176 19,212 20,099 22,551 0.0% 0.5% 0.7%5 to 14 41,078 39,756 39,346 44,486 -0.7% -0.4% 0.3%15 to 19 20,220 20,990 21,668 22,203 0.8% 0.7% 0.4%20 to 24 18,964 20,159 21,151 21,411 1.2% 1.1% 0.5%25 to 34 39,892 36,933 38,851 42,872 -1.5% -0.3% 0.3%35 to 44 45,149 42,716 39,443 43,234 -1.1% -1.3% -0.2%45 to 54 37,678 41,891 44,161 38,291 2.1% 1.6% 0.1%55 to 64 24,274 29,690 35,429 40,125 4.1% 3.9% 2.0%65 to 74 18,391 18,461 21,154 35,603 0.1% 1.4% 2.7%75 to 84 12,361 12,943 12,775 19,598 0.9% 0.3% 1.9%85+ 4,240 4,968 5,786 7,441 3.2% 3.2% 2.3%Total 281,422 287,716 299,862 337,815 0.4% 0.6% 0.7%

Source: Statistical Abstract of the United States, 2001.

...which have becomeincreasingly important to

industry profits



The increase in annuity profits does not fully capture the significance of assetaccumulation products to the bottom line because ordinary life insurance productshave become increasingly investment (savings) oriented. Table 2 illustrates theincrease in the combination of universal life, variable-universal life and variablelife as a percentage of total life insurance in force for the years 1983-2000 (latestavailable data). The preference for fixed products over variable products duringthe past couple of years has led to an increase in market share for universal lifeand a decrease in market share for variable-universal life and variable life.Despite the mix shift, investment-oriented product sales have remained animportant source of new business, but the drop in demand for variable productshas led to a decline from 63% of total life sales in this category to approximately50% of total life sales in 2002. For all savings-oriented life products, the commoncharacteristic is that the investment component is evident to policyholders.Therefore, unlike traditional life insurance, returns must be competitive withcomparable market rates or there will be an increased risk of policy lapsation. Asa result of the growth in investment-oriented life insurance, we believe that alarger portion of ordinary life earnings relates to accumulation-type products.

Table 2: Increased Importance of Investment Oriented Life Insurance (In Force Life Insurance, $ in Mils.)

% of % of % of Total Investment % ofOrdinary Life Variable Life Ordinary Universal Life Ordinary Variable-UL Ordinary Oriented Life Ordinary

1983 2,544,275 13,885 0.5% 131,309 5.2% 145,194 5.7%1984 2,887,574 21,506 0.7% 319,922 11.1% 341,428 11.8%1985 3,247,289 29,055 0.9% 563,609 17.4% 6,052 0.2% 598,716 18.4%1986 3,658,203 38,037 1.0% 864,479 23.6% 26,486 0.7% 929,002 25.4%1987 4,139,071 49,230 1.2% 994,863 24.0% 57,813 1.4% 1,101,906 26.6%1988 4,511,608 50,277 1.1% 1,169,892 25.9% 85,911 1.9% 1,306,080 28.9%1989 4,939,963 53,849 1.1% 1,390,937 28.2% 107,219 2.2% 1,552,005 31.4%1990 5,366,982 52,087 1.0% 1,618,653 30.2% 114,033 2.1% 1,784,773 33.3%1991 5,677,777 51,529 0.9% 1,520,098 26.8% 175,762 3.1% 1,747,389 30.8%1992 5,941,810 52,328 0.9% 1,735,084 29.2% 217,834 3.7% 2,005,246 33.7%1993 6,428,434 64,170 1.0% 1,976,651 30.7% 274,787 4.3% 2,315,608 36.0%1994 6,407,399 68,313 1.1% 2,113,981 33.0% 338,551 5.3% 2,520,845 39.3%1995 6,815,630 72,677 1.1% 2,171,598 31.9% 411,219 6.0% 2,655,494 39.0%1996 7,294,079 84,550 1.2% 2,157,591 29.6% 507,027 7.0% 2,749,168 37.7%1997 7,854,570 105,440 1.3% 2,122,419 27.0% 792,323 10.1% 3,020,182 38.5%1998 8,505,894 87,649 1.0% 2,128,217 25.0% 1,096,193 12.9% 3,312,059 38.9%1999 9,172,397 100,714 1.1% 1,897,059 20.7% 1,095,141 11.9% 3,092,914 33.7%2000 9,376,370 83,802 0.9% 1,839,089 19.6% 1,328,407 14.2% 3,251,298 34.7%CAGR 1990-00 5.7% 4.9% 1.3% 27.8% 6.2%CAGR 1995-00 6.6% 2.9% -3.3% 26.4% 4.1%Source: American Council of Life Insurance.

Mix Shift Adds Significant Complexity

The shift in the industry’s business mix meaningfully complicates the financialanalysis of life insurance companies, in our view. As recently as the mid-1980s itwas easier to understand life insurers’ financial results and make company-to-company comparisons because the key profit drivers were premium income,policy benefits and expenses. Policy benefits for most products primarily were afunction of mortality and morbidity experience, and expense levels were afunction of commissions and general expenses. In 1986, product lines for whichpremium growth and the margin on premium determine financial results (healthinsurance, industrial life, credit insurance and group life) accounted for 45% oftotal stock life insurance company profits. In contrast, these product lines haveaccounted for approximately 20% of stock life insurance company profits over thepast five years. Also, in 1986 ordinary life still was primarily a margin-on-premium business and accounted for 41% of profits. Over the past five years,ordinary life has accounted for 27% of stock life insurance company profits and isnow a mixture of return-on-premium and return-on-asset products.

Accumulation products includemore than just annuities

For accumulation products, thekey metrics are different…



It was reasonable to assume in the mid-1980s that premium income, mortality andmorbidity experience and expense levels drove approximately 85% of theindustry’s profits. Today, pure risk products are substantially less important to thebottom line, and it is no longer reasonable to assume that ordinary life is a margin-on-premium business (because of the mix shift to investment-oriented products).Also, the increasingly important asset accumulation product lines (both annuitiesand life insurance) are return-on-asset businesses with substantially differentmargin characteristics depending on whether the top-line contribution is from aninvestment spread or fee income. Adding to the confusion, most of the premiumincome from savings-oriented products (FAS 97) does not flow through theincome statement, while premium income is considered revenue for traditionalproducts (FAS 60). Statement of Financial Accounting Standards No. 97 becameeffective for fiscal years beginning after December 15, 1988.

Variable Product Growth Adds Another Wrinkle

From the early 1980s to the early to mid 1990s, investors and analysts were forced todeal with the profit implications of a mix shift away from mortality and morbidityproducts and toward investment spread-based products (fixed annuities and universallife). Since the mid 1990s, variable policies – products with another set of profitcharacteristics – have become a more important part of the life insurance story. As aresult, investors need to think about profits in the following three general categories:(1) mortality and morbidity risk; (2) investment spread; and (3) fee income.

Variable annuities and variable life insurance had been two growth businesseswithin the generally slow growth life insurance industry until the bear market tookits toll on demand for these equity-linked products. However, over the long-term,it is remains reasonable to assume that variable product demand will outpace fixedproduct demand, in our opinion. With variable products, the policyholder bearsthe investment risk because the bulk of the premium dollars typically are investedin separate account funds, which are essentially tax-advantaged mutual funds ofthe policyholder’s choice. For a variable annuity, the primary source of revenuefor the insurance company is a fee on account balances. For variable life, theinsurer earns both a fee on account balances and a premium to cover the cost ofinsurance. As a result of both strong premium growth and exceptional equitymarket returns through the late 1990s, separate account assets had grown toaccount for a substantially greater portion of life insurance industry assets (Figure6). Even with the decline in the equity market since early 2000, separate accountassets still account for a substantial portion of total industry assets, and – whenequity market returns normalize – we believe that separate account assets willgrow in importance for the industry over time. The bear market has disruptednear-term growth, but our view is that individuals will funnel more dollars intovariable products over the long term to alleviate retirement savings concerns. Inour opinion, most individuals now realize that it is necessary to move further outon the risk frontier – and hopefully earn a long-term annual return of 8% to 10% –rather than buy a general account insurance product that generates a 4% to 5%annual return.

…and the accounting isdifferent as well

Because it is a fee-drivenbusiness, variable products

have different profit dynamics



Figure 6: Separate Account Assets as a Percentage of Admitted Assets for Stock LifeInsurance Companies, 1984-2001

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Note: Codification of statutory accounting in 2001 has led to comparability issues on a year/year basis, especially withregard to revenues and expenses.Sources: A.M. Best.

Example of Difference in Profit Characteristics

To illustrate the dramatic difference in margins and returns across product lines, itis instructive to compare variable annuity profitability with fixed annuityprofitability. Even though fixed annuities have gained substantial market sharerelative to variable annuities in recent years as a result of the bear market inequities, variable annuity products still account for a substantial portion of bothannuity premiums (Figure 7) and reserves (Table 3). However, the earningscontribution from variable products is probably less than many realize. Even atthe peak of the market in 2000, we think that variable annuities probablyaccounted for only 20% of total annuity earnings despite approximately a 50/50split between separate account and general account annuity reserves.

Figure 7: Individual Annuity Premiums, 1988 - 2002E

$0

$20

$40

$60

$80

$100

$120

$140

$160

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002E

Variable Fixed

CAGR: Variable Fixed 1996-2002E 6% 23%1991-2002E 14% 10%

Sources: LIMRA and Merrill Lynch estimates.

Even at the peak, bottom lineimpact from variable annuities

less than you think



Table 3: Individual Annuity Reserves, 1980 - 2002E

Total Individual Percent of Total Annuity Reserves % chg. Fixed % chg. Variable % chg. Fixed Variable

1980 31,543 28,819 2,724 91% 9%1981 38,800 23% 35,316 23% 3,484 28% 91% 9%1982 51,002 31% 46,597 32% 4,405 26% 91% 9%1983 64,661 27% 58,604 26% 6,057 37% 91% 9%1984 76,983 19% 70,512 20% 6,471 7% 92% 8%1985 96,969 26% 87,738 24% 9,231 43% 90% 10%1986 121,146 25% 107,755 23% 13,391 45% 89% 11%1987 156,135 29% 139,313 29% 16,822 26% 89% 11%1988 193,820 24% 174,438 25% 19,382 15% 90% 10%1989 239,593 24% 215,661 24% 23,932 23% 90% 10%1990 282,129 18% 255,887 19% 26,242 10% 91% 9%1991 328,325 16% 295,251 15% 33,074 26% 90% 10%1992 380,677 16% 332,203 13% 48,474 47% 87% 13%1993 439,390 15% 356,736 7% 82,654 71% 81% 19%1994 482,172 10% 374,280 5% 107,892 31% 78% 22%1995 594,147 23% 439,672 17% 154,475 43% 74% 26%1996 622,012 5% 427,815 -3% 194,197 26% 69% 31%1997 693,011 11% 458,958 7% 234,053 21% 66% 34%1998 763,330 10% 444,043 -3% 319,287 36% 58% 42%1999 873,519 14% 476,427 7% 397,092 24% 55% 45%2000 927,509 6% 481,120 1% 446,389 12% 52% 48%2001E 944,961 2% 583,308 21% 361,653 -19% 62% 38%CAGR:10 year 11% 7% 27%5 year 9% 6% 13%

Note: Variable reserves are the separate account portion only of variable annuity contracts.Sources: American Council of Life Insurance and Merrill Lynch estimates.

We have created an income statement for a hypothetical variable annuity companyand a hypothetical fixed annuity company to illustrate the different profitcharacteristics of the two businesses (Table 4). Although we have madesimplifying assumptions (e.g., no surrenders), the examples should be a reasonableapproximation of reality. We present the data as a percentage of assets becausethis is the relevant margin to consider for annuities. Revenue and expenses aremuch higher as a percentage of assets for a fixed annuity writer than for a variableannuity company. However, if the net investment spread (or the differencebetween investment income and credited interest) were considered a revenue item,the income statements would become more similar. Because the net investmentspread (in this example, 175 basis points) on a fixed annuity typically is greaterthan the retained fees associated with a variable annuity (in this example, 138basis points) and expense items are comparable, the margin on annuity accountvalues is substantially lower for a variable annuity company. Includinginvestment income on capital supporting the business, we estimate that variableannuity assets often generate less than one-third of the income produced by thesame amount of fixed annuity assets. It would be unwise to conclude that variableannuities are a less attractive business, however, because the required capital tosupport variable reserves is substantially less than the fixed annuity requirement.In our example, the variable annuity company is generating an unlevered after-taxreturn on capital of 19%, which is substantially greater than the 11% returnproduced by the fixed annuity company. In recent years, overall returns in thevariable annuity business have trailed the returns calculated in our example, andwe believe that marginal returns in the fixed annuity business have frequentlybeen in the single digits. Going forward, we think that variable annuities willproduce a higher return than fixed annuities, but the differential will probably notbe as wide as was the case during the bull market.

Capital requirements andreturns vary depending on

whether the product is fixed or variable



Table 4: Ratios as a Percentage of Account Values

Variable Annuity Income Statement Fixed Annuity Income StatementRevenue: Revenue: Mortality & expense charge 1.25% Investment income 7.00% Maintenance fees 0.13%Total revenue 1.38% Total revenue 7.00%

Expense:Expense: Credited interest 5.25% Amortization of acquisition costs 0.60% Amortization of acquisition costs 0.60% General expenses 0.55% General expenses 0.55%Total expenses 1.15% Total expenses 6.40%

Pretax income 0.23% Pretax income 0.60%Taxes 0.08% Taxes 0.21%After-tax income (1) 0.15% After-tax income (1) 0.39%

Capital to reserves (account values) 1.00% Capital to reserves (account values) 6.00%After-tax earnings on capital as a % of account values (2) 0.05% After-tax earnings on capital as a % of account values (2) 0.27%Total return on account values (1 + 2) 0.19% Total return on account values (1 + 2) 0.66%Unlevered after-tax return on capital 19.2% Unlevered after-tax return on capital 11.1%

Note: Income statements do not include earnings on capital and assume no surrenders.Source: Merrill Lynch estimates.

What does this income statement comparison mean for those who analyze thefinancial statements of life insurers in the variable business? In our opinion, it hasprofound implications for expected growth and returns on capital. For example,AXA Financial was often perceived to be more of a variable products companythan it was in reality, in our opinion (similar to the misperception of SunAmerica).AXA Financial had been highly successful in the variable life and variable annuitybusinesses, but the substantially wider margin on assets for general account (fixed)products suggested that spread and risk businesses accounted for the lion’s shareof profitability as recently as 2000. The split between fixed and variable isimportant because fixed product businesses typically produce a lower return oncapital and have a less favorable long-term growth outlook relative to variablebusinesses.

Our analysis of the earnings contribution from variable products is based on 2001data because we believe that 2002 results are distorted by the bear market (i.e, adecline in fee income and charges related to both deferred acquisition costs andguaranteed minimum death benefits). Even though variable product earnings weresomewhat above the long-term trend in 2001, in our opinion, we estimate that thebusiness contributed less to the bottom line of publicly traded life companies thanis generally perceived (Table 5). For example, although variable productsaccount for a meaningful portion of earnings for Nationwide (NFS, $26.01, B-1-7),Hartford (HIG, $38.78, B-1-7) and Lincoln (LNC, $29.05, B-1-7), we estimatethat the earnings contribution from variable products is less than 10% for 9 of the14 life companies on our coverage list. Assuming a more normal stock marketenvironment going forward, we believe that variable products will contribute alarger portion of total profits in the future. However, we caution investors andanalysts not to overestimate the contribution to the bottom line for mostcompanies because the variable annuity business is a thin-margin business. Also,the margin for our hypothetical variable annuity writer may exceed the returnsachieved by many companies, in our view, because most players in this marketlack economies of scale.

Understand product mix tounderstand earnings growth

and return outlook



Table 5: Importance of Variable Products to the Bottom Line, 2001

Estimated Portion of Earningsfrom Variable Products

Variable Assets as a % ofTotal Assets

Nationwide 45% 64%Hartford 35% 62%Lincoln National 30% 44%Phoenix 20% 22%Principal 15% 37%Prudential 8-10% 25%John Hancock 6-8% 25%MetLife 6-8% 24%Jefferson-Pilot 5-7% 8%Torchmark 3-5% 19%Protective Life 2% 9%StanCorp 0% 15%UnumProvident 0% 0%AFLAC 0% 0%Composite 13% 32%

Note: Phoenix is based on cash earnings and excludes venture capital and Prudential is based on our estimate ofnormalized earnings.Source: Merrill Lynch estimates.

In Table 6, we have shown our estimate of earnings derived from all equity-sensitivebusinesses. Historically, non-insurance businesses that are considered equity sensitivewere relatively insignificant for publicly traded life companies. Today, largely as aresult of the demutualization trend, businesses such as asset management andsecurities brokerage are important to more than 20% of the companies on our coveragelist. For example, we estimate that non-insurance equity sensitive businesses are moreimportant to the earnings of Phoenix (PNX, $8.12, C-2-7) and Prudential (PRU,$30.65, B-2-7) than are variable insurance products.

Table 6: Importance of Equity Market Sensitive Businesses, 2001

Estimated Portion of Total Earnings fromVariable, Asset Mgmt & Brokerage Operations

Phoenix 55%Nationwide 45%Hartford 35%Lincoln National 30%Prudential 25%Principal 15-20%John Hancock 15%MetLife 6-8%Jefferson-Pilot 5-7%Torchmark 3-5%Protective Life 2%StanCorp 0%UnumProvident 0%AFLAC 0%Composite 17%

Notes: Phoenix is based on cash earnings and excludes venture capital and Prudential is based on our estimate ofnormalized earnings.Source: Merrill Lynch estimates.

Margin analysis for investment-oriented life insurance products is more complicatedthan it is for annuities because profits are not solely a function of assets. Specifically,the investment margin (spread or fees) is a function of account values and the mortalitymargin is a function of the cost of insurance portion of premium income. One elementthat does simplify the profitability analysis of investment-oriented life insurance,however, is that the gap between variable and fixed life profits is narrower than it is for

Investment-oriented life acombination of old and new,

which complicates analysis



annuities. Therefore, mix shifts between fixed and variable life will not affect profit tothe same extent as comparable shifts in the annuity business. The explanation involvesthe mortality margin, which still accounts for a significant portion of the profitabilityof life products. We estimate that a variable life policy produces 70% to 80% of theprofit generated by a comparable fixed life policy, compared to a variable annuity thatmight produce 30% of the profit generated by a comparable fixed annuity. As is thecase for annuities, the capital charge for variable life is lower than it is for fixed lifebecause the policyholder bears the variable product’s investment risk.

Variable Life Earnings Not as Equity Sensitive asWe Previously Thought

Variable life insurance earnings are not as volatile as variable annuity earnings becausea substantial portion of the revenue stream for this product is related to the cost ofinsurance, not fees on account balances. To illustrate the importance of variable lifecharges that are not solely based on account balances, it is useful to examine therevenue breakdown of Nationwide Financial Services’ individual investment lifeoperation in 2000 and 2001 (Table 7). (This analysis has not been updated for recentresults because it is meant to illustrate a point about variable life product profitability,not the current mix of revenue for Nationwide. Throughout this report, examples usedto illustrate a concept or an approach to analysis are typically not updated for the mostrecent results.) Cost of insurance charges accounted for almost 60% of total revenuein 3Q01, and are based on life insurance in force less the reserve balance, which iscalled the net amount at risk. The net amount at risk for Nationwide is substantialgiven the size of the in force coverage relative to the reserve balance (Table 8), andthis seems to be the case for other variable life insurers that disclose in force statistics(Table 9).

Table 7: Nationwide – Individual Investment Life Net Revenue Analysis

4Q00 1Q01 2Q01 3Q01Asset Fees 6.1% 5.0% 5.9% 5.7%Admin Fees 31.6% 34.3% 24.1% 22.9%Surrender Fees 2.2% 2.5% 2.8% 2.4%Cost of Insurance 52.3% 47.1% 57.3% 59.8%Spread Income 4.3% 8.0% 8.0% 7.3%Other 3.4% 3.0% 1.8% 2.0%

Note: Net revenue is operating revenue less interest credited.Source: Company reports.

Table 8: Nationwide – Individual Investment Life Reserves and In Force

4Q00 1Q01 2Q01 3Q01Policy Reserves 2,092 1,958 2,139 1,945Insurance In Force 26,782 27,242 28,673 29,493

Source: Company reports.

Table 9: Variable Life Insurance Statistics, 9/30/01

Reserves Insurance In Force Reserves/In ForceJohn Hancock 5,627 57,748 10%Hartford 3,460 46,086 8%Nationwide 1,945 29,493 7%Phoenix 948 18,434 5%

Sources: Company reports and Merrill Lynch estimates.

Variable life product chargesthat are not tied to assets offset

some of the equity sensitivity



Cost of insurance (COI) charges on variable life contracts will most likely increasewhen the stock market is weak because reserve balances are apt to decline under thisscenario, increasing the net amount at risk. We illustrate this concept using ahypothetical example based on what seem to be reasonable assumptions for cost ofinsurance and asset-based charges (Table 10). In this example, approximately 30% ofthe adverse change in asset fees that would result if separate account performance was-10% rather than +10% is offset by higher cost of insurance charges. For Nationwide,the offset would appear to be more significant given that cost of insurance charges arehigher than we have assumed in our example (on new business, we believe thatNationwide’s cost of insurance charges are in line with the level assumed in ourexample). Finally, this analysis is meant to illustrate a point, and does not account forall of the factors that could impact revenue as a result of a difficult equity marketenvironment. For example, a below trend year for the stock market could lead to adecline in variable life premiums, which would have a negative effect onadministrative fee income.

Table 10: Impact from Stock Market on Individual Variable Life Revenue

Market Up 10% Market Down 10% DeltaReserves 7,700 6,300Insurance In Force 100,000 100,000Cost of Insurance 212.3 215.5 3.2Asset Fees 57.8 47.3 (10.5)Total 270.0 262.8 (7.3)

Source: Merrill Lynch estimates.

As a block of variable life business matures, it should exhibit a higher level ofsensitivity to the equity market because the net amount at risk declines when account(reserve) balances increase. (Premium payments plus market appreciation less policycharges and asset fees drive the growth in account balances.) We attempt to illustratethis point in Tables 11 and 12. Again, we have constructed a hypothetical examplebased on realistic assumptions. In this instance, we are looking at a single variable lifepolicy and model out the expected revenue stream over a ten-year period. In the firstyear, asset-based fees are only 4% of total revenue, but reach 27% of total revenue bythe tenth year (Table 12).

Table 11: Financial Characteristics of a Single Variable Life Contract

Year Reserves Premium In Force COI Asset Fees Admin Fees Revenue1 9,202 10,000 500,000 1,129 69 400 1,5982 18,979 10,000 500,000 1,217 142 400 1,7593 29,367 10,000 500,000 1,310 220 400 1,9304 40,407 10,000 500,000 1,407 303 400 2,1105 52,140 10,000 500,000 1,508 391 400 2,2996 64,615 10,000 500,000 1,613 485 400 2,4977 77,880 10,000 500,000 1,720 584 400 2,7048 91,991 10,000 500,000 1,829 690 400 2,9199 107,011 10,000 500,000 1,938 803 400 3,14010 123,004 10,000 500,000 2,045 923 400 3,367

Simplifying Assumptions:1) all premiums occur at beginning of year2) all fees occur at end of year3) fund fees are 75 basis points on ending reserve balance4) cost of insurance is $2.30 per thousand initially and increases 10% per year on ending net amount at risk5) administrative fees are 4% of premiums6) all funds are allocated to separate account and annual return is 8%Source: Merrill Lynch estimates.

COI charges could movein opposite direction

of asset-based fees

Older blocks of business areprobably more equity sensitive



Table 12: Revenue Breakdown for a Single Variable Life Contract

Year Cost of Insurance Asset Fees Admin Fees1 71% 4% 25%2 69% 8% 23%3 68% 11% 21%4 67% 14% 19%5 66% 17% 17%6 65% 19% 16%7 64% 22% 15%8 63% 24% 14%9 62% 26% 13%10 61% 27% 12%


Assessing the Outlook of Fixed versus Variable

As we stated previously, we believe that variable products will account for anincreasing portion of the industry’s new business volume. But, recent experiencesuggests that it is also reasonable to conclude that there is a cycle around this long-term secular trend. For example, we estimate that fixed annuity sales growth (+23%)has substantially outpaced variable annuity sales growth (+6%) during the past fiveyears. Therefore, we believe that it is useful to look at a couple of measures to gaugethe relative attractiveness of fixed versus variable products from a consumer’sperspective.

� Two Key Factors to Watch for Indication of Future Sales Trends

In our view, the performance of the equity market and the attractiveness ofcredited rates of interest on insurance products relative to other safe investments(certificates of deposit and money market funds) are the two key determinants ofrelative product demand (fixed versus variable). Therefore, we track both of thesefactors (Figure 8). This chart at least partially explains why variable productsenjoyed rapid growth from 1995 to 1998 while fixed product sales languished.First and foremost, equity market returns were very strong. The trailing twelve-month total return for the S&P 500 averaged 27% on a monthly basis from thebeginning of 1995 to the end of 1998. We look at the trailing twelve-month returnbecause we believe that there is a lag between the performance of the market andthe level of demand for equity-linked products. For example, we believe thatannuity producers use recent historical results (12-month period) to illustrate thebenefits of exposure to the equity market. Second, over the same period, theadvantage of fixed annuity crediting rates relative to substitute productsdiminished from north of 200 basis points in 1992-1993 to less than 125 basispoints during most of the 1995-1998 period. Since the end of 1998, theenvironment for annuities has changed dramatically. In 1999, both fixed andvariable annuity sales increased at a rapid pace, with fixed outdistancing variable(which was at least partially related to an easy comparison in 1998). Trailing 12-month equity returns remained strong and fixed annuity crediting rates becamemore competitive with certificates of deposit. In 2000, both product typesregistered sales gains for reasons similar to 1999. In 2001 and 2002, it was acompletely different story, however, as trailing 12-month returns for the S&P 500were negative during the entire two-year period and the spread between fixedannuity crediting rates and CD yields reached a record level. Not surprisingly,according to LIMRA, variable annuity sales declined 18% in 2001 while fixedannuity sales increased 36%. In 2002, consumers continued to favor fixedannuities over variable annuities, and fixed annuity crediting rates remainedcompetitive relative to bank CD yields. According to LIMRA, through the firstnine months of 2002, fixed annuity sales increased 60% versus a 6% increase forvariable annuities.

Variable vs. fixed demanddepends on market

performance & yield onalternative investments



The usefulness of these two data series in forecasting top-line trends is illustratedbeginning in late-1998. Although equity market returns remained strong, thevolatility in the fall of 1998 (captured in this analysis) highlighted for someannuity buyers the risks of the equity market. This suggested that the marginalview of fixed annuity products would probably improve. More importantly,however, the advantage of fixed annuity crediting rates relative to certificates ofdeposit began to widen beginning in late-1998/early-1999 (captured in thisanalysis). The impact of this development on the top line began to emerge in thelast two quarters of 1999 as a number of annuity writers experienced substantialimprovement in fixed product sales. For example, Hartford’s fixed annuity salesin each of the last two quarters of 1999 eclipsed the annual total for 1998 by awide margin. As trailing twelve-month returns began their slide toward the latterhalf of 2000 and remained negative throughout 2002, the relative attractiveness offixed annuities was evidenced by material sales increases for many companies.

Figure 8: Indicators to Assess Attractiveness of Fixed versus Variable

-40%-30%

-20%-10%

0%10%20%30%40%50%60%

12/8

612

/87

12/8

812

/89

12/9

012

/91

12/9

212

/93

12/9

412

/95

12/9

612

/97

12/9

812

/99

12/0

012

/01

12/0

2

-3.00-2.25

-1.50-0.750.000.751.502.253.003.754.50

S&P 500 Latest Twelve Month Total Return (Left Axis)

Fisher Annuity Index Minus CD Composite (Right Axis)

Sources: Compustat PDE database, Bloomberg and Fisher Publishing.

� What About Profitability?

Our discussion of annuity profitability begins with fixed products, whichcontribute more to the industry’s bottom line than variable annuities. On balancewe believe that declining interest rates are better for the profitability of in-forcebooks of fixed annuities, but this would not be the case if minimum rateguarantees limit a company’s ability to lower credited interest rates. The issue ofminimum rate guarantees does deserve more attention today given the low level ofinterest rates, but we do not believe that a material margin squeeze is likely unlessrates fall by perhaps another 50 to 100 basis points. Overall, our conclusion is thatthe fixed annuity business – if managed properly – is probably not as sensitive tointerest rate movements as you might think. To prove this point, we have includedthe historical investment spreads for two well-run fixed annuity companies thatwere acquired in the latter half of the 1990s – Equitable of Iowa and WesternNational (Figure 9). Despite a 250 basis point increase in ten-year Treasury yieldsfrom the fall of 1993 to the end of 1994 and a record number of Fed tightenings,both companies maintained relatively stable investment spreads (the differencebetween the earned yield on the investment portfolio and the credited rate on fixedannuity reserves).

Resurgence in demand for fixedannuities was foretold by our

fixed vs. variable indicator

Don’t automatically assumethat fixed annuity earnings arehighly sensitive to interest rates



Figure 9: Investment Spread for Pure Fixed Annuity Companies, 1993-1996

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

1993 1994 1995 1996

Western National Equitable of Iowa


To assess the marginal profitability of the fixed business, it is necessary todetermine the spread between investment yields and interest credited topolicyholders. To estimate the investment spread, we have constructed a LifeCompany New Money Index – which is a reasonable proxy for the new moneyyield available to life companies – and compare it to the Fisher Annuity Index, anaverage of new money crediting rates based on more than 900 fixed annuitiesoffered by more than 140 companies (Figure 10). The Life Company New MoneyIndex includes a 50% weighting for A-rated corporate bonds, a 15% weighting forBaa-rated corporates, a 5% weighting for high-yield corporates, and a 30%weighting for mortgage-backed securities.

The investment spread depicted in Figure 10 is understated in recent periodsbecause the Fisher Index includes annuities that offer first-year bonus rates, whichhave become more prevalent in the early to mid 1990s. We believe that bonusrates should be excluded from this analysis and thought of as policy acquisitioncosts. To adjust for this distortion, we estimate that 50-75 basis points should beadded back to the calculated spread starting in 1992. However, even after theadjustment, it appears that in recent years the investment spread often has been at alevel that implies inadequate returns on capital. We base this conclusion on ourestimate that the average annuity company must realize at least a 170 basis pointinvestment spread to earn a low double-digit return on equity.

We believe that some companies may be justifying uneconomic business today byassuming that crediting rates can be lowered substantially after the initial guaranteeperiod (one-year). However, we think that this is a risky strategy when business isput on the books during a period of relatively low interest rates. Specifically, ifrates begin to rise, the ability to ratchet crediting rates downward may be limited.In our opinion, even policyholders only one year into a contract would likely find itin their best interests to pay a surrender charge and move money to another carrierif the crediting rate differential is 200 basis points. It certainly seems that annuitycompanies that wrote business recently will be looking to reduce crediting rates by50 to 100 basis points in the second year of the contract (over and above the bonuscrediting rate that goes away in the second year). Therefore, as little as a 100 basispoint increase in market rates could lead to difficulties for these companies (i.e.,100 basis point lower crediting rate plus 100 basis point higher market rates equalsthe 200 basis point differential that could spur surrender activity). The questionthen becomes do these carriers let the business go? From a practical standpoint, atleast some fixed annuity companies may choose to live with inadequate spreadsrather than sell bonds at a loss to fund withdrawals.

Our investment spreadindicator provides a sense for

marginal returns on capital



Figure 10: Investment Spread Analysis, 1987-2002 (Basis Points)

0

25

50

75

100

125

150

175

200

225

250

12/86

12/87

12/88

12/89

12/90

12/91

12/92

12/93

12/94

12/95

12/96

12/97

12/98

12/99

12/00

12/01

12/02

Life Company New Money Index less Fisher Annuity Index 6 Month Moving Average

Sources: Merrill Lynch, Bloomberg and Fisher Publishing.

In our view, it is more difficult to determine the “normalized” profitability for in-force variable products than it is for fixed products because stock marketperformance has had a substantial impact on the variable business. Theassessment of marginal profitability is an even more arduous task, in our opinion.The returns on in-force variable products were better than expected during thelatter part of the 1990s because of a strong equity market. The benefit of above-average market returns was two-fold. First, account values – which determine feeincome – increased at much faster than expected rates. For example, from 1994 to1999, market appreciation accounted for more than 50% of variable annuityaccount balance growth at both Hartford and Nationwide. Second, variablewriters benefited from substantial operating leverage. For example, Nationwide’sgeneral expense ratio in the variable annuity segment declined from 88 basispoints in 1994 to 28 basis points in 1999 despite compound annual growth ingeneral expenses of 13%.

At the margin, it is even more difficult to determine the trend in returns because ofa proliferation of new product features in recent years. On the variable annuityside, some of these “bells and whistles” are dollar-cost averaging (DCA) bonusrates, guaranteed minimum death benefits (GMDB), guaranteed minimum incomebenefits (GMIB) and extra-credit (a one-time up-front increase in annuity accountvalues). In our view, it is often difficult to assess the economics of these benefits onnew business, but it is clear that the cost of guaranteed benefits has exceededexpectations. Also, fee-sharing arrangements with fund partners are not readilyavailable. Investors should keep in mind that it only takes a few basis points tosubstantially impact return on assets because the best variable annuity companiesgenerate a pretax return on assets of slightly better than 50 basis points.

We believe that investors need to qualitatively assess the direction of profitability byfocusing on factors such as market growth, market appreciation, surrender rates,amortization of deferred acquisition costs and the direction of return on assets.Also, we believe that the variable annuity business could be on the verge of a“shakeout” as a result of abysmal financial results during the bear market. In ouropinion, a tough stock market environment has highlighted that full-cycle return onequity is well below peak returns (greater than 20% ROE), and this lower returnexpectation should make the business less attractive for marginal players. If scaleplayers such as Hartford, Nationwide and Lincoln are experiencing profit pressure,marginal players will find it extremely difficult to remain in the business, in ouropinion. In less than two years, we have shifted from concern about margin pressurein the variable annuity business (as a result of outsized returns) to optimism about thepotential for an increase in pricing power for large VA writers.

More difficult to assessnormalized and marginal

returns for variable annuities

New variable product introsonly add to this challenge



2. Making the Most of What’s AvailableAlthough analyzing life insurance financial statements can be difficult and the lackof disclosure of certain items can be frustrating, it is possible to use availableinformation to develop important insights. Keep in mind that business mix issuescomplicate comparisons between companies, so trend analysis for a given insurertypically is more useful. Also, although they are bulky and intimidating at first,statutory statements can be helpful in the assessment of capital adequacy andearnings quality. In the end, the highly reliable nature of life insurers’ earningsstreams removes some of the pressure for those struggling to identify andunderstand the specific determinants of profit.

Leverage & ROA a Function of Business Mix

Analysts should proceed with caution when comparing financial ratios for two lifecompanies with different business mixes. To illustrate this point, it is useful toconsider a simplified DuPont Model analysis or leverage (as measured by assets toequity), after-tax return on assets and after-tax return on equity (Figures 11, 12 and13). It is clear that to some extent business mix will dictate the leverage ratio that isacceptable. For example, Hartford Life is a high quality company, yet its assets toequity ratio is an eye-popping 30:1. Supplemental health and individual lifeinsurers, on the other hand, have assets to equity ratios of less than 10:1. The returnon assets also varies dramatically depending on the mix of business. Assetaccumulators produced an after-tax ROA of 51 basis points in 2001, whichcompared to 173 basis points for life insurers. However, despite a return on assetsthat was 70% below the ROA for life insurers, operating ROE was 16% for the assetaccumulators or approximately 100 basis points above the ROE for the life insurers.

Even with the differentials in business mix, however, we think that some usefulcomparisons can be made as long as the analysis is performed carefully. Forexample, all of these companies have significant investment portfolios, and assetquality has typically been one of the factors that can lead to financial difficultiesfor a life insurer. Therefore, more invested assets for every dollar of equityprobably means a higher level of risk regardless of business mix. To illustratehow careful analysis can yield reasonable company to company comparisons, let’sreturn to Hartford Life. The assets-to-equity ratio is extremely high, but asubstantial portion of the company’s balance sheet represents separate accountassets where the policyholder – not the shareholder – bears the risk. If we adjustfor this distortion, Hartford’s assets to equity ratio falls to less than 9:1 or belowthe level for supplemental health insurers and individual life insurers.

It is possible to comparecompanies with differentbusiness mixes, but make

necessary adjustments



Figure 11: Assets-to-Equity Ratio, 2001

0

5

10

15

20

25

30

35

Asset Accumulators Diversified Companies Life Insurers Supplemental HealthInsurers

Asset Accumulators = Hartford (Life Operation) and Nationwide Financial Services.Life Insurers = Jefferson-Pilot, Protective Life and Torchmark.Supplemental Health Insurers = AFLAC, StanCorp Financial and UnumProvident.Diversified Companies = John Hancock, Lincoln National, MetLife and Principal Financial Group.Note: DAC and equity exclude the effect of FAS 115.Sources: Company reports and Merrill Lynch estimates.

Figure 12: After-tax Operating Return on Assets, 2001

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

1.2%

1.4%

1.6%

1.8%

2.0%


Note: DAC and equity exclude the effect of FAS 115, and returns are calculated on ending balances.Sources: Company reports and Merrill Lynch estimates.

Figure 13: After-tax Operating Return on Equity, 2001

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%


Note: DAC and equity exclude the effect of FAS 115, and returns are calculated on ending balances.Sources: Company reports and Merrill Lynch estimates.



Proceed with Caution when PerformingCompany-to-Company Comparisons

Because of business mix differentials (as discussed above) and various levels ofdisclosure, analysts should be cautious when comparing the financial ratios of twolife insurance companies. To illustrate how even the most straightforwardcompany-to-company comparisons can be misleading, we examined the 1996financial results for two high quality, high return insurers that, on the surface,appear very similar (Table 13). The first company is Equitable of Iowa, which isan annuity company that was acquired by ING Groep in 1997. The second insureris The Variable Annuity Life Insurance Company (VALIC), a subsidiary ofAmerican General which was acquired by American International Group in 2001.We chose to compare these two companies on the basis of 1996 data because: (1)fixed annuities accounted for the vast majority of operating income for bothinsurers in 1996; (2) each company earned a return on equity of approximately15.5% that year; and (3) 1996 was the final year that detailed annual financial datawas available for Equitable of Iowa.

We begin our comparison with an analysis of deferred acquisition costs (DAC).Deferred acquisition costs receive a great deal of attention from insurance analystsbecause: (1) the asset is sizable; and (2) the carrying value is only as good as theaccuracy of estimated future gross profits or premium income, depending on thetype of product. (We include a detailed discussion of deferred acquisition costs ina later section of this report.) The DAC asset for Equitable of Iowa was asubstantially higher percentage of both reserves and equity compared to the sameratios for VALIC in 1996. This appears to suggest that there is reason to beconcerned about the quality of Equitable of Iowa’s earnings and balance sheet.(Reserves are a key determinant of future gross profits for annuities.) The specificconcerns would be that Equitable of Iowa is sacrificing profitability relative toVALIC by paying too much to put business on the books and/or the company ismore aggressive on the deferral and amortization of costs than VALIC.

Table 13: Comparison of High Return, High Quality Annuity Writers, 1996Equitable of Iowa VALIC

Insurance intangibles excluding fair value adjustment 870 819Annuity liabilities 9,415 21,067Separate account liabilities 1,658 7,134Total policy reserves 11,073 28,201Equity excluding fair value adjustment 819 1,444

Insurance intangibles/policy reserves 7.9% 2.9%Insurance intangibles/equity 106.2% 56.7%

Investment spread 2.83% 1.80%Expense ratio 0.62% 0.52%Pretax operating return on assets 1.69% 1.21%After-tax operating return on equity 15.3% 15.7%

Note: Insurance intangibles are deferred acquisition costs and the present value of future profits (a DAC-like asset).Source: Company reports.We believe that VALIC has a higher quality annuity business than Equitable ofIowa because VALIC is concentrated in the tax-qualified market, which tends toproduce stable reserves and cash flow. However, the DAC analysis that we havedescribed leads to an erroneous conclusion on the quality of Equitable of Iowa’sfinancial results, in our opinion. Equitable of Iowa’s investment spread was morethan 100 basis points higher than VALIC’s in 1996, which – given reasonablycomparable operating expense ratios – meant that gross profit (i.e., earnings beforeDAC amortization) was a higher percentage of reserves for Equitable of Iowarelative to VALIC. The higher gross profit translated to a pretax ROA of 169basis points for Equitable of Iowa, which was almost 50 basis points greater thanVALIC’s pretax ROA. Despite a higher return on assets, however, return on

Business mix and non-standarddisclosure hinder company-to-

company comparisons

Erroneous conclusionsare sometimes hard

to avoid, so be careful



equity was comparable for both companies in 1996. In our view, this relates to alower capital requirement for VALIC because of the stability and predictability ofthe tax-qualified annuity business.

The next issue to consider is the sustainability of the 100 basis point spreadadvantage because, if it is short-term in nature, there is a profitability problem. Itwas reasonable to assume that the 1996 investment spread could be maintainedbecause significant surrender charges on Equitable of Iowa’s product offeringsmeant that persistency would remain high for a long period of time. As a result,the company had substantial flexibility on policyholder crediting rates. If weassumed that Equitable of Iowa could sustain a 100 basis point spread advantageover VALIC for ten years, we calculate that 80% of the incremental DAC on thecompany’s balance sheet was easily justified. This estimate is based on aninternal rate of return assumption that was consistent with the company’s targetedreturn on equity. Therefore, the five percentage point difference in the DAC-to-reserves ratio between the two companies was not a major point of concern.

Trend Analysis for Individual Insurers More Useful

The absence of detailed financial information, in combination with business mixconsiderations, means that company-to-company comparisons are often muchmore difficult than the Equitable of Iowa/VALIC example included above.Therefore, more information often can be gleaned from trend analysis for anindividual company. We will go into additional detail on the use of trend analysiswhen we describe our methods of forecasting life insurance company earnings. Inthis section, however, we continue with our analysis of American General’sannuity operation, with particular attention paid to trends in the deferredacquisition cost asset.

We examine five years of data on American General’s Retirement ServicesSegment (Table 14), which includes both VALIC and American General Annuity(formerly Western National). In our analysis, we again begin with a focus on thedeferred acquisition cost asset. DAC as a percentage of annuity reserves isrelatively constant at 2.8% to 3.0%, suggesting that there have not been majorchanges in the cost of acquiring business, deferrals or amortization rates. Givenour initial assessment that nothing unusual is happening with DAC, we turn ourattention to the key drivers of gross profit for an annuity company: (1) theinvestment spread; (2) fee income; (3) surrenders; and (4) operating expenses.The investment spread has remained relatively stable over time, so this does notappear to be an area of concern. Fee income has declined as a percentage ofseparate account (i.e., variable) assets, which should prompt some questions.Surrenders have increased modestly but still are very low. This is not an alarminglevel of lapses, in our view. Finally, the operating expense ratio has trendeddownward every year, which is clearly a positive development. Overall, the profitoutlook appears to remain favorable, which suggests that a return on equity of15% to 16% is probably sustainable.

Looking at trends for individualcompanies provides info on thesustainability of results, and...



Table 14: American General Retirement Services Segment, 1993-19971993 1994 1995 1996 1997

Balance Sheet Data:DAC excluding fair value adjustment 546 641 734 819 903General account annuity reserves (fixed) 17,029 18,656 20,147 21,067 21,995Separate account annuity reserves (variable) 1,890 2,507 4,541 7,134 10,564Total annuity reserves 18,919 21,163 24,688 28,201 32,559Equity excluding fair value adjustment 1,153 1,208 1,445 1,444 1,546Ratios:DAC/annuity reserves 2.89% 3.03% 2.97% 2.90% 2.77%DAC/equity 47.4% 53.1% 50.8% 56.7% 58.4%Investment spread 1.66% 1.80% 1.83% 1.80% 1.75%Fee income/separate account assets 1.42% 1.34% 1.28%Expense ratio 0.59% 0.57% 0.53% 0.52% 0.49%Surrender ratio 3.7% 4.4% 4.7%Operating return on equity 14.6% 15.5% 15.3% 15.7% 16.3%


This type of analysis will not provide all of the answers, but it should at least giverise to a series of questions. In this case, although we are comfortable thatearnings quality is high and that trends are favorable, at least a few questions areworth asking. Why has fee income as a percentage of separate account assetsdeclined? Where does the surrender rate plateau, and what are the lapseassumptions built into the pricing model?

Overall, the following generalizations appear to be reasonable, in our view:

1. If the DAC-to-reserves ratio is constant and key profit measures are stable,the earnings quality/outlook remains unchanged.

2. If the DAC-to-reserves ratio is constant and key profit measures areimproving or the DAC-to-reserves ratio is declining and key profit measuresare stable, the earnings quality/outlook probably has improved.

3. If the DAC-to-reserves ratio is declining and key profit measures areimproving, the earnings quality/outlook has improved.

4. If the DAC-to-reserves ratio is constant and key profit measures aredeteriorating or the DAC-to-reserves ratio is increasing and key profitmeasures are stable, the earnings quality/outlook probably has deteriorated.

5. If the DAC-to-reserves ratio is increasing and key profit measures aredeteriorating, the earnings quality/outlook has deteriorated.

6. If the DAC-to-reserves ratio and key profit measures are both moving in thesame direction, this may suggest that a mix shift is occurring.

More on DAC

We believe that analyzing the trends in DAC for an individual company at theoperating segment level is more useful than performing company-to-companycomparisons because business mix differentials significantly affect the level ofDAC on the balance sheet and the life of the DAC asset. To illustrate this point,we have grouped a sample of publicly traded life insurance companies into fourcategories depending on their major product focus. The categories are lifeinsurance, supplemental health insurance, asset accumulation and diversified. Foreach category, we calculated the ratio of deferred acquisition costs-to-assets(Figure 14) and the ratio of deferred acquisition costs-to-equity (Figure 15). Therange of DAC to assets is 4% to 10% and the range of DAC to equity is 60% to120%. Not surprisingly, DAC is a lower percentage of assets for assetaccumulation companies (annuity writers) because the gross profit margins tend tobe thin relative to life and health insurance products.

...raises specific questions thatshould be asked

Product mix can wreak havocon DAC analysis, so only

compare similar companies



Figure 14: Deferred Acquisition Costs as a Percentage of Assets, 2001

0%

2%

4%

6%

8%

10%

12%

Life Insurers Supplemental HealthInsurers

Diversified Companies Asset Accumulators

Asset Accumulators = Hartford (Life Operation) and Nationwide Financial Services.Life Insurers = Jefferson-Pilot, Protective Life and Torchmark.Supplemental Health Insurers = AFLAC, StanCorp Financial and UnumProvident.Diversified Companies = John Hancock, Lincoln National, MetLife and Principal Financial Group.Note: DAC and equity exclude the effect of FAS 115.Sources: Company reports and Merrill Lynch estimates.

Figure 15: Deferred Acquisition Costs as a Percentage of Equity, 2001

0%

20%

40%

60%

80%

100%

120%

140%

Asset Accumulators Life Insurers Supplemental HealthInsurers

Diversified Companies

Note: DAC and equity exclude the effect of FAS 115.Sources: Company reports and Merrill Lynch estimates.

In addition to analyzing the trend in DAC as a percentage of reserves, it is alsoinstructive to look at the rate at which the DAC asset has been amortized and howthe amount amortized compares to gross profits (defined as pretax earnings beforeamortization). In Figure 16, we show the annual amortization of DAC associatedwith operations (i.e., excludes amortization related to realized gains and losses) inrelation to the beginning DAC asset balance for Hartford Life and NationwideFinancial Services. The DAC asset used to derive these charts excludes theimpact from FAS 115 “Accounting for Certain Investments in Debt and EquitySecurities”. Under FAS 115, there is an adjustment to the DAC asset balancerelated to unrealized gains and losses on investments associated with FAS 97products, which we will discuss in more detail later in this report. It is importantto exclude FAS 115 for this analysis because the unrealized gain and lossadjustment can distort the true amortization rate. In Figure 17, we show therelationship for the individual annuity line between DAC amortization and grossprofits, which under the FAS 97 model is the basis for amortization (discussed indetail in Section 17, “Tackling DAC”), for both Hartford Life and Nationwide.

The rate of DAC amortizationcan be a good indicator of

earnings quality



It is instructive to analyze results in recent years for Hartford Life and Nationwideto better understand the issues surrounding the DAC asset, DAC amortization andthe quality of earnings. The first reasonable conclusion from Figures 16 and 17 isthat Hartford Life employed a more conservative approach than Nationwideduring the bull market to determine the rate at which deferred acquisition costswere amortized. From 1997 through 2000, Hartford wrote off more DAC thanNationwide relative to the beginning intangible asset balance and DACamortization in individual annuities consumed a higher percentage of gross profitsas well. Definitive conclusions from these comparisons would have been difficult,as we have pointed out that company-to-company comparisons are fraught withchallenges in the life industry. However, the analysis does suggest that a greaterlevel of concern over the carrying value of the DAC asset was appropriate forNationwide, and this concern would have been well placed. In the third quarter of2002, Nationwide recognized a sizable DAC charge that produced a loss in thequarter and dropped operating ROE from 14% in 2001 to 3% for the first ninemonths of 2002.

Our conclusion about the relative conservatism of Hartford is also supported byinformation disclosed on the DAC models employed by each company.Specifically, the long-term market appreciation assumption does not change inHartford’s model as a result of actual market performance whereas Nationwide’smodel limits the extent to which the assumed performance in future years offsetsactual performance that is above or below the long-term rate. The result, in ourview, is that Hartford’s model is generally more conservative during a bull market,but could be considered more aggressive during a bear market.

The second reasonable conclusion from Figures 16 and 17, in our opinion, is thatthe “margin for error” in Hartford Life’s DAC balance is probably small today(i.e., if the market does not resume an upward trend soon, negative DACunlocking is a real possibility). Two things from this analysis suggest thatinvestors should monitor the DAC issue closely. First, the life of the total DACasset at Hartford has extended from 6.3 years in 2000 (amortization relative tobeginning balance was 15.9%) to 8.9 years in 2002 (amortization relative tobeginning balance was 11.3%). Second, as a result of Nationwide’s 3Q02unlocking, the cumulative amortization from 1997 to 2002 is now at a higher levelrelative to gross profits for Nationwide than it is for Hartford. The amortizationrelative to gross profits comparison is probably more meaningful because adistortion based on business mix is less likely than is the case for the life of theDAC asset analysis. The gross profit analysis is based on individual annuitiesonly whereas the life of the DAC asset analysis is based on total company data.

Figure 16: DAC Amortization as Percentage of Beginning DAC Asset

0%

5%

10%

15%

20%

25%

1996 1997 1998 1999 2000 2001 2002E

Nationwide Financial Services Hartford Life

Note: 2002 is actual for Hartford Life and estimate for Nationwide excludes impact from Provident.Sources: Company reports and Merrill Lynch estimates.

Hartford was more conservativethan Nationwide during bull

market

Use other information sourcesto check the reasonableness of

conclusions

Margin for error appears smallat Hartford today



Figure 17: Individual Annuity DAC Amortization as a Percentage of Gross Profits

0%

10%

20%

30%

40%

50%

60%

70%

1997 1998 1999 2000 2001 2002E Cumulative

Nationwide Financial Services Hartford Life

NM

Note: 2002 is actual for Hartford Life and estimate for Nationwide excludes impact from ProvidentGross profits are defined as pretax operating earnings before DAC amortization expense.Sources: Company reports and Merrill Lynch estimates.

DAC Charges not Simply a Bear Market Issue

The potential for DAC charges as a result of the bear market in equities hasreceived a lot of attention from investors during the previous 12 months. In ourview, DAC is a less pressing issue today because equity-sensitive life companieshave already written down this intangible asset and the stock market hasrebounded off its lows. However, investors should be aware that an equity marketdecline is not the only development that could lead to a negative surprise related toDAC. Historically, persistency experience has been considered an importantdriver of gross profits for both variable and fixed annuities, and persistencybecomes more uncertain as a book of business loses surrender charge protection.

We believe that it is useful to monitor the portion of a company’s annuity book ofbusiness that is out of the surrender charge protection period and the amount thatwill be losing surrender charge protection in a relatively short period of time. It isreasonable to be at least somewhat concerned by the increasing percentage ofindustry annuity reserves that are protected by minimal or no surrender charges(Figure 18). However, although higher withdrawal rates appear likely forannuities, analysts should remember that the persistency of insurance productscompares very favorably to the mutual funds industry (Figure 19).

Adequate surrender charge protection is important because it acts as a deterrent topolicyholder withdrawals and, therefore, leads to more stable, longer-termliabilities. If annuity withdrawal rates are above pricing expectations and there isno other positive offset, amortization of DAC will accelerate and GAAP profitswill be reduced. Information on the withdrawal characteristics of annuity reservesis presented in footnote twelve “Analysis of Annuity Reserves and DepositLiabilities” to the annual statutory financial statement.

There is a recent argument that the persistency of variable annuity contracts willbe higher than expected even after surrender charges have expired. The theory isthat many policyholders have “in the money” death benefits associated with thesecontracts, and are therefore more likely to keep these contracts in force. Theinsurance companies would benefit from this development because a variableannuity book would generate gross profits over time even with the cost ofadditional death benefits.

As annuities move out ofsurrender protection, DAC

issue is more pressing



Figure 18: Annuity Reserves with Minimal or No Surrender Charge Protection

0%

10%

20%

30%

40%

50%

60%

70%

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Sources: A.M. Best and Merrill Lynch estimates.

Figure 19: Withdrawal Rates – Mutual Funds versus Insurance Products, 1993-2001

0%

5%

10%

15%

20%

25%

30%

1993 1994 1995 1996 1997 1998 1999 2000 2001

Mutual Funds Individual Annuities Life Insurance

Note: It appears that there was an unusual item in the 2000 data for annuities. We do not believe that the lapse rate wasthis high for the industry.Sources: Investment Company Institute and A.M. Best.

Use of Statutory Financial Statements

Statutory accounting principles (SAP), which are prescribed or permitted byinsurance regulatory authorities, generally produce a conservative view of aninsurance company’s financial position. (We discuss the differences betweenstatutory accounting and GAAP in more detail later in the report.) However,because SAP to GAAP differences relate to timing, both approaches ultimatelywill produce the same cumulative income. Figure 20 presents the statutory andGAAP earnings stream for a fixed annuity product. In general, statutoryaccounting tends to produce a loss in the first year (as a result of up-frontacquisition costs) and, relative to GAAP, higher earnings in the later years. In thisfixed annuity example, there is a loss in the first year and statutory earnings areless than GAAP earnings through the eighth year. (The modest level of statutoryearnings in the seventh year and a slight loss in the eighth year relates to adifference in accounting for reserves.) Statutory earnings then exceed GAAPearnings from year 9 through year 20 for this example, and are equivalent toGAAP earnings from year 21 through year 25 because deferred acquisition costsare completely amortized during the first 20 years in this example.

Statutory (SAP) is conservativevs. GAAP, but both must get to

the same place in the end



Figure 20: Profit Emergence for a Fixed Annuity Product

-10

-5

0

5

10

15

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25

Year

GAAP Profit Statutory Profit

Source: Merrill Lynch.

We have dedicated most of this report to the interpretation of GAAP financialstatements for life insurers, because we believe that GAAP results receive the mostattention from investors. However, the statutory income statement and balance sheetare important determinants of free cash flow and free capital, respectively, andstatutory earnings provide a check on the quality of a company’s GAAP earnings.

� Use of SAP to Assess Existing and Prospective Excess Capital

We use statutory financials to assess the capital position of an insurer and to check ourGAAP-derived estimates of free cash flow. On the first point, we compare the currentrisk-based capital ratio (actual capital relative to required capital) to what we believe isnecessary for the maintenance of current financial strength ratings or the achievementof targeted ratings. If the difference is positive, we assume that this amount is excesscapital. However, analysts should remember that excess capital is not solely a functionof the difference between existing and necessary capital at the subsidiary level but alsois a function of other assets at the holding company and borrowing capacity. Assets atthe holding company level may be significant because companies often strive toremove capital from regulated entities.

We also use statutory earnings to check our assessment of free cash flow. In a latersection, we detail our use of the sustainable growth rate equation to calculate anestimate of free cash flow. However, the ability to pay dividends, repurchase stock orcomplete acquisitions is a function of statutory earnings, not GAAP earnings.Typically, available cash flow from an insurance company – without special approval– is limited by regulation to the previous calendar year’s statutory net operating gain or10% of statutory surplus (equity). Depending on the state, the distribution may belimited to the smaller or larger of the two figures. Therefore, we check our theoreticalcalculation of free cash flow (GAAP derived) with the practical limitation on dividendsfrom insurance subsidiaries (SAP operating earnings).

For example, based on the sustainable growth rate formula, we calculate thatTorchmark (TMK, $34.69, B-1-7) is generating $240 million of excess capital(approximately $45 million for common dividends and $195 million for sharerepurchase). We then look to statutory earnings to see if cash is actually availablefor distribution. Although full-year 2002 statutory information is not yetavailable, it is reasonable to conclude that Torchmark’s statutory operatingearnings were between $260 and $280 million last year. So, the ability toupstream capital from the insurance subsidiaries does not appear to be an issue.Also, as was the case in the assessment of existing excess capital on the balancesheet, analysts should remember that regulated entities often are not the onlysource of cash flow for insurance holding companies.

RBC levels a useful gauge forestimating excess capital or a

deficiency

Use statutory earnings as guideto distributable cash flow



� Use of SAP to Assess Earnings QualityStatutory earnings are a means of checking the quality of GAAP earnings. Webelieve that this “check” should be performed over a period of years, rather thanusing any single year because unusual items can produce atypical earnings on aSAP basis. For example, we did not update our illustration of this type of analysis(Table 15) for 2001 data because the ratios for the highlighted company (ProtectiveLife) and the Merrill Lynch Life Index were heavily distorted by unusual items. Overtime, statutory earnings have averaged approximately 73% of GAAP earnings forthe companies in the Merrill Lynch Life Insurance Index, and we believe that2001 was in line with this average excluding unusual items. Given our belief thatthe Merrill Life Index is comprised of high quality companies, this is ourbenchmark for assessing the earnings quality of any individual insurer.

Table 15 presents our analysis of statutory earnings to assess quality. In this case,we are comparing Protective Life (PL, $25.75, B-1-7) to the Merrill Lynch LifeInsurance Index. From 1995 to 2000, Protective’s cumulative statutory netincome was 93% of GAAP net income, compared to 73% for the Merrill LifeIndex. The strong level of cash flow over time suggests that we should haveconfidence in the quality of earnings. The favorable ratios for Protective overtime reflect the strong cash flow produced by the company’s acquisition segment,the modest up-front acquisition costs for some other segments and the use ofconservative assumptions in the calculation of GAAP profit.

In our opinion, the decline in the ratio of statutory-to-GAAP earnings in 1999 and2000 reflects to some extent a potential shortcoming of this analysis (i.e., newbusiness production can have a substantial negative impact on statutory earnings).Protective’s individual life businesses produced pretax statutory operating lossesof $19 million in 2000 and $37 million in 1999, which compared to a $38 milliongain in 1998. The driver of the losses in both years was individual life insurancesales growth (27% in 2000 and 28% in 1999). On a statutory basis, first-yearpolicy acquisition costs (which are typically high for life products) are expensedversus capitalized on a GAAP basis.

Table 15: Quality of Earnings Analysis, 1995-2000

1995 1996 1997 1998 1999 2000 CumulativeProtective Life:Statutory Profit 115.3 102.3 134.4 158.9 83.7 69.9 664.5GAAP Profit 76.7 89.0 112.0 130.8 151.3 153.5 713.3Ratio of SAP/GAAP 150% 115% 120% 122% 55% 46% 93%Merrill Lynch Life Ins. Index:Statutory Profit 2,431.5 2,430.4 3,460.5 4,235.5 4,035.2 4,802.5 21,395.7GAAP Profit 3,058.8 3,656.7 4,981.4 5,417.2 5,447.4 6,688.4 29,250.0Ratio of SAP/GAAP 79% 66% 69% 78% 74% 72% 73%

Note: The absolute earnings level for the index is of limited usefulness because it is a mix of pretax and after-tax figures.In 2000, index included AFL, AGC, JP, JHF, LNC, MET, NFS, PL, TMK and UNM. In prior years, composition varies.Sources: Company reports, company contacts and Merrill Lynch estimates.

� Limitations of Statutory EarningsThe major limitation of statutory earnings, in our opinion, is the same as theshortcoming of any cash flow-based analysis. Namely, cash flow can represent boththe return on investment and the return of investment. In insurance, the quickest wayto increase statutory earnings is to stop growing the business. This is apparent in thefixed annuity example presented above (Figure 20), which illustrates the negativeimpact on cash flow from first-year policy acquisition costs. In our opinion, strongstatutory earnings are not always an unambiguous positive. Our view that the currentstatutory earnings level may not be the key driver of firm value is supported by theprivate market valuations assigned to life insurance companies. An analysis ofacquisition multiples on current year SAP earnings has been in a wide range of 10 to27 times in recent years.

The ratio of SAP to GAAPearnings is a measure of

quality...

…but as with other measures,be careful

SAP earnings could representthe return on & of investment,

so not always a good thing



Equity Sensitivity Adds a Wrinkle, but Don’t Panic

There is no question that it is difficult to decipher life insurance company financialresults and volatility has increased at the margin, but do not panic because there is aninherent level of stability to life insurance company earnings. Earnings estimaterevisions for the Merrill Lynch Life Index have been modest relative to the broadermarket averages despite the increased importance of variable insurance products(Figure 21). However, estimate revisions for life insurers with a substantial over-weighting in variable product lines have been materially negative during the pastcouple of years while traditional life companies have delivered operating results in linewith expectations (Figure 22). Therefore, although the overall revision trend stillsuggests relative predictability, there are life companies where earnings stability is nolonger a realistic expectation. On the plus side, negative estimate revisions forvariable product companies have been less pronounced than the downward revisionsto S&P 500 earnings expectations (Figure 23).

Figure 21: Merrill Lynch Life Insurance Index – EPS Estimate Revision Index, 1988-2002

30

40

50

60

70

80

90

100

110

120

130

12/87

12/8

812

/89

12/9

012

/91

12/9

212

/93

12/9

412

/95

12/96

12/97

12/98

12/99

12/00

12/01

12/0

2

Merrill Lynch Life Insurance Index Standard & Poor’s 500

Note: The revision indices are based on current-year estimates from January through June and on following-yearestimates from July through December.Source: I/B/E/S.

Figure 22: Operating EPS Revision Trend – VA Companies Versus Traditional Life Cos.

60

65

70

75

80

85

90

95

100

105

110

6/99

8/99

10/9

912

/99

2/00

4/00

6/00

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012

/00

02/0

104

/01

06/0

108

/01

10/0

112

/01

02/0

204

/02

06/0

208

/02

10/0

212

/02

Traditional Life Companies Variable Annuity Companies

Traditional Life Companies = AFLAC, Jefferson-Pilot, Protective Life, StanCorp and Torchmark.Variable Annuity Companies = Hartford Financial, Lincoln National and Nationwide.Source: I/B/E/S.

Overall, earnings stability highbut not the case for variable

product companies



Figure 23: Operating EPS Revision Trend – VA Companies versus S&P 500

20

40

60

80

100

120

140

6/99

8/99

10/9

912

/99

2/00

4/00

6/00

8/00

10/0

012

/00

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104

/01

06/0

108

/01

10/0

112

/01

02/0

204

/02

06/0

208

/02

10/0

212

/02

S&P 500 Variable Annuity Companies

Correlation = 95%

Source: I/B/E/S.

There are still many investors who believe that earnings are highly sensitive tochanges in interest rates. We believe that limited volatility in GAAP earnings – asevident by the stable estimate revision trend (Figure 21) – and modest fluctuations incash flow – as evident by the stable statutory operating earnings trend (Figure 24) –disproves the notion that earnings are highly dependent on the interest rateenvironment. The stability of earnings and cash flow are especially noteworthy giventhat we have lived through a variety of different interest rate scenarios since the mid1980s (Figure 25). (Note: Statutory operating earnings were somewhat depressed in1998 and 2001 as a result of unusual items.)

Figure 24: Stock Life Industry – Statutory Operating Profit, 1989-2001($ in Mils.)

R2 = 81%

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

18,000

20,000

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Approximately $1.7 billion of the 1998 decline relates to a single acquisition (i.e. an unusual item)

9-11 losses account for perhaps 1/2 of decline

Note: Excludes group health results and codification of statutory accounting in 2001 has led to comparability issues on ayear/year basis, especially with regard to revenues and expenses.Sources: A.M. Best’s Aggregates & Averages.

Sensitivity to interest ratemovements isn’t as great as one

might expect



Figure 25: Level of Interest Rates and Slope of the Yield Curve, 1988-2002

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

10.0%

12/87 12/88 12/89 12/90 12/91 12/92 12/93 12/94 12/95 12/96 12/97 12/98 12/99 12/00 12/01 12/02-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

10-year Treasury Yield (Left Axis) Yield Curve Slope (Right Axis)

Sources: Bloomberg and DRI.



3. Product Type Drives Modeling ApproachThe evolution of earnings models over the years has reflected the industry’s mixshift toward savings oriented (asset-based) products and away from protectionoriented (premium-based) offerings. However, many life insurers continue tooffer both types of products, which presents challenges for the analysis ofconsolidated results. Because of this, an examination of financial results forindividual segments is considerably more useful. On the following pages weillustrate modeling techniques using: (1) UnumProvident’s (UNM, $14.45, B-2-7)group disability insurance segment as a premium-based example; (2) NationwideFinancial Service’s variable annuity segment as an asset-based example driven byfees; and (3) Nationwide’s fixed annuity segment as an asset-based exampledriven by investment spreads. (For Nationwide, we have used the company’sprevious reporting format, which is more illustrative for this example than thecurrent presentation of segment data). A common element in all three examples isthat new sales do not have the impact on the bottom line that might be expected.In our opinion, one point of frustration for individuals who analyze this industry isthe disconnect between sales and earnings growth in any one period. We discussthis issue in more detail in Section 7, “Understanding Sales and Premium”. Newsales are obviously important to top-line growth, but other factors (e.g., marketappreciation and persistency) are critical as well.

We have intentionally selected straightforward examples to illustrate our modelingtechniques. For the three business segments presented below, profit primarily isdriven by either premium income or asset balances (not a combination of the two).It is not always this easy. For example, profit in life insurance is a function ofpremium income (cost of insurance) and asset balances (spread and fee income),and it is usually difficult to determine the margin on each component. For lifesegments, we often default to a margin on assets given the increasing importanceof investment-oriented life products. However, we would look at a margin onpremium if the company were a significant player in term insurance or traditionalprotection-oriented life insurance. The companies examined on the followingpages also provide fairly detailed financial information. It is not unusual fordisclosure to be more limited. For example, all of the pieces necessary tocomplete an asset roll-forward may not be available (although thankfully this hasbecome less of an issue given expanded disclosure). In those instances, an analystshould use the data that is presented and create an “all other” category to completethe link between beginning and ending assets.

Disability Insurance – A Premium-Based Product

For disability income products, premiums represent the vast majority of revenue inany period and are the basic driver of the bulk of the expenses. In our example(Table 16), since 1996, premiums have comprised more than 80% of total revenuefor UnumProvident’s group disability segment. Logically, because premiumsdrive the income statement, we pay close attention to the assumptions involved inour premium forecast. The most important variables are the current base ofpremiums and the expectations for sales and persistency. New sales andpersistency (or lapses for the glass-is-half-empty crowd) are important becausethey affect premium income at the margin. The more stable the trends ofpersistency and sales, the more one can depend on the premium forecast. We notethat growth in sales does not directly translate into a similar percentage increase inpremium income. This is because the pool of premium dollars is quite largecompared to the annual sales figure – by a factor of 4.7 in 2001 forUnumProvident’s disability segment. When forecasting the other, less important,revenue items for this type of product (e.g., net investment income and fees andother income), we make minor adjustments to an extrapolation of the historicalquarterly and annual trends.

Modeling approach variesdepending on product mix

Unfortunately (as you mightexpect), it’s not always

straightforward

Premium income drivesmodeling approach fortraditional mortality &

morbidity-type products



Our approach to modeling annual earned premium growth for UnumProvidentgenerally would apply to any traditional life or health insurance product line. ForUnumProvident specifically, we would typically assume that 85% to 90% of theprevious year’s premium would remain in force in the current year. We thenestimate that 60% of the sales in the previous year and 40% of the sales in thecurrent year will flow through the earned premium line. A seasonally strongfourth quarter affects the timing of the impact from sales on earned premiums.Finally, we make an assumption for block buyouts, which are essentiallyacquisitions of business that occur every year.

We estimate the various expense line items as percentages of premiums, withpolicy benefits and operating expenses being the most important assumptions. Toforecast policy benefits we consider the historical trend of benefits to premiums,our assessment of pricing and underwriting trends and the economic environment.The benefit ratio had been fairly stable in 1997 and 1998, and then resultsdeteriorated in 1999 and 2000 primarily as a result of poor underwriting andpricing decisions in prior years. We believe that aggressive renewal rate increasesand more disciplined new business pricing began to favorably impact the benefitratio in 2001, and expect this ratio to decline somewhat going forward.

Historical trends of various expenses as percentages of premiums and expectedchanges such as product mix shifts or expense reduction programs guide ourexpense assumptions. We also forecast commissions as a percentage ofpremiums, although one could also use sales as a reasonable basis for forecasting.The deferral (capitalization) of acquisition costs is projected as a percentage ofcommissions and operating expenses. This measures the portion of variable andfixed expenses that are capitalized.

The DAC amortization itself is projected as a percentage of premiums, which isconsistent with the FAS 60 accounting model. The amortization of DAC as apercentage of premiums had remained fairly stable until 2000, when there was amaterial increase. The increase in amortization in the past few years reflectsbelow trend persistency, and has also fueled speculation that UnumProvident maytake a “one-time” DAC write-off. We believe that UnumProvident has been moreaggressive with the deferral of acquisition costs in group insurance relative toother market participants (e.g., Hartford). To adjust for this “quality of earnings”differential it may be appropriate to adjust earnings downward by the “net deferralof acquisition costs” (the combination of deferred acquisition costs andamortization of acquisition costs).



Table 16: UnumProvident – Group Disability Income Segment Earnings Model, 1997-2002E, ($ and Shares Mil.)

1997 1998 1999 2000 2001 2002EGroup DisabilityRevenue:Premium Income 1,807.3 2,168.1 2,508.4 2,597.1 2,721.4 2,927.5Net Investment Income 419.6 443.4 495.2 576.9 603.7 643.0Other Income 18.2 20.6 25.4 26.4 27.6 34.3Total Revenue 2,245.1 2,632.1 3,029.0 3,200.4 3,352.7 3,604.9

Benefits and Expenses:Total Benefits 1,433.3 1,722.0 2,093.3 2,327.8 2,296.1 2,449.3Commissions 149.7 184.3 217.0 216.6 216.9 240.7Interest Expense 0.0 0.2 0.0 0.0 0.0 0.0Deferral of Acquisition Costs (108.0) (146.6) (156.3) (135.5) (158.9) (167.3)Amortization of Acquisition Costs 46.5 58.1 73.6 99.7 104.6 111.6VOBA Amortization 2.6 2.6 2.5 2.4 2.0 2.3Operating Expenses 394.8 426.8 473.7 478.4 555.1 625.7Total Benefits and Expenses 1,918.9 2,247.4 2,703.8 2,989.4 3,015.8 3,262.4

Pretax Income 326.2 384.7 325.2 211.0 336.9 342.5

Percentage changeLTD sales - old method 31.0% 17.9% -12.8% -13.3%STD sales - old method 36.7% 30.4% -2.4% -13.7%Total group disability sales 32.5% 21.2% -9.8% -13.4%LTD sales - new method 19.4% 11.4%STD sales - new method 19.1% 25.4%Total group disability sales 19.3% 15.7%Premiums 23.0% 20.0% 15.7% 3.5% 4.8% 7.6%Net investment income 17.4% 5.7% 11.7% 16.5% 4.6% 6.5%Other income 0.0% 13.2% 23.3% 3.9% 4.5% 24.4%Total revenues 21.7% 17.2% 15.1% 5.7% 4.8% 7.5%Operating expenses 15.9% 8.1% 11.0% 1.0% 16.0% 12.7%Income before income taxes 25.0% 17.9% -15.5% -35.1% 59.7% 1.7%Percent of premiumsInvestment income 23.2% 20.5% 19.7% 22.2% 22.2% 22.0%Total benefit ratio 79.3% 79.4% 83.5% 89.6% 84.4% 83.7%Operating expenses 21.8% 19.7% 18.9% 18.4% 20.4% 21.4%Commissions 8.3% 8.5% 8.7% 8.3% 8.0% 8.2%DAC Amortization 2.6% 2.7% 2.9% 3.8% 3.8% 3.8%VOBA Amortization 0.1% 0.1% 0.1% 0.1% 0.1% 0.1%Net Deferral -3.4% -4.1% -3.3% -1.4% -2.0% -1.9%Pretax Income 18.0% 17.7% 13.0% 8.1% 12.4% 11.7%Percent of Total RevenuePretax Income 14.5% 14.6% 10.7% 6.6% 10.0% 9.5%Percent of Commissionsand Operating ExpensesDeferral of Acquisition Costs 19.8% 24.0% 22.6% 19.5% 20.6% 19.3%

DAC Amort % GP b/f DAC Amort 12.5% 13.1% 18.5% 32.1% 23.7% 24.6%

Sales - Old MethodGroup Long Term Disability 374.7 441.7 385.2Group Short Term Disability 135.1 176.2 172.0Total Group Disability 509.8 617.9 557.2

Sales - New MethodGroup Long Term Disability 333.8 398.4 443.7Group Short Term Disability 148.5 176.9 221.8Total Group Disability 482.3 575.3 665.4

Sources: Company reports and Merril Lynch estimates.



Asset-Based Products – Roll-forwards Are Critical

Projecting reasonably accurate asset growth is the most important aspect offorecasting the income statements for life insurers’ asset-based segments. This isbecause FAS 97 products generate revenue through investment income or fees thatare based on account balances. In our view, the estimation of account-balancegrowth for modeling should be accomplished using an asset roll-forward. Anasset roll-forward includes the details of the changes in the account balances fromthe beginning of the period to the end of the period. In the context of a roll-forward discussion, we often use the terms account balance, assets and reservesinterchangeably. We pay considerable attention to all of the elements that driveasset growth, the prime determinant of earnings growth over the long term.

� Variable Product Assets Generate Fees

As policyholders bear the investment risk with variable annuity products, revenueprimarily is generated through the assessment of fees, with the bulk of these feesrelated to asset balances. For example, fees contribute virtually all of the revenueof Nationwide’s variable annuity segment. As a demonstration of how we forecastasset balances, a reserve roll-forward is included as part of the Nationwidevariable product earnings model presented in Table 17. To estimate the endingreserve balance, the starting point is the beginning balance. To the beginningbalance we add the period’s deposits, add the positive or negative investmentperformance, subtract withdrawals and policy charges, and add or subtracttransfers, benefits and other changes. (Net fund flows are deposits lesswithdrawals and benefit payments.) When forecasting variable product assetgrowth, macro issues are important because capital market performance will havean effect on the investment performance of the pool of assets. The state of thecapital markets also will influence deposits and withdrawals as well as transfers toand from fixed annuities. For example, market appreciation accounted for morethan 70% of the increase in Nationwide’s account balances in 1999. In our model,we forecast transfers, withdrawals and surrenders as percentages of beginningreserves, and we base all fees (asset, administrative, and surrender) as percentagesof estimated average reserves for a given period. We tend to use annualizedpercentages when forecasting to make the quarterly ratios appear consistent withthe annual totals and to improve our chances of spotting meaningful trends.

Death benefits are calculated as a percentage of average assets. This item is smallbecause benefit expenses for Nationwide’s variable products are shown only inexcess of the associated account balance. (This line item is more meaningfultoday than in this illustration given the increased cost of guaranteed minimumdeath benefits.) We also estimate general expenses as a percentage of averageaccount balances. We forecast commissions as a percentage of deposits, andacquisition costs deferred are calculated as a percentage of commissions (by farthe largest policy acquisition cost). Amortization of DAC is forecast as apercentage of average assets, but we also look at amortization as a percentage ofgross margins, which is the basis of the FAS 97 accounting model (which will bediscussed in a subsequent section). Pretax profits before amortization isconsidered a reasonable proxy for gross profits.

In addition to watching the components that drive changes in account balances, wealso focus on trends in the deferral and amortization of acquisition costs becausethese are two areas that are subject to manipulation. In the case of Nationwide, thedeferral of costs has approximated commissions, which suggests that the companyis not aggressively deferring fixed costs. Also, the deferral ratio has remainedrelatively stable, suggesting that a consistent methodology has been applied. Thetrend in DAC amortization would seem comforting because it has been steadywith an upward bias (obviously the large DAC unlocking charge in 3Q02 impliesthat what may seem conservative can actually prove aggressive with the benefit ofhindsight). Fixed expenses should receive a fair amount of attention becauseeconomies of scale are key in the variable annuity business. Also, analysts should

A good model for asset growthis key to earnings forecast for

accumulation companies

Understand fees, net fund flowsand market impact for variable

product businesses



be aware that variable product companies benefited from operating leverageduring the late 1990s as a result of a strong stock market. However, as a result ofthe bear market, we have begun to see the negative impact of operating leverage insome instances.



Table 17: Nationwide Financial Services Individual Annuity Segment Earnings Model, 1993-1999, ($ and Shares in Mil.)

Variable Products 1993 1994 1995 1996 1997 1998 1999

Asset Fees $83.4 $120.4 $172.8 $261.8 $370.2 $479.1 $596.7

Admin. Fees 8.5 10.9 14.0 18.2 21.8 24.2 25.8

Surrender Fees 4.3 6.7 10.0 13.6 21.9 29.6 45.8

Total Fees $96.2 $137.9 $196.8 $293.5 $413.9 $532.9 $668.3

Net Investment Income (7.3) (13.4) (17.6) (21.5) (26.8) (31.3) (41.4)

Other Income 6.0 8.2 9.9 12.6 16.9 0.0 0.0

Total Revenues $94.8 $132.7 $189.1 $284.6 $404.0 $501.6 $626.9

Variable Death Benefits 1.4 2.3 2.9 4.6 5.9 3.5 2.2

Commissions 99.6 149.4 191.0 283.8 324.7 364.3 347.4

General Expenses 68.8 81.7 108.1 128.2 148.8 144.9 148.7

DPAC (100.3) (147.4) (190.0) (279.6) (314.1) (353.4) (319.8)

Amortization of DPAC 15.0 22.1 26.3 57.4 87.8 123.9 162.9

Total Benefits and Expenses $84.5 $108.1 $138.2 $194.4 $253.1 $283.2 $341.4

Pretax Operating Earnings $10.3 $24.6 $50.8 $90.3 $150.9 $218.4 $285.5

Variable Policy Reserves

Balance, beginning of period $5,028 $7,855 $10,751 $16,762 $24,278 $34,487 $46,421

Deposits 2,414 3,821 4,399 6,500 7,536 9,543 9,942

Investment performance 798 (85) 2,935 2,716 5,207 6,805 10,550

Withdrawals and surrenders (402) (685) (1,072) (1,697) (2,683) (4,261) (6,519)

Policy charges (88) (129) (185) (287) (405) (533) (668)

Transfers, benefits and other 105 (26) (66) 285 554 380 1,415

Acquisitions 0 0 0 0 0 0 84

Balance, end of period 7,855 10,751 16,762 24,278 34,487 46,421 61,224

Year/year change

Deposits 58.3% 15.1% 47.8% 15.9% 26.6% 4.2%

Policy reserves 36.9% 55.9% 44.8% 42.0% 34.6% 31.9%

Pretax earnings 137.6% 106.9% 77.5% 67.2% 44.7% 30.7%

Ratio to beg reserves (annualized)

Investment performance 15.9% -1.1% 27.3% 16.2% 21.4% 19.7% 22.7%

Withdrawals and surrenders -8.0% -8.7% -10.0% -10.1% -11.1% -12.4% -14.0%

Transfers, benefits and other 2.1% -0.3% -0.6% 1.7% 2.3% 1.1% 3.0%

Ratio to avge reserves (annualized)

Asset fees 1.29% 1.29% 1.26% 1.27% 1.25% 1.19% 1.14%

Administrative fees 0.13% 0.12% 0.10% 0.09% 0.07% 0.06% 0.05%

Surrender fees 0.07% 0.07% 0.07% 0.07% 0.07% 0.07% 0.09%

Total fees 1.49% 1.48% 1.43% 1.43% 1.40% 1.32% 1.28%

Net investment income (0.11%) (0.14%) (0.13%) (0.10%) (0.09%) (0.08%) (0.08%)

Other income 0.09% 0.09% 0.07% 0.06% 0.06% 0.00% 0.00%

Variable death benefits 0.02% 0.02% 0.02% 0.02% 0.02% 0.01% 0.00%

Amortization of DPAC 0.23% 0.24% 0.19% 0.28% 0.30% 0.31% 0.31%

General expenses 1.07% 0.88% 0.79% 0.62% 0.50% 0.36% 0.28%

Pretax operating earnings 0.16% 0.26% 0.37% 0.44% 0.51% 0.54% 0.55%

Commissions / deposits 4.12% 3.91% 4.34% 4.37% 4.31% 3.82% 3.49%

DPAC / commissions (100.8%) (98.6%) (99.5%) (98.5%) (96.7%) (97.0%) (92.1%)




� Fixed Product Assets Generate a Spread

As a demonstration of how we forecast asset balances, a reserve roll-forward isincluded as part of the Nationwide fixed annuity earnings model presented inTable 18. To estimate the ending reserve balance, we add new deposits andinterest credited to the beginning balance, subtract withdrawals and surrenders,and add or subtract transfers, benefits and other charges. The same macro factorscan have different effects on the fixed and variable product businesses. Forexample, if the stock market is doing poorly, fixed annuities should capture agreater share of the investment dollar. Changes in interest rates and thecompetitiveness of substitute products could also materially affect asset growth inthe fixed segment. Generally, an upward sloping yield curve with modestvolatility is the preferred environment. From a profitability standpoint, decliningrates typically have at least a modestly positive effect on the investment spreadbecause the duration of assets is usually longer than the duration of fixed annuityliabilities. However, if interest rates fell dramatically, there could be an issue withminimum guaranteed crediting rates.

The most important revenue item is investment income. For Nationwide, it hasaveraged roughly 96% of total revenue for the fixed product segment. Similar tomost other income statement items, investment income is calculated as apercentage of average assets. The various fees are also calculated as a percentageof average assets, but these items are very small compared to investment income.

The investment income earned on assets less the amount credited to policyholdersis the investment spread, which is the key driver of profitability for fixed products.For Nationwide, the spread generally remained within the range of 190 to 200basis points during the illustration period. Note that interest credited in the fixedexample is analogous to investment performance in the variable example. Forfixed products, the insurance company accepts the investment risk and credits theaccounts at a selected interest rate. Unlike investment performance in the variableroll-forward, interest credited will always be a positive number and reasonablypredictable. We forecast interest credited as a percentage of beginning assets.Withdrawals, surrenders and other benefits are forecast as a percentage ofbeginning assets. The withdrawal and surrender rate is a key driver of fixedannuity profitability, so this line item warrants extra attention. General expensesare forecast as a percentage of average assets, while commissions are calculated asa percentage of deposits. The deferral of acquisition costs is calculated as apercentage of commissions, and DAC amortization is projected as a percentage ofaverage assets.

Like we do for the variable segment, we focus on the factors that drive assetgrowth, deferrals and amortization for the fixed annuity segment. But we also payclose attention to the investment spread, which can exhibit more volatility thanfees on assets in the variable segment. In our opinion, a wide spread is desirable,but if it is too wide it is reasonable to wonder if the company is taking too muchrisk (interest rate and/or credit)? Is the company including prepayment income asoperating earnings or treating it as a capital gain? Is the company offeringuncompetitive rates to policyholders so that surrenders will be an issue in thefuture? In this example, Nationwide’s spread of approximately 200 basis points(which includes a benefit from earnings on capital) translates to a low double-digitreturn on equity.

Understand the investmentspread and net fund flows for

fixed product businesses

For fixed products, investmentspread is the key profit driver



Table 18: Nationwide Financial Services – Fixed Product Segment Earnings Model, 1993-1999, ($ and Shares Mil.)

Fixed Products 1993 1994 1995 1996 1997 1998 1999

Asset Fees $7.0 $7.1 $7.1 $6.3 $3.0 $0.8 $1.2

Admin. Fees 3.8 5.2 5.2 6.5 6.8 4.9 8.4

Surrender Fees 5.0 3.8 4.1 5.1 6.1 6.9 7.0

Life Contingent Payout 35.3 20.1 32.8 24.0 27.3 23.1 26.8

Total Fees and Premiums $51.2 $36.2 $49.2 $42.0 $43.2 $35.7 $43.4

Net Investment Income 871.6 903.6 1,002.8 1,050.6 1,098.2 1,116.6 1,134.5

Total Revenues $922.8 $939.9 $1,052.0 $1,092.6 $1,141.4 $1,152.3 $1,177.9

Interest Credited 673.3 680.9 775.7 805.0 823.4 828.6 837.5

Life and Annuity Benefits 39.0 21.2 29.3 33.5 23.3 19.0 21.7

Policyholder Dividends 0.3 (1.0) 0.2 0.3 0.0 0.0 0.0

Total Benefits $712.6 $701.1 $805.2 $838.8 $846.7 $847.6 $859.2

Commissions 43.0 44.7 71.7 67.4 78.7 81.3 128.4

DPAC (35.9) (38.8) (62.3) (60.0) (75.7) (83.1) (130.1)

Amortization of DPAC 28.3 29.9 29.5 38.6 39.8 44.2 49.7

General Expenses 68.9 64.1 70.9 72.3 82.4 87.0 93.5

Total Expenses $104.3 $99.8 $109.8 $118.4 $125.2 $129.4 $141.5

Total Benefits and Expenses $816.9 $800.9 $915.0 $957.2 $971.9 $977.0 $1,000.7

Pretax Operating Earnings $105.9 $138.9 $137.0 $135.4 $169.5 $175.3 $177.2

Fixed Annuity Policy Reserves

Balance, beginning of period 9,659.8 10,154.1 11,247.0 12,784.0 13,511.8 14,194.2 14,898.9

Deposits 1,300.9 1,308.6 1,864.2 1,600.5 2,137.9 2,068.0 3,467.2

Policyholder interest credited 672.9 679.0 772.8 805.0 823.4 828.6 837.5

Withdrawals and surrenders (1,242.6) (788.9) (1,027.9) (1,263.8) (1,583.0) (1,669.6) (1,568.6)

Policy charges (14.6) (14.2) (14.7) (17.3) (14.7) (12.6) (16.6)

Transfers, benefits and other (222.3) (91.6) (57.4) (396.6) (681.2) (509.7) (1,595.9)

Acquisitions 0.0 0.0 0.0 0.0 0.0 0.0 569.4

Balance, end of period 10,154.1 11,247.0 12,784.0 13,511.8 14,194.2 14,898.9 16,591.9

Year/year change

Deposits 0.6% 42.5% -14.1% 33.6% -3.3% 67.7%

Pretax earnings 31.2% -1.4% -1.2% 25.2% 3.4% 1.1%

Ratio to beginning reserves (annualized)

Withdrawals and surrenders -12.9% -7.8% -9.1% -9.9% -11.7% -11.8% -10.5%

Transfers, benefits and other -2.3% -0.9% -0.5% -3.1% -5.0% -3.6% -10.7%

Life and annuity benefits 0.40% 0.21% 0.26% 0.26% 0.17% 0.13% 0.15%

Ratio to average reserves (annualized)

Investment income 8.80% 8.44% 8.35% 8.02% 7.96% 7.76% 7.29%

Policyholder interest credited 6.80% 6.36% 6.46% 6.15% 5.97% 5.76% 5.38%

Investment spread 2.00% 2.08% 1.89% 1.88% 1.99% 2.00% 1.91%

Asset fees 0.07% 0.07% 0.06% 0.05% 0.02% 0.01% 0.01%

Administrative fees 0.04% 0.05% 0.04% 0.05% 0.05% 0.03% 0.05%

Surrender fees 0.05% 0.04% 0.03% 0.04% 0.04% 0.05% 0.04%

Life contingent payout 0.36% 0.19% 0.27% 0.18% 0.20% 0.16% 0.17%

Policyholder dividends 0.003% -0.009% 0.002% 0.002% 0.000% 0.000% 0.000%

Amortization of DPAC 0.29% 0.28% 0.25% 0.29% 0.29% 0.30% 0.32%

General expenses 0.70% 0.60% 0.59% 0.55% 0.59% 0.60% 0.59%

Pretax operating earnings 1.07% 1.30% 1.14% 1.03% 1.22% 1.21% 1.13%

Commissions / deposits 3.3% 3.4% 3.8% 4.2% 3.7% 3.9% 3.7%

DPAC / commissions (83.5%) (86.8%) (87.0%) (89.0%) (96.2%) (102.2%) (101.3%)




4. Why We Pay So Much Attention to ROEWe estimate that the operating return on equity for the Merrill Lynch LifeInsurance Index was 12.4% in 2002, which is the lowest it has been since 1995.The key driver of lower returns has been the weak performance of equity sensitivebusinesses, which we believe have generated an operating ROE of approximately10% in 2002. Although operating ROE has generally remained in relatively tightrange over the past decade (Figure 26), we still believe that there is little marginfor error in life insurance. In our opinion, new business returns could easily dipbelow the cost of capital if management is not keenly focused on profitability. Forexample, in at least some cases, we believe that current marginal returns in fixedproduct lines are creating little if any value for shareholders. The risk of a profitdisappointment is especially pronounced given that returns are estimated whenbusiness is written and policy acquisition costs are front-end loaded. Therefore,we believe that the level of return on equity and the trend in ROE both deserve asubstantial amount of attention.

Figure 26: Operating ROE for the Merrill Lynch Life Insurance Index, 1990-2003E

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002E 2003E

Med

ian

Op

erat

ing

RO

E


Profit Sensitive to Modest Change in Assumptions

To support our contention that the margin for error is slight in the life insurancebusiness, we have included an example of the sensitivity of returns to a modestchange in assumptions (Table 19). We calculate two scenarios for profit from afixed annuity product, and the only difference between the two is the investmentspread. Specifically, we assume a 25 basis point lower investment spread in thesecond scenario. We then compute the internal rate of return, which is based onthe cash flow generated by the product, the interest income on the capitalsupporting reserves and the release of capital over time as reserves decline. Underthe first set of assumptions, the unlevered, after-tax internal rate of return is11.8%, which suggests the creation of shareholder value. Under the second set ofassumptions, the internal rate of return is 9.2%, which suggests little, if any,increase in shareholder value.

Investors should be mindful that it is sometimes easy for companies to foolthemselves about the profitability of new business. In this example, managementmay justify a higher crediting rate (which translates to a lower investment spread)by assuming an unrealistically low policy surrender rate. And, it may take anumber of years before these assumptions are tested because some products havesurrender charge protection for a long period (e.g., 10 years). From a GAAPstandpoint, the company in this instance will amortize acquisition costs too slowlyas a result of the erroneous assumption about persistency. So, the GAAP return onassets for the company with the lower investment spread might initially mirror thereturn on assets achieved by the company with the higher spread, but it is afictional return to the extent that DAC is amortized too slowly.

Little margin for errorin product pricing

GAAP accounting cansometimes delay the

recognition of problems



Table 19: Fixed Annuity – Sensitivity of Returns to a 25 Basis Point Change in the Investment Spread Assumption

Scenario 1: 195 bps Investment Spread Scenario 2: 170 bps Investment SpreadCapital Outflow (Inflow) (1) After-tax Income (2) After-tax Cash Flow (3) After-tax Income (2) After-tax Cash Flow (3)

1 (56,411) (3,648) (60,059) (5,327) (61,738)2 (238) 6,269 6,031 4,596 4,3583 325 6,453 6,778 4,799 5,1244 887 6,574 7,461 4,956 5,8425 1,432 6,633 8,065 5,064 6,4976 1,944 6,624 8,568 5,119 7,0637 1,896 911 2,807 (516) 1,3808 13,797 (294) 13,504 (1,479) 12,3189 3,204 8,913 12,117 7,972 11,17610 2,979 8,114 11,092 7,256 10,23411 2,768 7,370 10,138 6,590 9,35812 2,569 6,681 9,250 5,973 8,54313 2,382 6,042 8,424 5,401 7,78314 2,206 5,450 7,657 4,871 7,07815 2,042 4,902 6,944 4,381 6,42316 1,888 4,397 6,284 3,929 5,81617 1,743 3,931 5,674 3,512 5,25518 1,607 3,501 5,108 3,127 4,73519 1,479 3,105 4,584 2,773 4,25320 1,358 2,741 4,100 2,448 3,80621 1,243 2,408 3,651 2,150 3,39322 1,133 2,105 3,238 1,880 3,01323 1,028 1,830 2,858 1,634 2,66224 928 1,580 2,508 1,410 2,33825 5,810 1,130 6,940 984 6,79426 0 0 0 0 0Internal Rateof Return 11.8% 9.2%

Note 1: The change in capital is a function of maintaining a 6% capital-to-statutory reserves ratio.Note 2: After-tax income is a combination of statutory insurance product earnings and earnings on capital.Note 3: After-tax cash flow is a combination of statutory insurance product earnings, earnings on capital and the increase or decrease in capital required to support the business.Source: Merrill Lynch.

The discussion of actual versus perceived return highlights a big challenge that isfaced by users of life insurance company financial statements. Namely, the cost ofgoods sold and selling expenses are both estimates. In our example, because wehave assumed that the company offering a higher crediting rate has incorrectlyestimated policy persistency, the reported selling, general and administrativeexpense will be inaccurate because DAC amortization expense will be too low. Inaddition to SG&A expense, life insurance companies also estimate cost of goodssold. For example, it is necessary to forecast future benefit payments to establishreserves. If benefit payments prove to be higher than expected, prior periodearnings would be overstated because reserve increases would have been too low.Depending on the type of product and the degree to which the estimate wasincorrect, a miscalculation of reserves may also affect DAC amortization as well.

Because a life insurer’s earnings are an estimate, we prefer companies that have areturn on equity that is both comfortably above the cost of capital and stable totrending upward. In fact, many disciplined companies target minimum returns oncapital that are somewhat above acceptable levels under the conservativeassumption that a miscalculation is more likely to be negative than positive. Thereis a balance, however, that must be struck. The intensely competitive insurancemarket suggests that if return targets are set at unreasonably high levels, growthwill be difficult to achieve.

Remember, the incomestatement is an estimate



The DuPont Model – A High Level Starting Point

The DuPont model is a useful, high level starting point for the analysis of anycompany, in our view, and we adamantly disagree with the notion that thisapproach is somehow not applicable to financial companies. There are many waysto deconstruct return on equity in a DuPont framework, and we have utilized thetraditional approach. For each company we look at pretax operating margin onrevenues, revenues to assets (the productivity of assets or asset turnover), the taxcomplement (one minus the tax rate) and assets to equity (leverage). Themultiplication of these factors produces operating return on equity (Table 20).

The industry’s business mix has shifted in recent years toward asset accumulationproducts, so we believe that for some companies the combination of margin andasset turnover – pretax return on assets – should receive more attention than theindividual components. We have not included off-balance sheet assets undermanagement in the analysis, but do not believe that this alters the fundamentalconclusions. Most of the industry’s exposure to the asset management business iscaptured in the separate account, which is an on balance sheet asset. For insurers withbusiness mixes skewed toward traditional mortality and morbidity-based productlines, we think it makes sense to analyze the components of ROE beginning withthe pretax margin on revenues. In both cases, we believe it is useful to compareactual and projected earnings per share growth with sustainable earnings per sharegrowth, which is operating ROE multiplied by the earnings retention rate (1-dividend payout ratio).

Table 20: DuPont Model

Margin Asset Turnover Tax Complement LeveragePretax Operating Income / Revenues X Revenues / Assets X (1 – Tax Rate) X Assets / Equity = Operating Return on Equity

Margin Asset Turnover Return on AssetsPretax Operating Income/Revenues X Revenues/Assets = Pretax ROA

ROE Earnings Retention Sustainable GrowthReturn on Equity X (1 – Payout Ratio) = Growth

Source: DuPont.

� Use Caution When Interpreting Leverage Ratio, but Still Valuable

Leverage in the DuPont Model framework is measured as assets to equity.Historically, we believe that this ratio was a pretty good measure of financial risk forinsurance companies, but deeper analysis is required today because of the increasedimportance of separate account (variable) products. General account liabilities, whichwe define as total liabilities less separate account liabilities, are the best measure offinancial exposure because shareholders bear the risk. In the case of the separateaccount, policyholders bear the risk as assets and liabilities either equal each other orare very close and always move in tandem. If appropriate, we highlight when theDuPont measure of leverage sends a misleading signal about financial risk.

We like the concept of leverage defined by assets to equity because the traditionaldefinition of leverage (debt-to-capital) substantially understates financial risk for a lifeinsurance company, in our opinion. We estimate that debt currently accounts for 3%of the total liabilities excluding the separate account for publicly traded life companies.In an environment where investors are worried about the lack of balance sheettransparency, we believe that a more complete measure of leverage is particularlyrelevant. For example, we do not think that investors should assess companies basedon corporate debt levels while heavily discounting or ignoring the amount of leveragerelated to asset accumulation liabilities such as guaranteed investment contracts andfunding agreements.

Some argue DuPont analysisdoesn’t apply to financial

companies, but we disagree

For traditional insurers we startwith pretax margin while for

asset accumulators, we usepretax return on assets (ROA)

Separate account assets candistort leverage, so look at

general account

Assets to equity is morecomplete measure of financial

risk



� Deconstructing ROE and EPS

The DuPont Model is traditionally viewed as a tool to analyze return on equity,but changes in the component drivers of ROE also contribute to or detract fromearnings growth. We think it makes sense to look at the impact on earnings pershare from changes in revenues or assets, margin, tax rate and shares outstanding.We suggest that the top line should be defined differently depending on the mix ofbusiness. For companies with heavier weightings in asset accumulation productlines, we consider the change in assets to be the most relevant measure of top lineperformance. For companies with more traditional product mixes, we considerrevenue to be the most important top-line measure.

� Not Rocket Science, but Doesn’t Get Attention it Should

Dissecting return on equity and earnings per share growth is not complicated, but thisanalysis does not seem to receive the attention that it should in the life insuranceindustry. In our opinion, investors and analysts tend to default to operating earningsper share growth and operating return on equity because differences in business mixoften make it challenging to compare one company to another. Even though mixissues can skew certain ratios in the DuPont analysis, we think that it makes sense tolook at these ROE drivers, if for no other reason than to decide if the recent trends foran individual company are sustainable. For example, should we count on a similarboost to ROE from the tax rate going forward? It is even more compelling, in ourview, to examine the component drivers of earnings per share growth. The onlydecision necessary for this analysis is whether revenues or assets should be consideredthe best measure of top-line growth, everything else is straightforward.

Applying the DuPont Model to a Life Insurer

Our valuation methodology is driven by “normalized” earnings, marginal return onequity (i.e., the returns on new money invested) and long-term growth. (The topic ofvaluation will be discussed in more depth in Section 10.) In our opinion, putting a lifeinsurance company into the DuPont model framework often provides usefulinformation on the trends in these key drivers of valuation. At the very least, it is astarting point for more detailed questions on financial performance and risk.

� Three Tools to Assess the Past & Gain Insight about the Future

There are many ways to analyze growth and returns using the DuPont Model , andwe take an approach that is in some ways standard (e.g., ROE deconstruction), butin other ways non-traditional (e.g., sustainable growth rate versus projectedgrowth rate to assess excess capital formation). We believe that an easy visualapproach makes the analysis of the key variables that determine growth and returnon equity simpler to understand. For all companies, analysts can use a three-stepmethodology to understand the fundamental drivers of value creation.

Breaking Down ROEThe most traditional use of the DuPont Model is the deconstruction of return onequity. With our approach, analysts can understand the relative importance of thepretax margin (pretax operating income/revenue), asset turnover (revenue/assets),the tax complement (one minus the tax rate) and leverage (assets/equity) to thechange in ROE over a specified period. To arrive at the overall percentage changein ROE it is necessary to “link” the percentage changes in the component variables[(1 + % change in margin) x (1 + % change in asset turnover) x (1 + % change intax complement) x (1 + % change in leverage) = (1 + % change in ROE)].

Business mix is an issue, butnot enough to discredit analysis

If nothing else, DuPont canhelp generate detailed questions

By linking the components weget a sense for the relative

importance each has on ROE

Helps understandcomponent drivers of

earnings as well as ROE



Building from Top Line to EPSTo illustrate the factors behind operating EPS growth over a given period, it issomewhat intuitive to follow a model that builds from the compound annualchange in the “top line” to the compound annual change in operating earnings pershare. Specifically, the impact on EPS can be determined from the changes inrevenues or assets, margin, tax rate and shares outstanding. As we mentionedearlier in this section, the definition of top line is dependent on the mix ofbusiness. For companies with more traditional product mixes, we believe thatrevenue is the most important top-line measure. For companies with heavierweightings in asset accumulation product lines, we consider the change in assets tobe the most relevant measure of top line performance.

Understanding Relevance of the Sustainable Growth RateIn our view, the sustainable growth rate equation is an extremely importantelement of any DuPont Model analysis, but not necessarily for the reasons thatmost people might think. Traditionally, the sustainable growth equation is used toassess the future EPS growth potential of the firm based on the earnings retentionrate and the current return on equity. This can be a flawed analysis, however,depending on the relationship between current, normalized and marginal returnson equity. Normalized return on equity is important because the base of earningsimpacts the calculation of the retention rate (e.g., depressed earnings will suggest asustainable growth rate that is too low). Marginal return on equity is importantbecause – assuming current returns are representative of normalized returns –earnings growth is driven by the return on new money invested in the business.For example, if the current ROE is above the marginal ROE, the model willsuggest a sustainable growth rate that is too high.

Going one step further, even if current ROE is equivalent to normalized andmarginal returns, this does not mean that actual EPS growth will approximatesustainable EPS growth. The inherent assumption of the equation is that allretained earnings can be invested in the business, which more often than not is anincorrect assumption for life companies, in our view. Therefore, we believe thatthe best way to use the sustainable growth equation for life companies is inconcert with the projected growth rate (which is based on a detailed assessment ofthe company’s fundamentals). The following generalizations apply when averagereturn on equity is equivalent to normalized and marginal returns on equity:

1. If the sustainable growth rate is greater than the projected growth rate, thecompany probably is generating excess capital.

2. If the sustainable growth rate is less than the projected growth rate, thecompany probably will need to raise capital.

We have examined Jefferson-Pilot (JP, $37.51, A-3-7) within the DuPont modelframework to illustrate the usefulness of this approach (Table 21). We show 11years of data in the DuPont model so that we can calculate 10-year compoundannual growth rates.

For EPS, it is easy to isolate thefactors that lead to bottom line

Relating sustainable andtargeted growth rates is a guide

to capital needs

Trend or level of assets-to-equity ratio provides

indication of risk



Table 21: Jefferson-Pilot DuPont Model Analysis, 1991- 2001

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001CAGR

10 YearCAGR5 Year

Assets - Ex.FAS 115 $4,945 $5,257 $5,641 $6,173 $16,234 $17,466 $22,856 $24,035 $26,513 $27,452 $28,837 19.3% 10.5%Common Equity - Ex.FAS 115 1,563 1,687 1,733 1,755 1,997 2,235 2,554 2,855 2,900 3,130 3,288 7.7% 8.0%Revenue 1,140 1,154 1,138 1,207 1,486 2,078 2,475 2,532 2,466 3,163 3,271 11.1% 9.5%Pretax Operating Income 211 237 269 300 334 391 441 538 611 674 704 12.8% 12.5%Tax Rate 27.4% 27.9% 32.5% 33.3% 33.1% 33.4% 32.6% 33.0% 33.9% 33.9% 32.9% 1.9% -0.3%After-Tax Operating Income 153 171 181 200 223 260 297 360 404 445 472 11.9% 12.7%Average Shares 173.2 172.0 169.6 164.2 161.3 159.9 160.5 160.6 159.3 155.9 153.4 -1.2% -0.8%Year-End Shares 173.1 170.2 166.9 163.5 160.2 159.2 159.4 158.8 155.0 154.3 150.0 -1.4% -1.2%Operating EPS 0.88 1.00 1.07 1.22 1.39 1.63 1.85 2.24 2.54 2.86 3.08 13.3% 13.6%Dividends Per Share 0.32 0.39 0.45 0.50 0.55 0.62 0.69 0.77 0.86 0.96 1.07 12.7% 11.5%Book Value/ Shr Ex.FAS 115 9.03 9.91 10.38 10.73 12.47 14.04 16.02 17.97 18.71 20.28 21.92 9.3% 9.3%

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001Average10 Year

Average5 Year

Pretax Operating Margin 18.5% 20.6% 23.6% 24.9% 22.5% 18.8% 17.8% 21.2% 24.8% 21.3% 21.5% 21.7% 21.3%Revenue / Assets 0.24 0.23 0.21 0.20 0.13 0.12 0.12 0.11 0.10 0.12 0.12 0.15 0.11Pretax Operating ROA 4.48% 4.66% 4.93% 5.09% 2.98% 2.32% 2.19% 2.29% 2.42% 2.50% 2.50% 3.2% 2.4%Tax Rate 27.4% 27.9% 32.5% 33.3% 33.1% 33.4% 32.6% 33.0% 33.9% 33.9% 32.9% 32.7% 33.3%After-Tax Operating ROA 3.25% 3.36% 3.33% 3.39% 1.99% 1.54% 1.47% 1.54% 1.60% 1.65% 1.68% 2.2% 1.6%Assets / Equity 3.25 3.14 3.19 3.39 5.97 7.96 8.42 8.67 8.78 8.95 8.77 6.72 8.72After-Tax Operating ROE 10.6% 10.5% 10.6% 11.5% 11.9% 12.3% 12.4% 13.3% 14.0% 14.8% 14.7% 12.6% 13.8%Dividend Payout Ratio 36.6% 38.7% 41.8% 40.8% 39.9% 38.1% 37.4% 34.2% 33.8% 33.6% 34.8% 37.3% 34.8%Sustainable EPS Growth 6.7% 6.5% 6.2% 6.8% 7.2% 7.6% 7.8% 8.8% 9.3% 9.8% 9.6% 7.9% 9.0%Actual EPS Growth 15.2% 12.6% 7.5% 14.0% 13.6% 17.4% 13.9% 21.2% 13.0% 12.6% 7.7% 13.3% 13.7%

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001CAGR

10 YearCAGR5 Year

Separate Acct Assets 56 67 84 210 346 492 1,282 1,754 2,272 2,311 2,148 43.9% 34.3%General Acct Assets 4,889 5,190 5,556 5,963 15,888 16,974 21,574 22,281 24,241 25,142 26,689 18.5% 9.5%General Acct Assets / Equity 3.22 3.10 3.14 3.30 5.82 7.77 8.05 8.11 8.08 8.19 8.08 9.6% 0.8%Percentage Change:Assets - Ex. FAS 115 10.5% 6.3% 7.3% 9.4% 163.0% 7.6% 30.9% 5.2% 10.3% 3.5% 5.0%Revenue 0.4% 1.3% -1.4% 6.1% 23.1% 39.8% 19.1% 2.3% -2.6% 28.3% 3.4%Pre-Tax Operating Income 9.0% 12.6% 13.2% 11.7% 11.3% 16.9% 12.8% 22.1% 13.7% 10.2% 4.4%After-Tax Operating Income 10.2% 11.8% 6.0% 10.3% 11.6% 16.3% 14.3% 21.3% 12.1% 10.2% 6.0%Average Shares -4.3% -0.7% -1.4% -3.2% -1.7% -0.9% 0.3% 0.1% -0.8% -2.2% -1.6%

Source: Company Reports.

There are many trends that can be identified from the model shown in Table 21,which we have detailed in this report in previous years. We have not included thisdiscussion this year, however, because we have created what we believe is an evensimpler – and more illustrative – approach to analyzing an individual company.(We have performed a similar analysis for most of the companies on our coveragelist in a report titled Operating on Earnings, February 8,2002).

� Jefferson-Pilot Five-year ROE Analysis

During the past five years, operating return on equity increased from 12.3% to14.7%, and is now in excess of the group average. Return on equity has steadilyimproved over this period, with pretax margin and leverage being the key driversof the 20% change in ROE from 1996 to 2001 (Figure 27). Unlike many lifecompanies during the last five years, Jefferson-Pilot’s ROE did not benefitmaterially from a decline in the tax rate. Margin improvement is generallyconsidered a desirable way to improve returns, but an increase in leverage isperceived to signal a higher level of risk. In our opinion, investors should not beoverly concerned by the increase in Jefferson-Pilot’s assets-to-equity ratio for a



couple of reasons. First, the company was substantially over-capitalized duringthe early to mid 1990s, so the increase in leverage – which has been the by-product of a disciplined acquisition strategy – is not troubling, in our view.Jefferson-Pilot acquired two companies since 1996 – Chubb Life and GuaranteeLife – for a total purchase price of $1.2 billion. These acquisitions were fundedwith cash and debt capacity, as shares outstanding at year-end 2001 were 6%below the level in 1996. Second, more than half of the increase in the leverageratio was a function of growth in separate account assets. The general accountassets to equity ratio increased by only 4% (from 7.8 in 1996 to 8.1 in 2001), andremains almost 20% below the level for the Life Insurance Composite.

Figure 27: Jefferson-Pilot – Component Drivers of Change in Operating ROE, 1996-2001

1%

-6%

14%

10%

20%

-10%

-5%

0%

5%

10%

15%

20%

25%

Pretax Margin Asset Turnover Tax Complement Leverage % Chg in ROE

Note: (1 + % Chg in Pretax Margin) x (1 + % Chg in Asset Turnover) x (1 + % Chg in Tax Complement) x (1 + % Chg inLeverage) = (1 + % Change in ROE)Source: Company reports.

� Jefferson-Pilot Five-year EPS Analysis

Over the five years ended 2001, Jefferson-Pilot’s operating earnings per shareincreased at a 13.5% annual rate, which would seem to suggest that management’s10% target going forward is conservative. This may seem like an especially safeconclusion given that revenue growth accounted for the bulk of the earnings gainssince 1996 (Figure 28). However, we estimate that excluding the impact of acquiredcompanies, revenue growth would have been in the low single digits over this period.We believe that the low level of organic top-line growth in recent years was thecatalyst for a number of strategic initiatives currently underway in the company’sindividual life business. Notice that acquired growth was not offset by the issuance ofshares because excess capital was plentiful. Margin expansion was material during thelast five years, and we believe that it was a function of acquisition cost saves and anoverall effort to lower operating expenses. Finally, as mentioned in the ROE section,the tax rate was not a meaningful factor.



Figure 28: Jefferson-Pilot – Deconstructing 5-Year Operating EPS Growth Rate

0.2%

13.6%

0.9%

9.5%

3.0%

0%

2%

4%

6%

8%

10%

12%

14%

16%

Revenue Growth Pretax Margin Tax Rate SharesOutstanding

EPS Growth

Note: The sum of the components equals the earnings per share growth rate.Source: Company reports.

� Jefferson-Pilot Sustainable Growth Analysis

We believe that the sustainable growth rate derived from the DuPont Model (9.6%)is aggressive because the return on equity in 2001 (14.7%) is above our estimate ofthe marginal ROE (12.0%). Our long-term earnings growth estimate for Jefferson-Pilot is 7% (1% less than we previously assumed), based on a more cautiousoutlook for top-line growth, so our projected growth rate is below the sustainablegrowth rate. The gap between projected and sustainable growth suggests that thecompany will generate some excess capital, which could boost EPS growth to 8%annually. We do not forecast as much excess capital production as managementhas indicated, and to some extent the discrepancy relates to the potential for anincrease in financial leverage and could also relate to differences in statutory versusGAAP accounting. However, we would still be conservative and assume excesscapital generation over the long term is at a level below management’s near-termguidance because we think that marginal returns are below management’sassumption. Finally, notice the convergence of actual EPS growth and sustainableEPS growth in recent years, with 2001 being the first year that actual growth wasless than sustainable growth. This phenomenon relates to the steady upward trendin return on equity since 1993 and the stabilization of ROE more recently.

The sustainable growth equation is also an effective check on how wellmanagement has thought through long-term growth and return goals. Mostcompanies put forth long-term financial goals, but sometimes the math does nothold together. For example, it is not unusual to see companies that are payingdividends have long-term growth and return targets that are equivalent. Forexample, 15% growth and 15% return targets do not work when the dividendpayout ratio is 20% unless management is factoring in the need to raise equitycapital to fund growth. For Jefferson-Pilot, we think that management’s statedEPS growth target of 10% is aggressive, largely because we have a more cautiousview of both organic growth and marginal returns.

Real World Example of Excess Capital Forecast

We believe that it is useful to describe how we apply the sustainable growth ratemodel to calculate excess capital in the context of a real world example.Torchmark’s shares trade at a discount to the group because investors believe thatthe company has modest growth prospects. In our opinion, investors have notassigned enough weight to the excess capital element of the story, which shouldadd as much as three percentage points to annual earnings per share growth. Thisestimate of excess capital is derived from the non-traditional application of thesustainable growth equation. Specifically, we input return on equity and growth

Use sustainable growth as a“reasonableness” check ofmanagement-stated targets



into the equation, and solve for the retention rate. In other words, based on ourprojection of long-term earnings growth and the marginal return on equity, wecalculate the amount of capital that needs to be invested in the business to fundgrowth.

In this example, we believe that Torchmark will continue to produce a superiorreturn on equity, largely because of a low cost structure and a favorablecompetitive environment in the company’s core business. We estimate that themarginal return on equity is 15%-16%. (Marginal return on equity, or the returnon new capital invested, will determine the amount of capital that is needed tofund growth.) For our long-term earnings growth forecast, we look at eachindividual business segment and consider the market growth and Torchmark’srelative position within that market. For example, the most rapid growth businessfor the company over time is a direct insurance unit. The outlook is favorable forthis segment because there is significant market potential and Torchmark, as oneof the few successful direct-marketers of life insurance, already is a leader in thisdistribution channel. In contrast, Torchmark is a meaningful player in Medicaresupplement insurance, which we estimate is a low- to mid-single digit top-linegrowth business. However, as a low-cost producer with effective distribution,Torchmark is better positioned than most insurers in Medicare supplement.Overall, we forecast that Torchmark’s mix of business will generate long-termearnings growth of 7%.

At this point, we have derived the two key assumptions necessary to determinecapital needs – return on equity and the potential for growth. It is now possible tosolve for the amount of capital needed to fund future investments. By inputting a16% return on equity and 7% earnings growth into the sustainable growth formula,we calculate that 44% of earnings are necessary to fund growth (7% divided by16%). Therefore, given that we estimate Torchmark will earn approximately $427million in 2002, our model suggests that $240 million, or 56% of the total, isavailable to pay dividends, make an acquisition or repurchase common stock.Given that dividends are $45 million annually, our analysis suggests that thecompany has approximately $195 million of additional free cash for acquisitionsor share buyback. Given the company’s history and recent actions, we areassuming that the free capital will be used to repurchase shares. The combinationof 7% internal growth and a consistent share repurchase plan should produceapproximately 10% long-term earnings per share growth.

This is a GAAP earnings-based approach to estimating free cash, which is notnecessarily representative of available cash flow (especially given regulatoryrestrictions on free cash in the insurance industry). However, this model has beenreasonably accurate over time, in our opinion. For example, our estimate ofTorchmark’s free cash after common dividends (approximately $195 million) isconsistent with management’s statement that this number is $190 to $200 million.Also, we estimate that the statutory operating earnings of the insurancesubsidiaries in 2002 (which determine operating cash available to the parent)would support a $260 to $280 million dividend to the parent in 2003.

The Bottom-Line Comparison

Because of differences in product mix, the most effective company-to-companycomparisons are often at the highest level or, stated differently, earnings per sharegrowth and return on equity. Figures 29 and 30 compare Jefferson-Pilot to theMerrill Lynch Life Insurance Index on these two performance measures. Thereturn on equity comparison illustrates that Jefferson-Pilot has produced a steadyupward trend, while the industry return has been slightly more volatile. For thefirst time in 2001, Jefferson-Pilot’s operating return on equity exceeded the returnfor the Merrill Lynch Life Insurance Index. Despite the high ROE currently,Jefferson-Pilot’s below-average return on equity historically deserves someexplanation. Further analysis uncovers that a higher commitment to equities in theinvestment portfolio over time has depressed reported (but not economic) return on

Non-traditional use ofsustainable growth rate formula

leads to excess capital forecast

ROE is a valuable tool tocompare companies with the

peer group



equity. Specifically, the numerator only reflects dividend income – which is lessthan a fixed income return would be – and the denominator reflects unrealizedequity investment appreciation, which does not flow through the income statement.

Figure 29: Operating Return on Equity Comparison, 1991-2003E

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002E 2003E

Jefferson-Pilot Merrill Lynch Life Insurance Index


The operating earnings per share growth comparison explains the strong relativestock price performance of Jefferson-Pilot in the mid to late 1990s, in our view.From 1994 to 1998, Jefferson-Pilot’s operating earnings per share growth handilyoutpaced the industry, as the benefit from acquisitions, the expansion ofdistribution and efficiency gains all had a positive effect on the bottom line.Growth slowed in 1999 and 2000, trailing the growth rate of the Merrill LynchLife Insurance Index for the first time since 1993. In 2001, the growth rate wasessentially in line with the index, and we estimate that Jefferson-Pilot’s EPSgrowth will be lower than the index in 2002 and 2003. Our estimates through2003 support an expectation for single-digit long-term EPS growth, in our opinion.

Figure 30: Operating EPS Growth Comparison, 1990-2003E

0%

5%

10%

15%

20%

25%

90/8

991

/90

92/9

193

/92

94/9

395

/94

96/9

597

/96

98/9

799

/98

00/9

9

01A/0

0

02E/0

1A

03E/0

2E

Jefferson-Pilot Merrill Lynch Life Insurance Index

Sources: Company reports, I/B/E/S and Merrill Lynch estimates.

The Industry in a DuPont Model Framework

Figures 31, 32 and 33 present the stock life insurance industry’s statutory resultsin a DuPont model framework. Financial leverage – as measured by the assets-to-equity ratio – trended upward from the mid-1980s to the early 1990s, remainedrelatively constant throughout the 1990s and has resumed an upward trend inrecent years. A higher leverage ratio does not necessarily suggest a materialchange in risk profile versus the early 1990s, in our view, because separateaccount assets (variable products) now account for larger portion of total assets.

DuPont Model highlightsimprovement in industry’sreturns and capitalization



At the end of 2001, separate account assets were 35% of total assets versusslightly more than 10% of assets at the beginning of the 1990s. (As discussedearlier, separate account products require substantially less capital than generalaccount products.) However, we do believe that the risk profile of the industrymay have increased during the past few years as the leverage ratio is up and thepercentage of assets in separate accounts has declined as a result of the bearmarket in equities. Also, general account asset quality has deteriorated in recentyears, entirely as a result of credit problems in the fixed income portfolio.

We have witnessed a reset downward in GAAP returns for the life insuranceindustry during the past few years, and statutory results have followed a similarpath. For example, statutory operating return on equity averaged slightly less than10% from 1998 to 2001, which compares to 12.6% from 1990 to 1997. Overall,we believe that a statutory return on equity of 10% is in line with the type of returnthat would be expected from a mature, fragmented industry that sells commodity-like products. After consideration of leverage (which is typically at the holdingcompany level for stock life insurers), we believe that a 10% statutory return at thesubsidiary level translates to perhaps a 12% return on equity for shareholders. Ourconfidence level that these returns reflect the economics of the business isbolstered by the fact that the figures are based on statutory accounting, aconservative measure of financial performance. In our view, statutory data shouldprovide some comfort for investors given the recent spate of accounting scandals.

Figure 31: Assets-to-Equity Ratio for Stock Life Insurance Companies, 1984-2001

6

8

10

12

14

16

18

20

1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001




Figure 32: Return on Assets for Stock Life Insurance Companies, 1984-2001

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

1.2%

1.4%

1.6%

1.8%

2.0%

2.2%

1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Note: Data is on a statutory basis. Codification of statutory accounting in 2001 has led to comparability issues on ayear/year basis, especially with regard to revenues and expenses.Source: A.M. Best’s Aggregates and Averages

Figure 33: Return on Equity for Stock Life Insurance Companies, 1984-2001

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001


Considerations when Analyzing ROE of aDemutualized Company

Given the recent wave of life insurance demutualizations, understanding thedifferences in returns on equity for mutual companies versus stock companiesshould be of some interest to investors. It is fairly well known that mutualcompanies have consistently generated below-average returns on equity (Figure34), which explains the below-average returns initially for most of the insurers thathave recently demutualized (Table 22). However, understanding why the returnon equity is low, and the relationship between current ROE, normalized ROE andmarginal ROE should lead to a better understanding of the fundamental outlookfor these newly public companies.



Figure 34: Statutory Operating Return on Equity, 1984-2001

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Stock Life Companies Mutual Life Companies

Estimate of long-term equity cost of capital.

Source: A.M. Best.

Table 22: Returns for Demutualized Life Cos. Generally Trail ML Index

Operating ROE Year of DemutualizationJohn Hancock (2000) 14.6%Principal (2001) 11.4%MetLife (2000) 10.3%Prudential (2001) 4.9%Phoenix (2001) -4.0%ML Index Average 2000 – 2001 14.4%

Note: Year of demutualization in parentheses.Sources: Company reports.

In our opinion, the bulk of the underperformance of the mutual life industry – asmeasured by operating return on equity – can be traced to an inefficient coststructure (Table 23). However, it is necessary to understand that a low operatingreturn on equity for a mutual is not always entirely the result of mismanagementor a weak competitive position. The only way for a mutual insurer to delivervalue to its owners (policyholders) is through the performance of the insurancepolicies that it sells. Therefore, the benefits and policyholder dividends paidrelative to the premiums collected determine the return generated for the owners,but this type of value creation also depresses return on equity. As a publiccompany, the profitability of new business will no longer be shared withpolicyholders unless those policyholders are also shareholders. Finally, the largestcompanies that have demutualized in recent years were at least somewhat over-capitalized upon conversion to a public company. For example, MetLife hasrepurchased $2.4 billion of stock since its IPO in early 2000, and Prudential hasidentified unallocated equity that is more than one-third of the company’s totalequity capital.

Table 23: General Expense-to-Assets Ratio, 1996-2001

Mutual Companies Stock Companies1996 1.59% 1.62%1997 1.90% 1.46%1998 1.73% 1.47%1999 1.72% 1.37%2000 1.63% 1.33%2001 1.72% 1.30%

Source: A.M. Best.

Inefficiency is the biggestissue, but not the only issue



In a subsequent section, we discuss in detail our valuation model and theimportance it places on normalized and marginal return on equity. (Normalizedreturn on equity is a reasonable expected return on the current book of businessand marginal return on equity is the expected return on new business.) Attentionto these factors is especially critical when valuing a newly demutualized lifecompany (e.g., Prudential) because we believe that current ROE is typically notindicative of normalized ROE (e.g., expense save opportunities) and marginalROE is often equal to or higher than normalized ROE.

In our opinion, a traditional price-to-book versus ROE valuation model is toosimplistic in general (which we discuss in the valuation section of this report), andparticularly inappropriate when valuing recently demutualized companies. Toillustrate this point, it is instructive to look at the relationship between price-to-book value and the operating ROE for the life group in early 2002 (Figure 35),which was shortly after the demutualizations of Phoenix, Principal (PFG, $26.81,B-2-7) and Prudential. Given that most demutualized life companies initiallygenerate returns below a normalized level, these insurers can appear to beovervalued based on the price-to-book versus ROE regression model even thoughmore often than not a discounted cash flow analysis would suggest otherwise.Notice that of the four companies that fell into “overvalued territory” in early2002, three were recent demutualizations. Also, according to the regression line,MetLife appeared fairly valued at the time versus our expectation that there wasstill upside potential for the shares.

Figure 35: Price-to-Book versus ROE Valuation Model (as of 01/07/02)

R2 = 87%

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

0% 5% 10% 15% 20% 25%

PNX

PRU PFG

MET

JHF

Note: Return on equity is 2002 estimate.Sources: ADP and Merrill Lynch estimates.

Ignoring normalized &marginal ROE is risky whenanalyzing demutualizations



5. Focus on Operating, but Don’t Forget NetSell-side analysts’ published GAAP earnings estimates for insurance companies are onan operating basis – defined as income before realized capital gains and losses andother unusual items. The determination of gains and losses is relativelystraightforward, although many insurers have converted gains to operating incomethrough investments in partnerships. The determination of other non-operating items ismore debatable, and we are less likely than most to agree that an “unusual” item isnon-operating in nature, often despite management’s view to the contrary.

The focus on operating results is justified because this earnings stream arguably bestreflects the underlying trend in the business. Realized investment gains and losses, onthe other hand, are impossible to predict in any one period and are subject tomanipulation by management. However, net – not operating – earnings drive growthin book value over time, so we think investors should factor gains and losses into theirvaluation framework for life companies.

Net Earnings Must Matter Eventually

Although we focus on operating earnings, we believe that investors care about netearnings over time, and will reward companies that do not deliver below the linesurprises with higher P/E multiples. Therefore, net realized investment gains andlosses and one-time charges should not be ignored. Investors should keep in mindthat book value grows a result of net results over time.

It seems to us that investors care more about bottom line results today versus evenas recently as one year ago. There are certainly more questions asked about theoutlook for net earnings. In general, we believe that net income will receive moreattention during a bear market if it is less than operating income, which is the casefor life companies. Specifically, bond losses recorded by the life industry duringthe past couple of years have caused net earnings to substantially trail operatingresults. In our opinion, there are instances where disappointing net results haveled investors to “mark down” valuations based on operating earnings(UnumProvident and John Hancock), and examples, in our opinion, whereconsistently good net results partially explain premium valuations over time(AFLAC and Jefferson-Pilot). It is impossible to craft a theoretical argument thatnet income does not matter for valuation, in our opinion. If we owned a lifeinsurer, we guarantee the reader that we would not be appeased by good operatingresults if net earnings were lousy.

Given the extreme decline in equity prices from peak levels and recent concernsabout the veracity of financial statements, it seems reasonable to assume that stockmarket participants may demand a greater “margin of safety” going forward. Thissuggests that investors will continue to move down the income statement in theirefforts to assess valuation, and life companies will not be immune to this trend, inour opinion. The market has already shifted away from price-to-sales metrics inmost cases, and there is an ongoing debate about the relevance of pro formaresults. In this environment, the overall concept of net versus operating earningsshould receive more attention, which is of particular relevance for life companies.

In our view, it is difficult to draw meaningful conclusions about a company’s netearnings performance without consideration of results over a multi-year timeframe. For example, it is unrealistic to assume that investment losses continue atthe current elevated rate indefinitely, in our view. Also, life insurers estimate bothcost of goods sold (future policy benefits) and selling expenses (DAC) underGAAP accounting, and it takes years to assess the accuracy of these estimates. Inour opinion, investors should think about the analysis of net versus operatingearnings in the same way that they utilize an analysis of accident versus calendaryear loss ratios for property-casualty insurers. Namely, both are tools to assess thequality of reported earnings over time with the understanding that history does notalways repeat itself.

A focus on operating earningsreduces risk of misinterpreting

results

Don’t forget about net earningsover time, the ultimate driver

of book value growth

More questions about netearnings today

Looking for thatmargin of safety

Comparison should be madeover time



Realized investment gains and losses, “non-recurring” charges, and gains or lossesfrom divestitures are the primary reasons that net earnings differ from operatingearnings. Sales of invested assets occur on a regular basis, so investment gainsand losses are more common than the other two items. Of the less frequent non-operating items, we believe “non-recurring” charges deserve more scrutiny thangains or losses on the sale of businesses. In our opinion, “non-recurring” chargesare often misplaced operating items (i.e., prior period operating results wereoverstated). The sale of a business, on the other hand, often reflects a realizationthat the operation is not a strategic fit or is an admission that management hasfailed to create value, either of which could be a positive development.

Credit is a Fundamental Issue & Net Tells the Story

We think that market participants need to factor in realized investment gains andlosses into their thought process on valuation. A quarterly forecast isinappropriate because the timing of investment gains and losses is subject tomanipulation in the short term. However, even though our published estimateswill continue to be for operating earnings, over the long term we believe thatanything that contributes to (or detracts from) book value is a fundamental factor.Investors who lived through the real estate and junk bond problems of the late1980s and early 1990s will recall (perhaps vividly) that the market focused on netearnings for life companies with asset quality issues. We certainly focused on netresults because the primary concern was to what extent was the book value forcompanies with asset troubles (e.g., Aetna and Travelers) impaired.

In our view, results during the last three years highlight the importance ofconsidering the impact on the bottom line from realized investment gains andlosses (Table 24). Realized losses have become commonplace and meaningful forsome companies as a result of elevated credit losses stemming from the difficulteconomic environment. It does not make sense to give companies credit for highcoupon income from risky assets and ignore principal losses simply because oneitem is operating and the other is not. Also, depending on your return estimate forequities and non-traditional asset classes (e.g., venture capital) and yourassumption about the level of bond credit upgrades versus downgrades, the “baseline” assumption for the industry is probably realized losses over time. Without achange in interest rates or credit ratings, the return on a portfolio of bonds andmortgages will be interest income (an above the line item) offset by credit losses(a below the line item). Bonds and mortgages account for approximately 90% ofthe total investment portfolio for the Merrill Lynch Life Index.

Table 24: Realized Investment Gains (Losses) as % of Operating Income

1997 1998 1999 2000 2001 9mos02AFLAC 0% 0% -1% -11% -5% -2%Hartford Life 0% 0% -1% -9% -11% -26%Jefferson-Pilot 23% 15% 15% 14% 9% 8%John Hancock 23% 19% 20% 9% -20% -28%Lincoln National 123% 3% 1% -2% -11% -40%MetLife 68% 109% -2% -15% -29% -26%Nationwide 3% 4% -2% -4% -4% -47%Phoenix na 57% 34% 27% nm nmPrincipal 33% 120% 56% 15% -45% -27%Protective Life 0% 1% -1% -3% -8% 1%Prudential na 45% 27% -24% -12% -24%Stancorp 13% 10% 0% -1% 0% -17%Torchmark -7% -8% -22% -1% -1% -18%UnumProvident -1% 4% 9% -2% -4% -39%Life Insurance Composite 20% 31% 6% -4% -15% -23%

Source: Company reports and Merrill Lynch estimates.

Focus attention on total returninvestment results and

“non-recurring” charges

History suggests investorsshould pay attention to

investment losses

Don’t give credit for highcoupon income and

ignore realized losses



Portfolio Turnover can Distort True Fundamentals

Realized gains or losses result not only from improvement or deterioration incredit, but also from fluctuations in interest rates. We believe that the latter ismore likely to produce a change in the timing, but not the amount, of profitsrecognized. For example, everything else being equal, a realized loss will producehigher future operating income because the offset to the loss is an increase in future netinvestment income. (Two bonds that are identical except for the coupon rate shouldtheoretically be priced to yield the same present value.)

It is easy to expose the shortcoming of a sole focus on operating income with ahypothetical example based on trading an investment portfolio while interest ratesare going up. Companies A and B both have identical balance sheets, books ofbusiness and GAAP return characteristics initially, but Company A sells bonds ina rising interest rate environment while Company B has zero turnover in itsinvestment portfolio (Table 32). Company A alters the timing of profitrecognition, but not the economics of the business, as realized losses in the nearterm are offset by higher operating income in the future. Company A’s strategydoes, however, produce a much more attractive operating earnings growth andreturn profile (Table 25). If you show this table to insurance analysts, theconclusions will probably be fairly similar – Company A is more “valuable” thanCompany B. This finding violates common sense when it is clear that both ofthese companies have the same economic profile.

Table 25: Profile of Operating Results

Operating Earnings Year 1 Year 2 Year 3 CAGRCompany A 23.4 26.4 30.5 14.2%Company B 23.4 24.7 26.1 5.7%

Operating ROE Year 1 Year 2 Year 3 AverageCompany A 11.1% 11.8% 13.4% 12.1%Company B 11.1% 10.5% 10.0% 10.5%


One way to avoid the seemingly obvious conclusion that Company A is worthmore than Company B is to consider net earnings and returns (Table 26). In thisexample, we know that the poor net results for Company A do not mean that it isworth less than Company B. However, an analysis of net earnings stronglysuggests that information that goes beyond reported operating results is necessaryto determine an appropriate valuation.

Table 26: Profile of Net Results

Net Earnings Year 1 Year 2 Year 3 CAGRCompany A 23.4 0.8 7.9 -41.9%Company B 23.4 24.7 26.1 5.7%

Net ROE Year 1 Year 2 Year 3 AverageCompany A 11.1% 0.4% 3.5% 5.0%Company B 11.1% 10.5% 10.0% 10.5%



Although the realization of interest-rate related gains would seem to penalize futureoperating income, we believe that companies have offset this negative impact at leastsomewhat with the accelerated amortization of deferred acquisition costs. It isconsistent with GAAP to accelerate (decelerate) DAC amortization when an

Realized losses related tointerest rate increases

boost operating Income

It seems counterintuitive, butrealized gains may not always

penalize operating income



investment gain (loss) is realized because of the change in the timing of expected grossprofits. However, we believe that some companies might adopt an aggressiveapproach toward the acceleration of DAC amortization in order to offset gains andavoid a hit to future operating income. For example, during 1992 and 1993 Consecooffset approximately 75% to 85% of realized gains with the amortization of DAC andpresent value of future profits (PVFP), which compared to 41% in 1991 (Table 27).This is an extreme example, but it would not surprise us to learn that other companiesthink about the interplay between gains, DAC amortization and future operatingincome.

Table 27: Analysis of Conseco Realized Investment Gains, 1991-1993

1991 1992 1993Realized gain 123.3 124.3 149.5DAC & PVFP Amortization 50.4 93.4 126.3Net gain 72.9 30.9 23.2DAC & PVFP Amortization / Realized Gain 41% 75% 84%

Note: PVFP is present value of future profits, which is the insurance intangible that results from acquisitions.Source: Conseco’s 1993 annual report.

Non-Recurring Charges Today Often Should havebeen Operating Expenses Yesterday

In our view, most managements exclude unusual expense items (non-recurringcharges) from their definition of operating income because these items depressresults and distort current period financials. It is clear that charges make it moredifficult to understand current trends, but this does not suggest that we shouldignore these expenses. Consideration of both operating and net results addressesthe need to evaluate current fundamental trends while guaranteeing that anyunusual negative item will receive the attention it deserves. Also, we cautioninvestors not to automatically ignore charges simply because these expenseshappen to be “non cash” items. For example, a reserve increase is a “non cash”item, but it is certainly fundamental in nature given that it reflects future cashoutlays (paid claims). Similarly, amortization of deferred acquisition costs (DAC)is a non-cash item, but it is certainly fundamental in nature. To the extent thatDAC amortization has been understated, gross profits (operating cash flow) overthe life of the contracts will be less than previously assumed.

Because non-recurring charges often result when prior period expenses wereunderstated, it is inappropriate to ignore these charges. Why should we penalizethe valuation of a company that “got it right” from the beginning and reward acompany that utilizes aggressive assumptions? To illustrate this concept, we havecreated a hypothetical example (Tables 28 & 29) that includes a variable annuitywriter that accounts for the business appropriately (Company A) and an insurerthat initially employs overly optimistic assumptions (Company B). This examplemay seem to state the obvious, but too many times we have witnessed marketparticipants gloss over “below the line” items.

The assumptions used for Company A are realistic, with the amortization ratebased on Hartford Life’s individual annuity business. We assume that Company Bhas the same book of business as Company A, but employs a more aggressiveDAC policy. Specifically, Company B has determined that the write-off of DACshould be approximately 35% of gross profits (pretax earnings beforeamortization) while Company A has determined that 45% is the appropriate rate.(In reality, a complicated process is required to determine the amortization ofdeferred acquisition costs.) During the first four years, operating results suggestthat Company B is more profitable than Company A, although some mightquestion the difference in DAC policy. In the fifth year, Company B recognizesthat the profitability of the business is less than initially assumed and records a“catch-up” DAC adjustment that it identifies as a non-recurring charge. As a

Charges may mask currenttrends, but this does not

justify ignoring net earnings

Don’t assumenon-cash = non-event

Easy to illustrate that chargesmatter with a simple example



result, both companies will have recognized the same amount of amortizationexpense by the end of year five, but operating results will strongly favor CompanyB over Company A. It is impossible to justify ignoring the charge because itreflects operating expenses that should have been booked during the first fouryears. An analysis of net results clearly illustrates that the economics of bothbooks are the same. Even though the economics are equivalent for the currentbook, we would argue that Company A deserves a premium valuation to CompanyB – everything else being equal – based on a higher level of confidence in theintegrity of financial statements going forward. In our opinion, investorsrecognize the fundamental nature of “DAC charges” today given the experience ofthe variable annuity industry in 2002, and realize that charges of this type reflectthe overstatement of prior period profitability.

Table 28: Company A - Variable Annuity Writer w/Accurate Assumptions

Year 1 2 3 4 5Assets 100,000 100,000 100,000 100,000 100,000

Fee Income 1,250 1,250 1,250 1,250 1,250Amortization of DAC 450 450 450 450 450General Expenses 250 250 250 250 250Pretax Income 550 550 550 550 550Taxes 193 193 193 193 193After-tax Operating Income 358 358 358 358 358“Non-Operating” Items - - - - -After-tax Net Income 358 358 358 358 358

Asset Fee 1.25% 1.25% 1.25% 1.25% 1.25%DAC Amortization/Gross Profits 45% 45% 45% 45% 45%General Expense Ratio 0.25% 0.25% 0.25% 0.25% 0.25%Tax Rate 35% 35% 35% 35% 35%After-tax Operating ROA 0.36% 0.36% 0.36% 0.36% 0.36%After-tax Net ROA 0.36% 0.36% 0.36% 0.36% 0.36%


Table 29: Company B - Variable Annuity Writer w/AggressiveAssumptions

1 2 3 4 5Assets 100,000 100,000 100,000 100,000 100,000

Fee Income 1,250 1,250 1,250 1,250 1,250Amortization of DAC 350 350 350 350 450General Expenses 250 250 250 250 250Pretax Income 650 650 650 650 550Taxes 228 228 228 228 193After-tax Operating Income 423 423 423 423 358“Non-Operating” Items - - - - (260)After-tax Net Income 423 423 423 423 98

Asset Fee 1.25% 1.25% 1.25% 1.25% 1.25%DAC Amortization/Gross Profits 35% 35% 35% 35% 45%General Expense Ratio 0.25% 0.25% 0.25% 0.25% 0.25%Tax Rate 35% 35% 35% 35% 35%After-tax Operating ROA 0.42% 0.42% 0.42% 0.42% 0.36%After-tax Net ROA 0.42% 0.42% 0.42% 0.42% 0.10%




There is a tendency to consider a restructuring charge as the purest form of aforgivable one-time charge. Although we would tend to agree with this view inmost instances, we believe that investors need to contemplate the components ofany restructuring charge before discounting its significance. To the extent that acharge reflects severance and facility closings, we would be less concerned. Tothe extent that it entails items that suggest prior years’ operating results wereoverstated or expenses that should be booked in the future instead of recognizedbelow the line today, we would be more concerned. It is not easy to figure outwhat portion of a restructuring charge falls into the latter category, but investorsshould be skeptical if items other than those related to severance and facilityclosings are substantial.

Operating Focus Can Create Misguided Incentives

We have been active participants in the wave of life insurance demutualizationsduring the last few years, and have listened to many due diligence and IPOpresentations about strategies to improve operating-based returns on equity. Mostof the levers that these newly public companies discuss, such as expense reductionand product pricing, reflect fundamental efforts to improve economic returns.However, we cringe somewhat when we hear initiatives to improve operatingROE that revolve around a shift from total return investing to an approach thatfavors coupon income. The implicit rationale is that interest income (above theline) is more valuable than capital gains (below the line), which is botheconomically false and fundamentally dangerous. On the latter point, we thinkthat a myopic view of operating earnings from an investment standpoint couldpush an organization to accept the attraction of a high coupon over a low couponwithout adequate consideration of risk. Although we have probably paid too muchattention to operating income ourselves from time to time, we are confident thatthis thought process is not conducive to long-term value creation.

Did Net Impact Takeout P/E for American General?

In our opinion, the valuation that AIG (AIG; $48.20; A-1-7) ascribed to AmericanGeneral was fairly low (16 times forward operating earnings) relative to otherrecent deals, especially given our belief that American General was one of the lastpotential franchise companies available to be acquired. Although AIG may havefelt it had the ability to offer a conservative price because the number of potentialbuyers was limited, the relatively low acquisition multiple may have also reflectedthe gap between American General’s net and operating earnings performance(Table 30). Perhaps AIG did not ignore the tendency for American General totake reserve charges in recent years.

Table 30: American General Earnings Analysis, 1991-2000

Operating EPS Net EPS Net/Operating1991 $1.07 $1.07 100%1992 1.21 1.23 102%1993 1.33 0.47 35%1994 1.50 1.23 82%1995 1.30 1.32 102%1996 1.54 1.38 90%1997 1.75 1.10 63%1998 2.03 1.48 73%1999 2.30 2.20 96%2000 2.58 1.98 77%Cumulative 16.58 13.44 81%


Don’t automatically gloss overrestructuring and merger-

related charges

Focus on operating can makeinterest income seem more

valuable than capital gains,which can be dangerous

AIG may have consideredAGCs below-average net

earnings performance when itvalued the company



In the case of American General, at least one non-recurring charge negativelyeffected the company’s ability to buy back shares, which was a key part of thefundamental story. Immediately following the announcement of a $175 millionafter-tax settlement for the sale of race-based and other industrial life policies in2000, American General management indicated that the targeted share repurchaselevel was more likely to be $400 million for the year versus the previouslyannounced target of $500 million.

Industry Findings

We have created a Life Insurance Composite to compare net and operatingearnings that is based on the companies that we have analyzed within thisframework. The Life Insurance Composite includes all of the life insurers undercoverage (Phoenix and Prudential beginning in 2002) plus American General(through 2000).

� Net versus Operating Relationship Heading in the Wrong Direction

The net earnings trend has worsened for the Life Insurance Composite, whichshould not be surprising given that realized gains have been replaced by realizedlosses in recent years (Figure 36). However, investment losses do not fullyexplain the deterioration in net earnings. The ratio of net earnings to operatingearnings was at a low level in 1999 despite modest realized gains, and realizedlosses accounted for only one-third of the gap between net and operating results in2000. Therefore, negative “non-operating” items were substantial in both periods.

Significant “non-operating” items had a negative impact on net earnings in 1999,2000 and 2001. UnumProvident booked substantial charges in 1999, accountingfor almost 40% of the total “non-operating” items for the Life InsuranceComposite. We do not believe that the difficulties experienced by UnumProvidentare necessarily indicative of the overall level of risk for the peer group. JohnHancock (JHF; $25.52; B-2-7) and MetLife both recorded a number of charges in1999 in advance of their demutualizations in early 2000. These companiescombined accounted for more than 50% of the total “non-operating” items for theLife Insurance Composite in 1999. The impact of the demutualization wavecontinued in 2000 and 2001as MetLife registered additional charges related to itsconversion to a public company and Principal Financial Group booked a charge inadvance of its demutualization in 2001. In 2002, several companies experiencedunusual charges related to the implementation of FAS 142 (accounting forgoodwill) and FAS 133, and Principal recorded a loss on the sale of BT Financial.

Approximately two-thirds of the sizable gap between net and operating earningsthrough the first nine months of 2002 resulted from realized investment losses.The industry has suffered from the elevated level of total bond defaults, and hasreported material losses related to high profile bankruptcies (e.g., WorldCom).Realized losses have received attention from investors as many are beginning toappreciate that credit is a fundamental issue regardless of whether the impact isabove or below the line. The experience in 2002 has crystallized, in our opinion,the downside of a credit-based investment strategy in the life insurance industry.We will discuss in detail in Section 6 how we factor realized investment lossesinto our valuation model.

Realized losses don’t fullyexplain the deterioration in net

results since the late 90s…

…as other “one time” itemshave been material…

…but fixed income losses werethe story in 2002



Figure 36: Life Insurance Composite – Ratio of Net Earnings to Operating Earnings

0%

20%

40%

60%

80%

100%

120%

140%

1996 1997 1998 1999 2000 2001 9-mo ’02


� Net Trails Operating ROE

On average, net return on equity has been 10% below operating ROE during thepast five years. The inclusion of 2002 results, which were negatively impacted byfixed income credit losses, lowered the five-year average ratio of net-to-operatingROE from 99% to 90% for the Life Insurance Composite (Table 31). Theperformance over the past five years is probably close to a normalized level, in ouropinion, as we expect that net results will trail operating over the long term(discussed in detail in Section 6).

Principal Financial registered the best net-to-operating performance, primarily as aresult of substantial capital gains from 1997 through 1999 and the absence of largeone-time charges (despite converting from a mutual to stock company). Itprobably will not surprise many that AFLAC and Jefferson-Pilot – both widelyregarded as high quality companies – have generated net returns in excess ofoperating returns over the past five years. UnumProvident has the lowest netreturn on equity in relation to operating ROE, which reflects numerous charges inrecent years. Finally, John Hancock and MetLife have generated unattractive netreturns in recent years relative to operating results, but this performance ispartially due to charges shortly before and after demutualization that shouldprobably be considered one-time in nature.

Table 31: Return on Equity Analysis

5 Year AverageOperating ROE

5 Year AverageNet ROE

Ratio of Net toOperating

Principal Financial Group 9.8% 11.5% 117%Jefferson-Pilot 14.1% 15.9% 112%AFLAC 20.0% 20.7% 103%Nationwide Financial 13.8% 13.3% 96%StanCorp Financial Group 10.8% 10.2% 94%Protective Life 14.2% 13.1% 92%Hartford Life 19.2% 17.6% 91%Torchmark 16.2% 14.2% 87%Lincoln National 11.8% 9.5% 80%John Hancock Financial 13.3% 10.0% 75%MetLife 9.3% 6.6% 72%UnumProvident 12.3% 7.9% 64%Life Insurance Composite 13.9% 12.5% 90%

Note: Data includes our ‘02 estimate. Table excludes Phoenix & Prudential, as we do not consider the data meaningful.Sources: Company reports and Merrill Lynch estimates.

Ratio of net to operatingranged from 73% to 130%

for companies in Composite



Table 32: Impact on Operating & Net Results from Portfolio Turnover during a Rising Interest Rate Environment

Company A t = 0 1 2 3 4 5 6 7 8 9 10 11 12Assets 1,200 1,223 1,224 1,232 1,265 1,300 1,337 1,376 1,418 1,461 1,508 1,557 1,609Liabilities 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000Equity 200 223 224 232 265 300 337 376 418 461 508 557 609

Investment Income 96.0 100.6 106.9 110.8 113.7 116.9 120.2 123.7 127.5 131.4 135.6 140.0Realized Loss - (39.4) (34.8) - - - - - - - - - Total Revenue 96.0 61.3 72.1 110.8 113.7 116.9 120.2 123.7 127.5 131.4 135.6 140.0 Expenses 60.0 60.0 60.0 60.0 60.0 60.0 60.0 60.0 60.0 60.0 60.0 60.0 Pretax Income 36.0 1.3 12.1 50.8 53.7 56.9 60.2 63.7 67.5 71.4 75.6 80.0 Taxes 12.6 0.4 4.2 17.8 18.8 19.9 21.1 22.3 23.6 25.0 26.5 28.0 Net Income 23.4 0.8 7.9 33.0 34.9 37.0 39.1 41.4 43.9 46.4 49.1 52.0 A-T Oper Income 23.4 26.4 30.5 33.0 34.9 37.0 39.1 41.4 43.9 46.4 49.1 52.0

Portfolio Yield 8.0% 8.2% 8.7% 9.0% 9.0% 9.0% 9.0% 9.0% 9.0% 9.0% 9.0% 9.0%Crediting Rate 6.0% 6.0% 6.0% 6.0% 6.0% 6.0% 6.0% 6.0% 6.0% 6.0% 6.0% 6.0%Tax Rate 35% 35% 35% 35% 35% 35% 35% 35% 35% 35% 35% 35%Net ROE 11.1% 0.4% 3.5% 13.3% 12.4% 11.6% 11.0% 10.4% 10.0% 9.6% 9.2% 8.9%Operating ROE 11.1% 11.8% 13.4% 13.3% 12.4% 11.6% 11.0% 10.4% 10.0% 9.6% 9.2% 8.9%

Company B t = 0 1 2 3 4 5 6 7 8 9 10 11 12Assets 1,200 1,223 1,248 1,274 1,302 1,331 1,362 1,395 1,430 1,466 1,505 1,547 1,598Liabilities 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000Equity 200 223 248 274 302 331 362 395 430 466 505 547 598

Investment Income 96.0 98.0 100.2 102.6 105.1 107.7 110.5 113.4 116.6 119.9 123.4 139.2Realized Loss - - - - - - - - - - - - Total Revenue 96.0 98.0 100.2 102.6 105.1 107.7 110.5 113.4 116.6 119.9 123.4 139.2 Expenses 60.0 60.0 60.0 60.0 60.0 60.0 60.0 60.0 60.0 60.0 60.0 60.0 Pretax Income 36.0 38.0 40.2 42.6 45.1 47.7 50.5 53.4 56.6 59.9 63.4 79.2 Taxes 12.6 13.3 14.1 14.9 15.8 16.7 17.7 18.7 19.8 21.0 22.2 27.7 Net Income 23.4 24.7 26.1 27.7 29.3 31.0 32.8 34.7 36.8 38.9 41.2 51.5 A-T Oper Income 23.4 24.7 26.1 27.7 29.3 31.0 32.8 34.7 36.8 38.9 41.2 51.5

Portfolio Yield 8.0% 8.0% 8.0% 8.0% 8.1% 8.1% 8.1% 8.1% 8.2% 8.2% 8.2% 9.0%Crediting Rate 6.0% 6.0% 6.0% 6.0% 6.0% 6.0% 6.0% 6.0% 6.0% 6.0% 6.0% 6.0%Tax Rate 35% 35% 35% 35% 35% 35% 35% 35% 35% 35% 35% 35%Net ROE 11.1% 10.5% 10.0% 9.6% 9.3% 8.9% 8.7% 8.4% 8.2% 8.0% 7.8% 9.0%Operating ROE 11.1% 10.5% 10.0% 9.6% 9.3% 8.9% 8.7% 8.4% 8.2% 8.0% 7.8% 9.0%

Assumptions:1) Both companies have the same economic profile.2) Only expense item is credited interest on policies.3) Company A sells portfolio yielding 8.0% during 8.5% rate environment at the beginning of t=2 and sells portfolio yielding 8.5% during 9.0% rate environment at the beginning of t=3.4) Realized losses based on bonds with 10-year maturities.5) Interest earned and credited based on beginning of year asset and reserve balances.6) Earnings retention is 100%, but no new business is written.Source: Merrill Lynch.



6. Tackling Normalized ROEThe past year has been a rude awakening for anyone who thought a life companywas a life company was a life company. Divergent performance trends within thegroup could be explained by insurers with credit “issues” versus those withimpeccable balance sheets and/or companies with traditional business mixesversus those with equity sensitivity. Besides suggesting that life insurance stockperformance will be less homogeneous going forward, we believe thatfundamental developments during the past twelve months underscore theimportance of normalized ROE. It is no longer appropriate to assume that latesttwelve months earnings are normal for a life company (and perhaps it never reallywas). In our view, identifying instances where current earnings deviate from trendline results should eventually lead to excess investment returns.

It’s a 12% ROE Business

In our opinion, the median normalized net return on equity for the life insurersunder coverage is 12%, which contrasts with a median operating ROE of 14.4% in2000 (the peak year for the group). Our assessment of normalized returns is belowthe prevalent targets put forth by life company management teams and we thinkbelow consensus expectations. Table 33 presents our conclusions on normalizedreturn on equity for the life insurers in our coverage universe, and highlights thecompanies where there is a meaningful difference between our normalized netROE assumption and our 2003 operating ROE estimate. Although we present ourexpectations for normalized operating and net returns on equity, it is our view thatnormalized net return on equity should be used for valuation purposes. There area few key overall conclusions that deserve mention.

� Assume Net ROE Trails Operating over the Long Term

We believe that net return on equity will trail operating return on equity for everycompany under coverage, and this needs to be factored into the assessment offundamental value. Credit losses were above a normal level in 2002, so recentperformance should not be extrapolated over the long term. However, it is ourview that credit will be a consistent drag on net returns over time and investorsshould not assume that investment gains partially offset credit losses.

� We May Seem Conservative, but We’re NotOur assumptions on normalized operating ROE could be aggressive even thoughthese estimates trail management’s long-term goals in most instances. We believethat our return expectations are more likely to prove aggressive for insurers withheavy weightings in fixed product businesses (e.g., universal life and fixedannuities) than for large players in variable life and variable annuities. To someextent, we believe that variable product lines are less likely to disappoint becausefull-cycle return expectations have already been reduced from the levelsanticipated a few years ago. During the past two years, competition has beenintense in some traditional product lines, in our view, and we think that returnshave dipped below the cost of capital in some instances.

� Companies Gravitate Toward the Average Return

Our normalized ROE assumptions are in a tight range relative to the dispersion ofoperating returns in 2000 (peak year for ROE). This is explained by the differencebetween our full-cycle ROE estimate for variable annuity companies (Hartford,Lincoln and Nationwide) and the peak returns generated in 2000. It is also relatesto our expectation that some higher ROE companies in 2000 (Jefferson-Pilot, JohnHancock and Protective Life) will generate economic returns at a lower levelgoing forward as a result of credit losses and/or marginal return pressure on an

The days of 14% to 15% returnson equity are behind us

Use normalized net ROE forvaluation purposes

We believe net will consistentlytrail operating

Operating return expectationsbelow management targets and

could still be aggressive

Expect tighter range of returnson a normalized basis



operating basis. Finally, we expect that some of the underperforming companiesin 2000 (MetLife, Principal, Prudential, StanCorp and UnumProvident) willproduce higher returns on a normalized basis. We have already witnessedmeaningful improvement at MetLife, StanCorp and Principal.

Table 33: ROE Analysis

2000Operating ROE

2003EOperating ROE

NormalizedOperating ROE

NormalizedNet ROE

AFLAC 20.9% 22.3% 20.0% 20.0%Torchmark 16.3% 16.1% 16.0% 15.5%Hartford Life 21.7% 12.2% 14.5% 14.0%StanCorp 10.8% 12.9% 14.0% 13.5%Principal 10.7% 13.1% 14.0% 13.0%Protective Life 14.3% 12.6% 13.0% 12.5%John Hancock 14.6% 13.7% 13.5% 12.0%Jefferson-Pilot 14.6% 14.8% 13.0% 12.0%Lincoln National 14.9% 12.2% 13.0% 12.0%MetLife 10.4% 12.4% 13.0% 12.0%Nationwide Financial 16.8% 11.1% 13.0% 12.0%UnumProvident 9.7% 9.9% 12.0% 11.0%Prudential 8.0% 7.2% 11.0% 10.5%Phoenix 11.0% 2.9% 5.0% 4.5%Median 14.4% 12.5% 13.0% 12.0%

Note: Normalized and marginal ROE assumptions are not always the same in our valuation model (most notably forrecent demutualizations). Normalized ROE in this table is a LT assumption (i.e., marginal ROE distinction less relevant).We believe that credit will be a slight drag for AFLAC over time, but not enough to alter our normalized ROE assumption.Sources: Company reports and Merrill Lynch estimates.

Don’t Assume LTM Operating = Normal

It used to be fairly easy to get a handle on normalized earnings power for lifeinsurers by simply looking at latest twelve-month operating earnings. Thisseemed to be a reasonable approach primarily because life company earnings werecharacterized by a high level of stability. However, we believe that times havechanged, and assessing normalized earnings today is more complicated than everbefore. First, the increased importance of variable products has created a muchhigher level of potential earnings volatility for certain companies. The relativelyhigh degree of bottom-line uncertainty for variable annuity writers has becomecrystal clear as a result of the extreme bull and bear markets of recent years.Second, the credit challenges of the past couple of years have reminded investorsthat realized investment losses during periods of economic weakness act to reducefull-cycle returns on equity. We believe that investment losses could persist forsome time because improvement in fixed income markets could very well beoffset by deterioration in the performance of commercial mortgage loan portfolios.Finally, it is necessary to think about the potential for ROE improvement fromcurrent levels for recently demutualized insurers related to expense reduction,financial engineering and, in general, more attention paid to bottom line results.

� Pendulum Swings in Variable Annuities

We need to look no further than the variable annuity business to understand theimportance of normalizing results for valuation purposes. In our view, investorswho understand the difference between peak and trough returns for large variablewriters are better positioned to capitalize on market inefficiencies. For example, itwas only a few years ago that analysts were pressuring the management ofNationwide Financial Services to increase its ROE target from 15% because actualoperating return on equity was 17%. Today, the investment community isskeptical of Nationwide’s 13% to 15% operating ROE goal because it looks likereturn on equity will be approximately 10% in 2003. For Nationwide, therecognition that returns were peaking in 1999-2000 might have translated to the

Assessment of normalizedreturns is more complicated

than ever before

Understanding cyclical natureof VA business critical to

investment decision-making



sale of NFS in the low $50s and the understanding that 2002 and 2003 (hopefully)represent trough returns would lead to the purchase of NFS in the $20s.

The volatility of the variable annuity business has added a new wrinkle to theanalysis of the life group because earnings stability is not an attraction forcompanies with a concentration in this business line (Figure 37). Historically, ithas been reasonable to assume that life companies would outperform whenearnings estimate revisions were negative for the S&P 500 and underperformwhen the outlook for S&P earnings was improving. This pattern has continued forthe group as a whole during the past year, but the divergence of performance hasbeen extreme between traditional life companies and variable annuity players.Since year-end 2001, the large variable annuity writers have underperformed themarket by 14% while traditional life companies have outperformed by 33%.Earnings revisions for variable companies are positively correlated with theperformance of the equity market, and – to the extent that earnings drive stockprices – positively correlated with estimate revisions for the S&P 500 (Figure 38).

Figure 37: Operating EPS Revision Trend – VA Companies Versus Traditional Life Cos.

60

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75

80

85

90

95

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105

110

6/99

8/99

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/99

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/02

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/02

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/02

Traditional Life Companies Variable Annuity Companies

Note: The revision indices are based on current year estimates from January through June and following year estimatesfrom July through December.Traditional Life Companies = AFLAC, Jefferson-Pilot, Protective Life, StanCorp and Torchmark.Variable Annuity Companies = Hartford Financial, Lincoln National and Nationwide.Source: I/B/E/S.

Figure 38: Operating EPS Revision Trend – VA Companies versus S&P 500

20

40

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140

6/99

8/99

10/9

912

/99

2/00

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/02

S&P 500 Variable Annuity Companies

Correlation = 95%

Note: The revision indices are based on current year estimates from January through June and following year estimatesfrom July through December.Source: I/B/E/S.

Earnings stability is not aselling point for variable

annuity writers



� Expect Continuation of Realized Investment Losses

In our opinion, investors should expect net earnings to trail operating earnings forlife insurance companies during the next couple of years and over the long term asa result of realized investment losses. If we are correct, operating return on equityoverstates the underlying economic return for life insurers, and any effort tonormalize results must take this into account. At the very least, investorconfidence in operating return on equity as an undisputed measure of valuecreation should be shaken given the differential between net and operating resultsin recent years (Figure 39). Although unusual charges related to demutualizationsexplain the gap between net and operating earnings in 1999, the primary driver ofthe relatively disappointing net earnings performance in the decade to date hasbeen realized investment losses.

Figure 39: Life Composite – Net as a % of Operating Earnings, 1996 – 9mos02

0%

20%

40%

60%

80%

100%

120%

140%

1996 1997 1998 1999 2000 2001 9-mos 2002


Near-term Argument for More Realized LossesIt seems reasonable to assume that credit issues will persist in fixed incomeportfolios at least through the early part of 2003, but we also believe thatcommercial mortgage losses will probably increase materially off a low base in2003 and 2004. Historically, credit problems in mortgage portfolios have laggeddifficulties in the bond market by a couple of years, and although we do not havethe excess supply of real estate similar to the early part of the 1990s, vacancy rateshave increased materially during the past couple of years. For example, officevacancy rates almost doubled from 2Q00 (8.2%) to 3Q02 (16.1%), and –according to the American Council of Life Insurance – this property type accountsfor 38% of the life insurance industry’s commercial mortgage portfolio. Althougha “rule of thumb” can be a dangerous assumption in real estate, we think that anoverall vacancy rate of 20% could spell trouble for mortgage lenders.

The impact from deterioration in the commercial mortgage market should varyconsiderably from company to company given that: (1) the allocation to this assetclass ranges from zero to 250% of GAAP equity; and (2) historical loss experiencefor the companies that we follow ranges from exceptional to average (at best). Webelieve that the combination of capital losses and lost net investment income couldreduce earnings by 0% to 10% for the companies in the Merrill Lynch LifeInsurance Index. The good news is we do not believe that deterioration in the realestate environment would have a material impact on the capital base of publiclytraded life insurers.

Losses on a Secular Basis as WellAt least as important as an expectation for realized losses in the near term is ourview that credit-related losses will cause net earnings to trail operating earningsover the long term. We believe investors should assume that absent a change ininterest rates, the returns on insurance company bond and commercial mortgage

Realized losses are probablymore than a short-term issue

Bond losses could give way tocommercial mortgage losses

Mortgage losses could reduceearnings by up to 10%

Interest income “above theline” and credit costs “below

the line”



portfolios should be primarily interest income (in operating income) offset bycredit losses (in net income). At the end of 3Q02, bonds and mortgages combinedaccounted for 90% of total invested assets for the Merrill Lynch Life InsuranceIndex. Even if rates decline, it is unlikely that interest rate-related gains will offsetcredit losses over time at least partially because insurance companies are oftenunwilling to sacrifice future operating income by selling bonds with above-marketyields. If a company does harvest interest rate-related gains to offset credit losses,investors should mark down future expectations for operating returns as a result ofthis strategy (i.e., spreads should compress as a result of the reinvestment ofproceeds at market rates). Also, given the current low interest rate environment, itmay be reasonable to argue that if there is a secular move in rates, an increase ismore likely than a decrease, which suggests limited opportunity for capital gains.Finally, we do not believe that capital gains from equity and venture capitalinvestments – which we estimate account for less than 3% of the Merrill LynchLife Index’s investment portfolio – will close the gap between net earnings andoperating earnings over time. Most of the “total return investment vehicles” heldby life insurance companies generate returns that have been and will continue tobe reflected in operating earnings, in our opinion.

90s Would Suggest Gains follow Losses, but Don’t Expect a RepeatThe life insurance industry posted credit, equity market and interest rate relatedgains in the mid to late 1990s (Figure 40), which might give investors hope thatrealized investment losses in recent years could be offset by gains in the future. Inour opinion, this should not be the base case assumption for a few reasons. First,it is probably unreasonable to expect that the strong equity market returns of the1990s are going to repeat anytime soon. Plus, as mentioned previously, webelieve that a large portion of the total return investments held by publicly tradedlife insurers are already reported in operating income. Second, tight credit spreadsfor an extended period of time in the 1990s (Figure 41) contributed to credit-related gains, and we do not believe investors should assume that this environmentrepeats. Finally, interest-rate related gains seem less likely given that rates are atrecord lows (Figure 42). Also, as mentioned previously, rate related gains couldbe thought of as front-end loading – rather than increasing – profits.

Figure 40: Life Industry Realized Capital Gains & Losses (bps of invested assets)

(40)

(30)

(20)

(10)

0

10

20

30

40

50

60

70

1993 1994 1995 1996 1997 1998 1999 2000 2001

Interest Rate Related Other

Note: Interest-rate related gains are calculated based on transfers to and from the Interest Maintenance Reserve (IMR),which is a statutory accounting concept.Source: A.M. Best.

Base case assumption shouldnot be that gains offset losses

going forward



Figure 41: Credit Spreads – Baa versus 10-Year Treasury, 1976 – 2002 (in bps)

0

50

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200

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300

350

12/76

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Average 1976 - 2002 = 163 bps

Sources: DRI and Bloomberg.

Figure 42: 10-Year Treasury Yield, 1976 – 2002

0%

2%

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12/7

612

/7712

/7812

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/0012

/0112

/02

Sources: DRI and Bloomberg.

� The Dilemma of Demutualizations

More thought is typically required on the topic of normalized ROE for recentlydemutualized life insurance companies, as opportunities for expense savings anddeployment of excess capital could be substantial. Mutual insurers haveconsistently generated below-average returns on equity (Figure 43), whichexplains the below average returns initially for most of the insurers that haverecently demutualized (Table 34). Understanding why return on equity is low, andthe relationship between current ROE and normalized ROE is necessary to betterappreciate the fundamental outlook for these newly public companies.

Reversion to the mean wouldsuggest higher returns for

demutualized insurers



Figure 43: Statutory Operating Return on Equity, 1984-2001

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Stock Life Companies Mutual Life Companies

Estimate of long-term equity cost of capital.

Source: A.M. Best.

Table 34: Returns for Demutualized Life Cos. Generally Trail ML Index

Operating ROE Year of DemutualizationJohn Hancock (2000) 14.6%Principal (2001) 11.4%MetLife (2000) 10.3%Prudential (2001) 4.9%Phoenix (2001) -4.0%ML Index Average 2000 – 2001 14.4%

Note: Year of demutualization in parentheses.Sources: Company reports.

In our opinion, the bulk of the underperformance of the mutual life industry – asmeasured by operating return on equity – can be traced to an inefficient coststructure (Table 35). However, it is necessary to understand that a low operatingreturn on equity for a mutual is not always entirely the result of mismanagement ora weak competitive position. The only way for a mutual insurer to deliver value toits owners (policyholders) is through the performance of the insurance policies thatit sells. Therefore, the benefits and policyholder dividends paid relative to thepremiums collected determine the return generated for the owners, but this type ofvalue creation also depresses ROE. As a public company, the profitability of newbusiness will no longer be shared with policyholders unless those policyholders arealso shareholders. Finally, the largest companies that have demutualized in recentyears were at least somewhat over-capitalized upon conversion to a publiccompany. For example, MetLife has repurchased $2.4 billion of stock since its IPOin early 2000, and Prudential has identified unallocated equity that is more thanone-third of the company’s total equity capital.

Table 35: General Expense-to-Assets Ratio, 1996-2001

Mutual Companies Stock Companies1996 1.59% 1.62%1997 1.90% 1.46%1998 1.73% 1.47%1999 1.72% 1.37%2000 1.63% 1.33%2001 1.72% 1.30%

Source: A.M. Best.

Inefficiency is the biggestissue, but not the only issue



Although there are potentially three substantial theoretical adjustments (expensereduction, deployment of excess capital and changes in policy pricing) to movefrom current ROE to normalized ROE, we think that investors should generallyhandicap the probability of success differently for each lever available. First, weare most comfortable assuming at least some level of success on expensereduction. The history of demutualizations suggests that this is perhaps the bestexample of “low hanging fruit”. Second, we are slightly less comfortable with theexcess capital story, largely because investors seem to have become a little bit toooptimistic about the potential on this front. For example, we believe thatPrudential has substantial excess capital, but not the amount that is consideredunallocated by the company and at least some investors. Third, we are less willingto assume that pricing discipline on new business is widespread. In our view, itwill take a number of years before it is reasonable to assume that the “mutualmentality” has been fully converted to a “for profit” orientation.

No Magic Formula

This job is about numbers, but that does not mean that qualitative assessments ofthe data are less relevant. When tackling the concept of normalized returns, a greatdeal of judgement is necessary because there is no universal equation. The keypoint, in our opinion, is that investors should always think about how currentresults relate to some measure of trend line performance. In our opinion, thisexercise is valuable even if the conclusion is only directional (i.e., current returnsare above or below trend by some unknown amount).

� Don’t Complicate Things, Just Take an Average

Sometimes a simple approach to estimating normalized returns works just fine, inour opinion. We think the best example is the variable annuity business for scaleplayers such as Hartford Life, Lincoln National and Nationwide (Figure 44).Following a 14% operating return on equity for this group of companies during thelate 1990s, the positive impact of the bull market was most pronounced in 2000and 2001 as ROE averaged a little more than 16%. It has been a much differentstory in 2002 as lower average asset balances have combined with DAC chargesand the cost of guaranteed minimum death benefits to produce a 10% operatingROE. In our opinion, looking at average returns as a guidepost for the futuremakes sense in this case.

Once it has been decided that an averaging approach is appropriate, perhaps themost important decision is which years should be included to represent a “fullcycle”? In this case, an average of four good years and one bad year is probably areasonable approximation of normalized operating returns for the leading variableannuity writers. We base this conclusion on asset growth over the 1997 to 2002period. In our view, asset growth is the key metric for variable annuity writers tojudge how actual results compare to a trend line environment. For example, it waspretty clear that the 24% asset growth rate for the variable annuity industry from1995 to 2000 was above trend. VA assets at Hartford and Nationwide grew fasterthan the industry over this period (30% annual growth) while Lincoln Nationaltrailed the industry (20% annual growth). As a result of a decline in assets duringthe past couple of years (driven by the extreme bear market), overall asset growthrates have reset dramatically. We estimate that organic growth in total assets wasbetween 6% (Lincoln) and 8% (Hartford Life and Nationwide) for leading VAcompanies from 1997 to 2002, which we could argue is on the low side of anormal expectation. Therefore, taking an average return on equity since 1998 hassome appeal.

Potential for ROE improvementvaries depending on the relative

importance of three factors

It is necessary to combinequalitative and quantitative

assessments

An average for a cyclicalbusiness is usually at least a

starting point

Make sure averaging period is areasonable proxy for full cycle



Figure 44: Operating Return on Equity, 1998 – 2002E

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

1998 1999 2000 2001 2002E Average

Variable Annuity Companies Traditional Life Companies


� Take Conservative Approach with Traditional Cos.

In our opinion, investors should typically default to conservative assumptions onnormalized returns for traditional life companies even if current returns and/orhistorical average returns may suggest a more optimistic view is appropriate. Webelieve that marginal returns in traditional business lines will usually be no morethan a couple hundred basis points in excess of the cost of equity capital, and thecurrent level of competition in traditional lines suggests that returns below the costof capital are a real possibility.

Look for Disconnect between Top and Bottom LineOne way to assess the direction of return on equity is a comparison of top andbottom line growth trends. (“Top line” is defined as either revenue or assetsdepending on the business mix.) For life insurers where ROE improvement isdriven by expense reduction (demutualizations), it will not be unusual to seebottom line growth outpace the top line. However, for companies where there arelimited opportunities to improve returns on the in force book (traditional lifecompanies that have been public for a long time), we would expect bottom linegrowth to match the top line performance. If top line growth does not have apositive impact on the bottom line, this is an early indication of ROE decline, inour view.

We have a Sell opinion on Jefferson-Pilot primarily because of concern about thepotential for near-term earnings disappointment in the group insurance business.Over the long term, we believe that the company will earn more than an adequatereturn on equity, but think that returns will compare unfavorably to the 14% to15% of recent years. Our conclusion on the direction of returns is based on thelack of follow through from the top line to the bottom line during the past coupleof years for the company’s two largest businesses – Individual Products andAnnuity & Investment Products (Table 36). These two segments accounted formore than 75% of the company’s total operating earnings in 2002. We do notbelieve that Jefferson-Pilot’s new business mix is less capital intensive than the inforce book, so we would assume that the required equity-to-assets ratio hasremained relatively stable. If we are correct about leverage, a decline in assetreturns dictates that return on equity will move downward as well. Offsetting therecent drag from lower product profitability has been an aggressive sharerepurchase program, but we do not see this level of support sustained over the longterm. Lower marginal returns should translate to less excess capital production.

Traditional lines are cost ofcapital plus a couple hundred

basis points at best

Watch for ROE decline whenbottom-line performance trails

top-line growth

Jefferson-Pilot is a recentexample of this type of

divergence



Table 36: Jefferson-Pilot Cumulative Growth Rates, 2000 – 2002

Assets Revenues Operating EarningsAnnuity & Investment Products 18.5% 9.2% 3.2%Individual Products 8.5% 8.2% 2.0%


Support for Our View from Well Thought of Management TeamWe are inherently skeptical of management targets for ROE because there is atendency to be overly optimistic about the extent to which a company candifferentiate itself in a very challenging business. However, there are a couple ofmanagement teams that seem to have more realistic outlooks, and share these lessrosy views with the investment community. For example, the management ofProtective Life is well regarded and generally thought to have a realistic view offuture prospects, in our view. Therefore, we think it is interesting that despiteproducing an operating return on equity of more than 16% during the mid- to late-1990s, management does not expect returns to exceed 13% to 14% going forward.Protective’s operating return on equity is slightly below the low end of this rangecurrently because there is modest excess capital and a drag from businesseseffected by the weak economy. In our valuation model, we assume normalizedROE is 12.5%.

There are ExceptionsIn our opinion, there are two companies (out of the 14 on our coverage list) thatshould sustain returns on equity greater than 15% – AFLAC and Torchmark. Thecommon characteristic of both companies is an extremely low cost structure,which probably remains the best way to earn an excess return in the life insuranceindustry. AFLAC has a franchise position in the work site market in the U.S., andappears to be distancing itself from the competition. In Japan, AFLAC remains aleader in the 3rd Sector insurance market (supplemental products) and has adistribution and cost structure advantage that will likely remain significant despitean increase in competition. Torchmark focuses on selling protection-oriented lifeand health insurance products to lower- and middle-income markets primarilythrough controlled distribution. It is the only company that we follow that hasbeen successful with this strategy largely because of its expense advantage. Weare comfortable that return on equity will be remain near the current level (16%)because most life companies continue to de-emphasize the products, distributionand markets that are the core of Torchmark’s strategy.

� Be Careful with Interpretation of Segment ROE

Segment return on equity information is theoretically valuable because it allowsfor the analyst to refine his or her assessment of business line profitability, whichshould help lead to a better understanding of normalized return on equity.However, reported segment returns on equity are of limited usefulness without aclear understanding of how these figures are derived. Two key areas of analysisshould be expense allocation methodology and the approach used to determinerequired capital. It is easy for business line management to report a 15% ROE andclaim that new business is priced for similar results when expenses are not fullyallocated and/or the attributed capital does not reflect the realities of the business.Our advice is never accept a reported segment return at face value.

The most significant concern for investors is the degree to which a company’sunrealistic assessment of segment returns reduces the long-term value of theenterprise. First, if a large amount of unallocated expense is tolerated, the chanceof inadequate pricing at the business segment level is high, in our opinion.Second, if capital is not accurately allocated by line of business, the potential forunderpricing some products and overpricing others is high. Importantly, thisscenario is not a “zero sum game” because underpriced products will sell andoverpriced products will not, leading to deterioration in profitability over time.

Realistic view from ProtectiveLife supports our case

Low cost structure remainseasiest way to earn excess

returns in competitive business

Lack of disclosure onassumptions limits usefulness

of segment returns

If management believesunrealistic assumptions, worryabout long-term value creation



Where are the Expenses?In our view, the veracity of segment returns increases substantially whenunallocated (corporate and other) expenses are held to a minimum. However, thedegree to which expenses are allocated by business line varies considerably amongthe companies in our coverage universe. We calculate that unallocated generaland administrative (G&A) expenses range from essentially zero to amounts thatequal 10% of total G&A expenses and almost 30% of pretax operating earnings(Table 37). In our opinion, investors should generally be more skeptical about theappropriateness of product pricing – and therefore economic returns by line ofbusiness – when corporate and other expenses are material. However, a high levelof corporate expense relative to total expense is not always a bad sign. Forexample, Torchmark’s above average ratio of corporate expense to total expense isa function of the company’s efficient insurance operation (i.e., low total expenses).This efficiency is evident from the company’s below average level of corporateexpense relative to pretax earnings.

Table 37: Wide Range of Unallocated Expense for Life Insurers

Corporate Expense /Total Expense

Corporate Expense /Pretax Operating Earnings

Principal -0.5% -1.0%UnumProvident 1.1% 1.9%John Hancock 1.3% 1.5%Nationwide Financial 1.2% 1.5%Hartford (life only) 1.7% 4.3%Phoenix 2.6% nmMetLife 3.0% 7.6%StanCorp 3.5% 4.2%Lincoln National 6.2% 6.9%AFLAC 6.5% 4.7%Protective 6.8% 5.6%Torchmark 8.0% 1.7%Jefferson-Pilot 8.2% 2.7%Prudential 10.3% 29.3%Average 4.3% 5.5%

Note: Data is through nine months of 2002.Sources: Company reports & Merrill Lynch estimates.

To illustrate the potential impact on segment returns from different expenseallocation methodologies, it is useful to look at data disclosed by Prudential at arecent investor meeting. Prudential released segment returns on equity for its mostmeaningful business lines at the gathering, and has made available to theinvestment community allocated equity for every line of business. The apparentconclusion from the data presented by management is that total business segment(allocated) equity capital is generating almost a 9% return. However, we believethat allocation of corporate expenses would paint a slightly different picture.

In the first data column of Table 38, we present segment returns on equity beforecorporate expense allocation, and these returns were either released by Prudentialor estimated by us in a manner that we believe is consistent with management’sapproach. In the second column, we calculate segment returns employing adifferent expense allocation methodology. First, we decided upon the“appropriate” level of corporate general and administrative expenses forPrudential by looking at the ratio of corporate G&A expenses to total G&Aexpenses for the peer group. Next, we allocated actual corporate expenses abovethe “standard practices” G&A assumption to the business lines based on revenue.Our conclusion is that this seemingly more conservative approach to expenseallocation would lead investors to be slightly less excited about individual lifeinsurance and retirement savings, concerned about group insurance and moredubious about the potential for attainment of the long-term ROE goal.

Higher corporate expensesuggests fictional boost to

segment ROE

Prudential is good example onexpense allocation

Corporate expense allocationreduces Prudential’s segment

returns by 150 basis points



Management is targeting a 12% run-rate ROE by 2005, which is well above ourcurrent ROE estimate for the business segments (allocated capital) of 7.0% to7.5% based on a more complete allocation of expenses.

We believe that cost cutting will boost return on equity for Prudential, at leastpartially because management has been successful to date with expense reductionprograms, and the ultimate decision on businesses of questionable strategicimportance (property-casualty and securities brokerage) could be a critical driverof return improvement as well. However, we do not believe it is accurate toconclude that Prudential is building from a current return on allocated equitycapital of 9%. In our opinion, the starting point for returns is 150 basis pointslower, which makes the 12% long-term ROE goal seem more aggressive.

Table 38: Prudential Segment Returns on Equity, 9mos02

Corp Expense AllocationSegments Before After CommentsIndividual Life 10.7% 10.1% Perhaps marginal value creation is no value creationIndividual Annuities -7.8% -8.9%Group Insurance 11.1% 7.2% More consistent with general impression of businessProperty-Casualty 2.7% 1.3%Financial Advisory -1.2% -2.9%Investment Mgmt 15.6% 13.6%Retirement 7.5% 5.9% Question categorization as “fundamentally sound”Other Asset Mgmt 18.6% 18.1%Int’l Insurance 21.3% 19.3%Int’l Secs & Inv -2.5% -3.3%Total Segment 8.8% 7.3% Skepticism about LT ROE goal may be appropriate

Sources: Company and Merrill Lynch estimates.

Is Allocated Capital a Realistic Number?Investors need to think about the calculation of both the numerator and thedenominator when considering the usefulness of a segment return on equitypresentation. We believe that the allocation of capital by business line can differmaterially on a company by company basis, and think that a recent change inmethodology at MetLife illustrates this point.

The concept of “economic capital” was unveiled at MetLife’s annual Investor Dayin December of last year. Management stated that its new capital allocation modelimproves upon the statutory (regulatory) risk-based capital model, which thecompany’s management considers too heavily weighted toward asset risk. In ouropinion, the detail provided by MetLife related to this change in methodologyillustrates how different approaches to capital allocation can materially alter theperception of returns by line of business.

We are recommending MetLife (MET; B-1-7; $25.56) at least partially because webelieve that top management has done a nice job of improving the return profile ofthe company and focusing the organization on expense reduction and culturalchange. However, that does not mean that we are fully comfortable withmanagement’s approach to capital allocation. Table 39 compares the requiredcapital by line of business for MetLife using the economic value concept with therisk-based capital approach. Table 40 shows operating return on equity on asegment basis under both methodologies. There are a few questions that arise as aresult of this data, in our view. First, the allocation of equity to the IndividualBusiness has been reduced by a material amount. Perhaps it is reasonable tospeculate that recent rapid growth in some individual lines relates to a less onerousview of capital requirements versus competitors, where a risk-based capitalapproach is more common. Is MetLife’s assessment of the risk inherent in theindividual life and annuity business more realistic or simply aggressive? Second,given a 40% decline in allocated equity capital, it now appears that the InternationalBusiness is deemed by management to be much less risky than previously assumed.

See meaningful ROEimprovement for Prudential,

but expense allocation analysiscould temper enthusiasm

MetLife disclosure providesinsight on various views of

capital allocation

Economic value versus risk-based capital produces very

different conclusions



It may be difficult for investors to get comfortable with this new assumptionbecause most U.S. life companies have stumbled internationally. Also, a lowerequity charge for international operations could make it easier to achieve targetedreturns for the recent acquisition of Hidalgo in Mexico. (The impact oninternational return on equity as a result of the capital change is modest at thispoint, however, because the return is close to an investment yield.) Finally, thechange in unallocated equity deserves some attention because it has moved fromalmost $900 million negative to almost $700 million positive with the change inmethodology. It appears that the potential for an overall return that is below thesum of the operating segment returns has increased with the change in unallocatedequity capital.

Table 39: MetLife – GAAP Equity Capital by Segment, 9mos02 ($ in Mils.)

Segment RBC-based EC-based changeIndividual $7,483 $6,404 -14%Institutional 4,261 4,837 14%Auto & Home 1,251 1,071 -14%International 1,930 1,158 -40%Asset Management 100 223 123%Reinsurance 829 577 -30%Unallocated Equity (891) 693 nmTotal 14,963 14,963 0%

Note: EC = economic capital.Source: Company presentation.

Table 40: MetLife – GAAP Return on Allocated Equity, 9mos02

Segment RBC-based EC-basedIndividual 10.6% 11.5%Institutional 22.5% 20.6%Auto & Home 12.2% 13.2%International 5.6% 6.3%Asset Management 9.3% 7.8%Reinsurance 10.3% 10.6%

Note: EC = economic capital.Source: Company presentation.



Forget 15% for Most Companies

Estimating normalized results is inherently difficult given the opaqueness of lifeinsurance product profitability, but we think it is fair to assume that return onequity will typically not meet the ubiquitous 15% long-term return expectation. Inour view, there are only two companies that we cover that should sustain a returnon equity in excess of 15% (AFLAC and Torchmark), yet many publicly tradedlife companies continue to believe 15% is a realistic goal (Table 41).

Table 41: Long-Term Return on Equity Goals

Hartford Life 13% - 15%Jefferson-Pilot 15%John Hancock 15%Lincoln National 15%MetLife 14% - 15%Nationwide 13% - 15%Protective Life 13% - 14%Prudential 12%StanCorp 14% - 15%UnumProvident 12% - 15%

Note: Either stated or interpreted to be operating return goals.Source: Company presentations.

We believe that goals stated on an operating basis (which is typically how ROEtargets are formulated) are bound to trail economic returns as a result of realizedinvestment losses, but we also think that the underlying operating return will oftenbe at least a couple of points below 15%. The industry is far too competitive toallow for returns well above the equity cost of capital (which we estimate at 10%to 11%), and the recent experience in both variable and fixed product linessupports this view.

Reset Return Expectations for Variable Products

It is clear that the variable annuity business is not as profitable on a full-cyclebasis as the returns from 1998 to 2000 would have suggested. Deferredacquisition cost write-downs, the cost of guaranteed death benefits and the overallnegative impact on fee income and margins from lower account values havedriven current returns for scale players close to the cost of capital. Therefore, full-cycle ROE for market leading VA companies is probably less than 15%, in ourview. For sub-scale players in the variable annuity business (less than $10 billionof assets), it is questionable that returns above the cost of capital are a reasonableexpectation, in our view. Of the remaining companies on our coverage list, onlyMetLife and Prudential had variable annuity assets greater than $10 billion at9/30/02 (VARDS). In our opinion, Jefferson-Pilot, John Hancock, Phoenix,Principal, Protective Life and Torchmark all have sub-scale variable annuityoperations. (Principal is a leading asset accumulation company in small-case401(k), however.) Also, we believe that $10 billion may be a low estimate forvariable annuity assets necessary to achieve economies of scale. Although theprofitability of variable life is driven more by cost of insurance charges, we alsothink that returns in this line are probably trailing the 15% target as well.

Scary Things Going on in Fixed Products?

We do not believe that the competitive structure of the industry (fragmented,commodity-like product, independent distribution) will allow for material excessreturns, and think that the rebound in fixed product sales during the past few yearssupports our view. Although demand for fixed annuities and fixed life insuranceis high today as individuals are focused on principal preservation, it appears that

Less than 15% of our coveragelist should achieve this

aggressive goal

Far too much competition toallow for 400 or 500 basis

points above cost of capital

Scale players in variableannuities are probably lookingat operating ROE of 13%-14%

Demand for fixed annuities anduniversal life not translating to

attractive shareholder returns



life companies have aggressively “competed away” margins in these businesses.At least a few companies we cover that had little interest in selling fixed productsa few years ago have now become aggressive competitors in the business. Thebottom-line impact has yet to be fully realized, in our opinion, and any increase ininterest rates could be the catalyst for margin pressure.

We have written and talked a lot about excessive competition in fixed annuities fora couple of years now, yet top line growth for companies under coverage suggeststhat management teams are less concerned than we think they should be (Table42). The good news is that some of these companies have recently begun torecognize the limited profit opportunity in fixed annuities. For example,Nationwide’s fixed annuity sales were down 34% in 4Q02, which was in sharpcontrast to 49% growth through the first nine months of last year. For the industryas a whole, the shift in demand from variable annuities to fixed has been dramatic(Figures 45 and 46), and the risk is that returns on fixed business written in 2001and 2002 could prove to be as disappointing as the returns on variable businesswritten in 1999 and 2000. We base our concerns about profitability on ourestimate of the investment spread (the difference between new money yields andcredited interest rates) on fixed annuities written during the past couple of years(Figure 47). The chart suggests that the marginal profitability of the fixed annuityline rebounded briefly in early 2002, but has generally been at a level that suggestslittle or no value creation for shareholders since mid-2000.

Table 42: Fixed Annuity Sales Growth, 2000 – 9mos02

2001 9mos02 CAGR ‘00 - 9mos02Nationwide 210% 49% 140%John Hancock 71% 101% 103%Prudential -46% 397% 76%Lincoln National 61% 34% 55%MetLife 23% 41% 37%Protective Life 9% 2% 6%Hartford -41% 69% 0%Jefferson-Pilot 17% -21% -4%Industry 36% 60% 56%

Source: Company reports, LIMRA and Merrill Lynch estimates.

Figure 45: Annuity Sales Growth – Fixed vs. Variable, 1998 – 2002E

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

1998 1999 2000 2001 2002E

Fixed Annuities Variable Annuities


Returns on fixed businesswritten in 2001-2002 could be

just as disappointing as returnson variable business written in

1999-2000



Figure 46: Sales Market Share – Fixed vs. Variable, 1998 – 2002E

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

1998 1999 2000 2001 2002E

Fixed Annuities Variable Annuities

low return business


Figure 47: Fixed Annuity Investment Spread on New Business, 1986 – 2002 (in bps)

0

25

50

75

100

125

150

175

200

225

250

12/86

12/87

12/88

12/89

12/90

12/91

12/92

12/93

12/94

12/95

12/96

12/97

12/98

12/99

12/00

12/01

12/02

Note: Estimated investment spread assumes asset mix of 50% single-A, 30% mortgage-backed securities, 15% triple-Band 5% below investment grade.Sources: Compustat, Bloomberg and Fisher Annuity Index.

The rebound in demand for fixed life insurance (as measured by universal life)versus variable life lagged the beginning of the mix shift in annuities by a coupleof years, but spread compression is evident in this line as well. We estimate thatuniversal life (UL) sales have grown at a 22% annual rate from 2000 to 2002,which compares to our estimate of a 15% annual decline in variable universal life(VUL) sales over the same period (Figure 48). This shift in product demand hascaused a substantial change in product market share during the past few years(Figure 49). However, like fixed annuities, we believe that fixed life margins havecome under pressure concurrent with an increase in sales. We estimate that theinvestment spread on new UL sales has been below the historical average sincemid year 2001, and it appears that some portion of the growth acceleration in ULsales beginning in 2H01 relates to the willingness of the industry to acceptnarrower investment margins. In the second half of 2001, universal life sales wereup 24% and variable universal life sales were down 23%, which compares to 10%growth for UL and a 2% increase for VUL in the first half of 2001. It is moredifficult to assess the marginal profitability of this line versus fixed annuitiesbecause higher cost of insurance charges could act as an offset to tighter spreads,but the data suggests that there has been at least some pressure on profitability, inour view (Figure 50). Also, anecdotally, we have been hearing more talk ofaggressive pricing of mortality risk in fixed life insurance.

Margin pressure seems likely inuniversal life as well



Figure 48: Life Sales Growth – Universal Life vs. Variable Universal Life, 1998 – 2002E

-30%

-20%

-10%

0%

10%

20%

30%

40%

1998 1999 2000 2001 2002E

Universal Life Variable Universal Life


Figure 49: Sales Market Share – Universal Life vs. Variable Universal Life, 1998 – 2002E

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

1998 1999 2000 2001 2002E

Universal Life Variable Universal Life

inadequate returns?

Note: Market share based on percentage of total individual life sales.Sources: LIMRA and Merrill Lynch estimates.

Figure 50: Universal Life Investment Spread on New Business, 1987 – 2002E

-1.00%

-0.50%

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

1Q87

4Q87

3Q88

2Q89

1Q90

4Q90

3Q91

2Q92

1Q93

4Q93

3Q94

2Q95

1Q96

4Q96

3Q97

2Q98

1Q99

4Q99

3Q00

2Q01

1Q02

4Q02

Average 1987 to 2002 = 99 basis points

Note: Estimated investment spread assumes asset mix of 65% single-A, 30% triple-B and 5% below investment grade.Sources: LIMRA, Compustat, Bloomberg and Merrill Lynch estimates.



Don’t Forget About Distributors

We think that investment margins in fixed annuities and UL suggest that returnsare questionable, but also suspect that pressure on overall product (fixed andvariable) profitability from distributors remains an issue as well. The base caseassumption, in our opinion, is that quality distributors (e.g., high-end producergroups, banks, wirehouses and regional broker-dealers) continue to have the upperhand in dealings with the insurance industry. Also, the growing importance ofindependent distribution suggests that the life and annuity business couldincreasingly exhibit characteristics of a “loser’s game” for the insurance industry.In other words, if a company is selling a lot of products through distributors thathave access to multiple carriers, the company may be willing to do something(e.g., higher commissions, more generous product features) that others are not inorder to win the business.

Take Almost a Point Off ROE for Credit

The last couple of years should serve as a reminder to investors that operatingROE does not fully capture the economics of the life insurance business. In ourview, it is impossible to ignore investment gains and losses over time given thatthe investment portfolio for the life insurance industry is 95% of general accountassets and 64% of total assets on a statutory basis. Therefore, it is necessary toconclude that investment performance (both above and below the line) is a criticaldriver of fundamental value.

We estimate that credit losses will cause normalized ROE for the group to beapproximately 90 basis points below operating ROE over time (Table 43). Therange of the potential impact from normalized credit losses on return on equity issizable (based on models we will detail in subsequent sections), with AFLAC atthe low end (approximately 20 basis points) and John Hancock at the high end(approximately 200 basis points).

Table 43: Operating Earnings Adjusted to Reflect Normalized Credit Losses (Based on 2003 Estimates)

(1)OperatingEarnings

(2)Normal Bond

Losses

(3)Normal Mortgage

Losses

(1) – (2) – (3)AdjustedEarnings

AverageEquity

OperatingROE

AdjustedROE

Adjustment toNormalize ROE for

CreditAFLAC 965 (10) - 955 4,342 22.2% 22.0% -0.22%Phoenix 57 (6) (0) 51 1,989 2.9% 2.5% -0.32%Hartford Life 645 (22) (1) 623 5,303 12.2% 11.7% -0.43%Torchmark 458 (14) (0) 444 2,779 16.5% 16.0% -0.50%StanCorp 136 (4) (2) 130 1,059 12.9% 12.3% -0.57%Prudential 1,360 (114) (23) 1,223 18,782 7.2% 6.5% -0.73%Principal 773 (38) (14) 721 5,902 13.1% 12.2% -0.89%Protective Life 201 (12) (3) 187 1,551 13.0% 12.1% -0.92%Jefferson-Pilot 478 (30) (5) 443 3,234 14.8% 13.7% -1.08%Lincoln 573 (45) (10) 518 4,694 12.2% 11.0% -1.17%Nationwide 471 (33) (17) 421 4,223 11.1% 10.0% -1.18%UnumProvident 631 (75) (1) 554 6,323 10.0% 8.8% -1.21%MetLife 2,083 (174) (43) 1,866 16,761 12.4% 11.1% -1.29%John Hancock 857 (106) (21) 731 6,257 13.7% 11.7% -2.02%Average 12.4% 11.5% -0.90%


The goal of this report is to help the reader with their assessment of normalizedROE, but it is worth noting that the two major asset classes that pose credit risk forthe life industry (bonds and commercial mortgages) seem to be at very differentstages in their respective loss cycles. Bond losses in 2002 were well aboveanyone’s expectation of a normalized level while mortgage losses have beeninsignificant. Our best guess is that the pressure on net earnings will ease over the

Producers take substantialportion of expected profit

margin

To understand economics,understand investment gains &

losses

Models suggest normal creditlosses could reduce ROE by up

to 200 basis points

Focus on normal losses, butrecognize that next issue could

be mortgages



next few years even if mortgage losses increase materially, as long as creditconditions improve in the bond market. This seems to be a reasonable expectation(barring a downturn in commercial real estate that rivals last cycle) because bondportfolios are much larger than mortgages relative to common equity.

� Bonds

Fixed income losses have recently been well above predicted levels, so we do notwant to overplay a risk factor that to some extent is yesterday’s news. However,we think that an assessment of normalized bond losses is worthwhile because weexpect a continued drag from credit over time. The impact on return on equityfrom normal loss experience is perhaps more substantial than some mightappreciate, and this has more to do with leverage than the level of risk in theportfolios, in our view. For the life companies under coverage, the ratio of bonds-to-common equity is approximately 6:1 (Figure 51).

Figure 51: Ratio of Bond Portfolio to Common Equity, September 2002

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

10.0

TMK

SFGPRU

UNMPFG HIG

PNX JP

Avera

geLN

CNFS PL

JHF

MET

AFL

Note: Data for Hartford is life company only.Source: Company reports.

Our MethodologyTo estimate bond defaults, we used Moody’s historical default study to projectdefault rates in normal and recessionary environments. We used mean one-yeardefault rates from 1970 to 2001 to determine our normal loss assumption, and the1989 to 1991 period as a proxy for our recession scenario. We suspect that ourrecessionary loss estimate might seem conservative once the study is updated for2002 results, but our focus is on the normal loss assumption (versus expectedmaximum loss) to calculate normalized ROE. We have applied the relevant one-year default rates to each rating class of bonds to determine expected losses on anindividual company basis. Most life insurers under coverage provide a breakdownof fixed income securities by rating at least on an annual basis. However, we donot have data on the priority of the debt securities owned (secured, unsecured,senior, subordinated). As a result, we have decided to assume an average recoveryrate of 40%, which is generally consistent with the overall assumption used byMoody’s. The combination of default and recovery assumptions produces expectednormal and recessionary principal losses for each company’s fixed incomeportfolio. Our estimate of normal principal losses ranges from 4 basis points to 42basis points of the fixed income portfolio for the life companies under coverage,while recessionary losses are estimated to be in a range of 15 basis points to 81basis points. The equal-weighted average principal loss rate for the Index was 21basis points and 46 basis points for the normal and recession scenarios,respectively. We did not estimate incremental lost net investment income becausewe believe that current operating results already capture the net investment incomeeffect given elevated losses recently.

Impact on normal ROE frombond losses relates more to

leverage than portfolio quality

Our estimate of normalprincipal losses ranges from 4basis points to 42 basis points



Does Model Understate Loss Potential during Times of Stress?The credit performance of life insurers’ fixed income portfolios in 2002 suggeststhat our assessment of recessionary losses could be optimistic. At the very least, itis clear that the concept of recessionary losses and maximum losses are not thesame. In Table 44 we compare actual losses for the life companies under coveragewith the predicted losses during a stressed environment from the loss rate model,and there are at least a few interesting observations, in our view. First, the actuallosses are only for the nine months of 2002, yet still exceed the theoretical annualrecessionary loss expectation for 11 of the 14 companies under coverage. Webelieve that the 4Q loss experience was generally better than the 3Q, but somecompanies (e.g., John Hancock) will likely report an increase in realized losses.Second, the average actual loss is almost 80% higher than the theoretical lossexpectation for this group of companies, with six companies posting actual lossesmore than double the theoretical expectation. Finally, the actual losses in Table 44typically understate the impact of credit deterioration for companies that onlydisclose net (not gross) realized investment losses.

Table 44: Bond Losses as a Percentage of Total Bond Portfolio

Actual Losses 9mos02Recessionary Annual

Loss ExpectationActual minus

Theoretical LossProtective Life 0.00% 0.33% -0.33%AFLAC 0.11% 0.15% -0.04%John Hancock 0.74% 0.77% -0.02%Nationwide Financial 0.43% 0.37% 0.06%Jefferson-Pilot 0.68% 0.48% 0.20%Phoenix 0.63% 0.41% 0.22%StanCorp 0.68% 0.36% 0.33%Prudential 0.85% 0.48% 0.37%Principal 1.03% 0.45% 0.58%Torchmark 1.17% 0.56% 0.61%Hartford Life 0.97% 0.26% 0.71%MetLife 1.24% 0.53% 0.72%Lincoln National 1.17% 0.45% 0.72%UnumProvident 1.74% 0.81% 0.93%Average 0.82% 0.46% 0.36%

Note: Loss data is not consistently presented because company disclosures vary. The following companies disclosegross loss data: AFLAC, Jefferson-Pilot, John Hancock, MetLife, Prudential, Torchmark and UnumProvident. We haveattempted to estimate gross losses for Principal.Sources: Company reports and Merrill Lynch estimates.

One reason for the discrepancy between actual losses and modeled losses has beenthe default experience of investment-grade debt. In 2002, some of the biggestlosses suffered by the industry were related to investment grade bonds (e.g.,WorldCom, Global Crossing), and this was also the case in 2001 (Enron was ratedinvestment grade until just before filing for bankruptcy). To the extent that theexperience of the past couple years is other than anomalous, it could be argued thata higher default rate assumption for triple-B rated securities is appropriate. This isnot an inconsequential issue because triple-B bonds account for a meaningfulportion of total fixed income assets for publicly traded life companies (Figure 52).

Performance in 2002 muchworse that peak loss scenario

from model

Investment grade defaults offthe charts, may need to rethinkloss expectations going forward



Figure 52: Ratio of Triple-B Bonds to Total Bond Portfolio, September 2002

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

HIG AFLM

ETSFG

PRUPNX PL JP

TMK

Avera

geLN

CNFS

UNMPFG JH

F


Normal and Recessionary Bond Loss ExpectationsIn Figures 53, 54 and 55 we present our conclusions on expected principal losseson bonds for each life insurer on our coverage list on a normalized basis andduring a stressed economic environment. The reader should keep in mind that theimpact on ROE from credit is a function of both the quality of the portfolio andthe leverage of the company. For example, Torchmark appears to have higher-than-average credit risk in its bond portfolio, but this is more than offset by abelow average level of bonds relative to common equity. As a result, the expectedimpact on ROE from credit losses under both the normal and stressed scenarios isless than the average company.

Figure 53: Expected Bond Principal Losses (as a % of total bond portfolio)

0.00%

0.10%

0.20%

0.30%

0.40%

0.50%

0.60%

0.70%

0.80%

0.90%

AFLHIG PL

SFGNFS

PNXPFG

LNC

Avera

gePRU JP

METTMK

JHF

UNM

Normal Recession

Note: Data for Hartford is life company only.Source: Merrill Lynch estimates.

ROE impact from normal bondlosses ranges from 20 basis

points to 170 basis points



Figure 54: Impact on ROE from Normal Bond Losses

-1.80%

-1.60%

-1.40%

-1.20%

-1.00%

-0.80%

-0.60%

-0.40%

-0.20%

0.00%

AFL PNX SFG HIG TMK PRU PFG PL NFS JP LNC MET UNM JHF

Note: Data reflects reduction in return on equity measured in percentage points. Data for Hartford is life company only.Source: Merrill Lynch estimates.

Figure 55: Impact on ROE from Recessionary Bond Losses

-4.00%

-3.50%

-3.00%

-2.50%

-2.00%

-1.50%

-1.00%

-0.50%

0.00%

PNX AFL SFG TMK HIG PRU PFG PL NFS JP LNC MET UNM JHF


� Commercial Mortgages

We doubt that any commercial real estate downturn in the near future willapproach the depths of the 1990s cycle, but it should be at least a little concerningto investors that this risk factor has not received a lot of attention. To some extent,the lack of concern about commercial real estate losses is reminiscent of themarket’s overall Pollyannaish view of credit risk in bond portfolios a couple ofyears ago. For example, we experienced a somewhat lukewarm reception to ourearly 2001 report on asset quality and equity market sensitivity (Potential Cracksin Safe Haven Story? 2/12/01).

The Good NewsIn our opinion, it is unlikely that commercial mortgage losses will reduce long-term return on equity to the same extent as bond losses largely because theexposure to mortgages is modest relative to bonds. On average, the ratio ofcommercial mortgages to common equity is a little more than 1:1 (Figure 56) forthe companies in our coverage universe, which compares to a ratio of fixedincome investments to common equity of more than 6:1.

Commercial mortgage exposurenot the industry risk it was a

decade ago, but don’t ignore it

Much lower exposure relativeto bonds



Figure 56: Ratio of Commercial Mortgage Portfolio to Common Equity, September 2002

0.0

0.5

1.0

1.5

2.0

2.5

3.0

AFLTM

KHIG

UNMPNX

PRULN

C JP

Avera

geM

ET PLPFG

JHF

SFGNFS


Investors should also take some comfort that life companies have establishedreserves for future losses on commercial mortgage loans. There are two types ofreserves on a GAAP basis for commercial mortgages: (1) a specific reserve foridentified problem loans; and (2) a non-specific reserve based on the risk profile ofthe performing mortgage loans. Therefore, in contrast to bond investments, thereis a cushion (non-specific reserve) to absorb some deterioration in the real estatemarket. Unfortunately, the portion of the reserve that is non-specific in nature itnot clearly identified, and it is our understanding that some companies may notcarry a non-specific reserve.

Data on the loss allowance (reserve) is required on an annual basis for allcompanies (10-K), so we have no choice but to deal with somewhat staleinformation at this point. However, we do not believe that mortgage allowanceschanged substantially during 2002, so meaningful conclusions are possible. Themedian loss allowance as a percentage of the mortgage portfolio was 61 basispoints at year-end 2001 for the companies under coverage (Figure 57). ForPrudential, it is necessary to isolate the allowance that is associated with themortgage portfolio excluding Gibraltar, where higher real estate losses werefactored into the purchase price and structure of the transaction.

Figure 57: Loss Allowance as a % of Commercial Mortgage Portfolio, 2001

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

AFL HIG TMK LNC SFG PL UNM NFS MET PFG JP JHF PRU PNX

NA NA NA

Median = 61 bps

Note: Use a median rather than a mean because PNX is an outlier and not particularly relevant given below averageweighting in commercial mortgages.Sources: Company reports and Merrill Lynch estimates.

Take comfort that some reserveshave been established

Loss allowance approximately60 basis points of mortgage

portfolio for mediancompany…



We have also attempted to estimate the level of problem loans that existingreserves would cover (Figure 58). We have assumed that 40% of delinquent loansand loans in the process of foreclosure lead to a loss and that all foreclosed loansproduce a loss. In both instances, we assume that loss severity is 25%. Althougha loss estimate is inherently risky for a mortgage portfolio because standardizedassumptions may be inappropriate, we still believe that this type of analysis isworthwhile. In practice, we would not expect companies to bring existingreserves down to a zero balance during a real estate downturn, but this analysisillustrates that to some extent potential losses have already been accounted forthrough the P&L. Currently, we believe that loans categorized as delinquent, inthe process of foreclosure and foreclosed, in total, are generally between zero and50 basis points of total commercial mortgages held by the companies on ourcoverage list.

Figure 58: Problem Loans Covered by Loss Allowance, 2001 (% of comm. mtg. porfolio)

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

18.0%

20.0%

AFL HIG TMK LNC SFG PL UNM NFS MET PFG JP JHF PRU PNX

NA NA NA

Median = 397 bps

Note: Use a median rather than a mean because PNX is an outlier and not particularly relevant given below averageweighting in commercial mortgages.Source: Merrill Lynch estimates.

The Bad NewsThe biggest issue for investors to keep in mind is that the environment cannot getany better for commercial mortgages. Problem loans (defined as 60 days or moredelinquent, in the process of foreclosure, foreclosed and restructured) were only1.1% of the industry’s commercial mortgage portfolio at September 30, 2002,which compares to more than 17% at the trough of the last real estate cycle(Figure 59). The industry has recorded realized gains on a statutory basis since1997 versus 128 basis points of losses in 1993 (Table 45). We do not expect theseverity of the next downturn to approach the experience of the early to mid1990s, but we think that a downturn could reduce return on equity by 70 to 100basis points for some publicly traded life companies.

…which could theoreticallycover a 4% rate of problem

loans

It can’t get any better than this,so watch out



Figure 59: Problem Loans as a % of Commercial Mortgage Portfolio, 1989 – Sep. 2002

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 3Q02

Delinquencies/In Process of Foreclosure Foreclosed Restructured

Source: ACLI.

Table 45: Mortgage & Real Estate Gains (Losses) – Industry ($ in 000s)

Realized Gain (Loss) Mortgage Loans & RE Gain (Loss) / Mortgage Loans & RE1989 73,960 278,919,036 0.03%1990 (651,312) 297,403,709 -0.23%1991 (1,915,760) 290,993,801 -0.64%1992 (2,610,188) 276,955,443 -0.90%1993 (3,544,641) 263,096,855 -1.28%1994 (3,290,233) 253,640,487 -1.25%1995 (2,994,738) 253,566,250 -1.18%1996 (1,899,967) 244,219,153 -0.75%1997 506,308 238,579,035 0.21%1998 1,447,126 238,963,136 0.61%1999 720,117 250,592,524 0.30%2000 212,206 253,584,202 0.08%2001 1,807,588 259,031,254 0.71%

Source: A. M. Best’s Aggregates & Averages

Realized losses on commercial mortgages and real estate understate the economicimpact of a real estate downturn because this statistic does not capture lostinvestment income on restructured loans. We have estimated the additional costof restructured loans using the simplifying assumption that these loans carryinterest rates that are 200 basis points below the original rate. Therefore, weconclude that the maximum economic loss for the industry was almost 150 basispoints of mortgage and real estate assets in 1993 and 1994, and the mean loss was40 basis points (Table 46).

Focus on economic losses,which includes give up on

restructured loans



Table 46: Economic Impact from Commercial Real Estate Problems

Realized Gain (Loss) Impact from Restructured Loans Total Economic Loss1989 0.03% -0.05% -0.03%1990 -0.23% -0.06% -0.29%1991 -0.64% -0.10% -0.75%1992 -0.90% -0.15% -1.05%1993 -1.28% -0.19% -1.47%1994 -1.25% -0.19% -1.44%1995 -1.18% -0.17% -1.35%1996 -0.75% -0.14% -0.89%1997 0.21% -0.09% 0.12%1998 0.61% -0.06% 0.55%1999 0.30% -0.04% 0.26%2000 0.08% -0.03% 0.05%2001 0.71% -0.02% 0.69%2002E 0.00% -0.01% -0.01%Average Loss -0.31% -0.40%Maximum Loss -1.28% -1.47%

Note: Expressed as a percentage of total mortgage and real estate assets.Sources: A.M. Best, ACLI and Merrill Lynch estimates.

Well Run Companies Anticipate DeteriorationIn our opinion, recent meetings with executives responsible for managing thecommercial mortgage portfolios at John Hancock and Protective Life pluscomments made by management of Nationwide Financial at its recent investor daysuggest that our concerns are not misplaced. These individuals are not expecting acommercial real estate downturn anywhere near the magnitude of the last cycle,and there are a number of arguments that support their view (e.g., savings & loansare not a disruptive force, tax laws do not encourage uneconomic projects,regulation and oversight is more stringent). However, all of them seem at leastsomewhat cautious about the outlook for the asset class. John Hancock believesthat real estate could be a problem if softness in the economy persists, whichwould increase the potential for leases to renew at materially lower rates.Hancock’s management is quick to point out that vacancies are at levels today thatare similar to those witnessed during the last downturn. Protective Lifemanagement stated that low interest rates and demand from investors that wereperhaps more interested in the equity market a few years ago have provided some“artificial support” for property values. Finally, at Nationwide’s December 2002Investor Conference, management said that “the real estate cycle will likelydeteriorate” and commented that it is seeing slightly less relative value in themortgage market today. We think that investors should take notice of thesomewhat cautious outlooks expressed by these management teams because thisgroup has a better-than-average investment track record in mortgages.

Worst Case Scenario Pretty UglyWe always hesitate to say “this time is different”, but it seems unlikely that thenext real estate downturn will be as severe as the early 1990s experience.However, to illustrate how bad it could get if we are wrong, it is instructive to lookat the performance of Lincoln National during the previous downturn. Lincoln’sloss experience was worse than the industry average in the 1990s and the impacton earnings was material. Based on disclosure in the 10-K on the allowance formortgage and real estate losses, we calculate that during the worst years in the1990s, commercial real estate problems reduced return on equity by three to fourpercentage points (Table 47). This analysis does not include the impact of lowernet investment income on restructured loans, but this adjustment is immaterialbecause Lincoln did not have a large restructured loan portfolio. During the lastdownturn, Lincoln offset mortgage and real estate losses with gains on the sale ofbonds and equities. In our opinion, investors should not assume that gains would

Some management teamsexpressing at least a little

concern about outlook

Lincoln National’s experienceduring last downturn illustrates

severe, but unlikely, scenario



offset losses this time if real estate problems approach the level of the previouscycle. The good news is Lincoln’s mortgage and real estate exposure is smaller inrelation to common equity than it was a decade ago (.94:1 today versus 1.38:1 in1991 and 1.25:1 in 1993).

Table 47: Lincoln National – Performance of Commercial Mtgs. & RE

Credit Losses / Beg Portfolio Comm. Mtgs. & RE / Equity Impact on ROE1990 0.71% 1.54 -0.69%1991 2.44% 1.38 -2.33%1992 3.78% 1.33 -3.25%1993 4.92% 1.25 -3.88%

Note: Credit losses defined as amounts charged to costs and expenses for mortgage loans and real estate fromSchedule VIII in 1991 and 1993 10-Ks. Ratio of mortgages and real estate to equity calculated with ending balances;impact on ROE based on average equity.Sources: Company reports and Merrill Lynch estimates.

Methodology based on Data from Multiple SourcesTo assess the average and maximum potential losses for each company on ourcoverage list we have used the following inputs: (1) historical commercialmortgage and real estate losses for the industry; (2) the historical delinquencyperformance of each company relative to the industry; (3) loss information fromJohn Hancock, Lincoln National, Nationwide Financial and Prudential; and (4) ourestimate of the impact from restructured loans on net investment income. Wehave attempted to arrive at an economic forecast for losses (i.e., we are notconcerned about GAAP accounting conventions or whether an item is consideredabove or below the line).

What Info Do We Have on Losses?In Table 48 we present actual and estimated loss statistics for John Hancock,Lincoln National, Nationwide Financial, Prudential and the industry. We areusing a sampling approach for the companies on our coverage list because: (1) wedo not have extensive historical data for some companies with large mortgageportfolios (MetLife and Principal); and (2) historical losses for other companieswith large mortgage portfolios have been insignificant and perhaps atunsustainable levels (Jefferson-Pilot, Protective Life and StanCorp). The numbersin bold are actual data and the rest of the loss statistics are based on our estimates.Although the comparisons are not on a consistent basis, we believe that theinformation from this table is sufficient to arrive at some general conclusionsabout commercial mortgage loss expectations:

1) Average principal and interest (P&I) losses as a result of defaulted loans areperhaps 25 to 35 basis points annually over time, with the low end of therange a reasonable expectation going forward if the 1990s experience isconsidered anomalous.

2) Average economic losses (P&I plus foregone investment income onrestructured loans) are perhaps 30 to 45 basis points annually over time, withthe low end of the range a reasonable expectation going forward if the 1990sexperience is considered anomalous.

Estimating maximum losses requires a little more guesswork, but our sense is thatthe real estate environment is sufficiently different today to expect that maximumlosses are somewhere between the average loss expectation and the worst years ofthe 1990s cycle. Therefore, we think that a maximum economic loss expectationfor the industry of perhaps 80 to 90 basis points is reasonable.

Focus on economic loss, notgeography of income statement

Estimate normal economiclosses are 25 bps and maximum

losses are 80 to 90 bps



Table 48: Actual & Estimated Historical Commercial Mtg. Loss Statistics

Average P&I Losses Max P&I Losses

Average Economic Loss

MaxEconomic Loss

John Hancock 0.24% 0.54% 0.36% 0.90%Lincoln National 1.07% 4.92% 1.09% 4.97%Nationwide 0.27% 1.12% 0.29% 1.16%Prudential 0.34% 2.01% 0.41% 2.11%Industry 0.31% 1.28% 0.40% 1.47%

Note: Bold = actual, everything else is an estimate. Time periods differ for each company and the industry. JohnHancock losses based on data from 1970 to 2002. Lincoln National losses based on provisions for mortgage and realestate losses from 1990 to 2001. Nationwide losses based on provisions for mortgages from 1992 to 2001. Prudentiallosses based on data from 1980 to 2002. Industry losses based on commercial mortgage and real estate data from 1989to 2001. Longer-term averages will more likely lead to lower average losses because 1990s cycle was severe.Sources: Company presentations, company data and Merrill Lynch estimates.

In our opinion, it is useful to contrast Prudential’s mortgage portfolio today with1990 as an example of why maximum loss expectations for one large insurer shouldbe less than the historical experience would suggest. Today, Prudential has a morediversified portfolio of loans (Figure 60) versus an over-weighting in offices in 1990(Figure 61). Also, concentration risk related to individual property exposures seemsmuch lower today given that 60% to 70% of the company’s mortgage loans arecross-collateralized (i.e., loan performance based on more than one property). Webelieve that it was an over-weighting in office properties and large individualexposures that created the bulk of the problems for Prudential last cycle.

Figure 60: Prudential Commercial Mortgage Portfolio, 2002

Apartments32.0%

Retail14.6%

Office25.5%

Hotel & Motel2.3%

Industrial22.1%

Other3.5%

Source: Company data.

Figure 61: Prudential Commercial Mortgage Portfolio, 1990

Apartments12.0%

Retail26.0%

Office45.0%

Hotel & Motel3.0%

Industrial12.0%

Other2.0%

Source: Company data.

Prudential’s mortgage strategyillustrates why this time is

probably different



Normal & Downturn Commercial Mortgage Loss ExpectationsWe have estimated company-specific commercial mortgage losses on an economicbasis (Table 49) by combining our conclusions about industry losses under normal(30 basis points) and cyclical downturn (80 basis points) scenarios with thehistorical delinquency performance of each company. We used A.M. Bestcompany reports for historical data on delinquencies from 1990 through 2001.Our general approach was to assume a tighter dispersion of experience during thenext downturn, with the worst companies last cycle performing better (butremaining below average) and the best companies performing worse (butremaining above average). The obvious shortfall of our approach is the relianceon historical delinquency performance. However, we believe that the tighter rangeof loss outcomes does not overly penalize one company versus another.

We have grouped the companies with meaningful commercial mortgage portfoliosbased on historical delinquency performance (Figures 62, 63, 64 and 65), and havedecided to use these four groupings to determine how individual loss rates willcompare to our industry loss assumptions. For the historical “Under-Performers”(MetLife and Lincoln National) we have decided to use a loss rate under both thenormal and downturn scenarios that is approximately 20% above the overallindustry assumption. For the historical “Average Performers” (John Hancock andPrudential), we have decided to use a loss rate under both the normal anddownturn scenarios that is in line with the industry assumption. For the historical“Out-Performers” (Jefferson-Pilot, Nationwide and Principal), we have decided touse a loss rate under both the normal and downturn scenarios that is approximately20% below the overall industry assumption. And, finally, for the historical“Exceptional Performers” (Protective Life and StanCorp), we have decided to usea loss rate under both the normal and downturn scenarios that is approximately50% below the overall industry assumption. For all of the companies with modestexposure to the asset class, we have used loss rate assumptions that are in line withour industry expectations.

Figure 62: Mortgage Loan Delinquencies – Under-Performers

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

Dec-90 Dec-91 Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01

MetLife Lincoln National Life Insurance Industry

Average Delinquency of 4.4% or higher from 1990 - 1995

Note: Delinquencies for total mortgages defined as 90 days or more past due and in process of foreclosure.Delinquencies are for Lincoln National Life and Metropolitan Life Insurance Company.Sources: A.M. Best, company reports and Merrill Lynch estimates.

Utilized historical delinquenciesto assess potential future losses

on individual company basis

Assume tighter range ofexperience, but best and worst

rankings based on history



Figure 63: Mortgage Loan Delinquencies – Average Performers

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%


John Hancock Prudential Financial Group Life Insurance Industry

Average Delinquency of 3.0% to 3.5% from 1990 - 1995

Note: Delinquencies for total mortgages defined as 90 days or more past due and in process of foreclosure.Delinquencies are for John Hancock Mutual Life Insurance Company and Prudential Insurance Company of America.Sources: A.M. Best, company reports and Merrill Lynch estimates.

Figure 64: Mortgage Loan Delinquencies – Out-Performers

0%

1%

2%

3%

4%

5%

6%


Jefferson-Pilot Nationwide Financial Principal Financial Group Life Insurance Industry

Average Delinquency of 1.00% to 1.25% from 1990 - 1995

Note: Delinquencies for total mortgages defined as 90 days or more past due and in process of foreclosure. Delinquencies arefor Jefferson-Pilot Life Insurance Company, Nationwide Life Insurance Company and Principal Life Insurance Company.Sources: A.M. Best, company reports and Merrill Lynch estimates.

Figure 65: Mortgage Loan Delinquencies – Exceptional Performers

0%

1%

2%

3%

4%

5%

6%


Protective Life StanCorp Life Insurance Industry

Average Delinquency of 0.5% from 1990 - 1995

Note: Delinquencies for total mortgages defined as 90 days or more past due and in process of foreclosure. Delinquencies arefor Protective Life Insurance Company and Standard Insurance Company.Sources: A.M. Best, company reports and Merrill Lynch estimates.

1



Table 49: Economic Losses (% of Total Commercial Mortgage Loans)

Normal Comm. Mtg. Loss Rate Real Estate Downturn Loss RateProtective Life 0.15% 0.40%StanCorp 0.15% 0.40%Jefferson-Pilot 0.25% 0.65%Principal 0.25% 0.65%Nationwide Financial 0.25% 0.65%Torchmark 0.30% 0.80%Phoenix 0.30% 0.80%Hartford Life 0.30% 0.80%UnumProvident 0.30% 0.80%Prudential 0.30% 0.80%John Hancock 0.30% 0.80%Lincoln National 0.35% 0.95%MetLife 0.35% 0.95%AFLAC NA NA


The impact on return on equity from commercial mortgage losses (Figures 66 and67) would seem to be modest for most companies because the exposure-to-equityratios are low. However, differences in leverage explain why some companies(Nationwide and Principal) could suffer a worse-than-average hit to ROE fromdeteriorating mortgage experience even though we expect better-than-averagemortgage loss performance for these insurers.

Figure 66: Impact on ROE from Normal Commercial Mortgage Losses

-0.45%

-0.40%

-0.35%

-0.30%

-0.25%

-0.20%

-0.15%

-0.10%

-0.05%

0.00%

AFL TMK PNX HIG UNM PRU JP PL SFG LNC PFG MET JHF NFS


Normal mortgage losses impactROE by zero to 40 bps; peaklosses could reduce ROE by

zero to 100 bps



Figure 67: Impact on ROE from Commercial Mortgage Losses during RE Downturn

-1.20%

-1.00%

-0.80%

-0.60%

-0.40%

-0.20%

0.00%

AFL TMK PNX HIG UNM PRU JP PL SFG LNC PFG MET JHF NFS




7. Understanding Sales and PremiumIn 2001, analysts and investors were faced with one of the more elusive conceptsthat can cloud the analysis of life companies. In July 2001, AFLAC (AFL,$30.97, B-2-7) announced that 2Q sales in Japan would be disappointing, and thatan immediate recovery was not imminent. The stock fell 11% the following dayand an additional 6% in the weeks leading up to September 11th. During that two-month period, however, consensus earnings estimates for AFLAC fell only 1%(which was slightly better than revisions for our coverage universe andsignificantly better than revisions for the S&P 500). So, how could the near-termsales outlook be so bleak for a business that represents 70% of earnings, but theexpectation for earnings remain essentially unchanged? The answer lies in thedifference between sales and premium and the link that each has to profitability.

Before we attempt to illustrate the important distinctions between sales andpremium, it is probably useful to discuss the definitions of both terms.Unfortunately, this is where the confusion begins because companies use varyingdefinitions for both measures. For example, Jefferson-Pilot and MetLife reportordinary life insurance sales as annualized first year, renewal and single premiumswhereas Lincoln National reports sales for the same products based on first yearpremiums collected in the quarter (not including renewals or single premiums andnot annualized). There is also some discretion on the timing that a sale is reported.In 2001, UnumProvident changed its reporting of sales to an effective date basis(when the policy “starts”) from a submitted date basis (when the policy is sold, butnot necessarily in-force). The definition of annuity sales also varies from onecompany to another. For example, Nationwide reports annuity deposits net ofinternal exchanges while Hartford shows annuity sales on a gross basis (beforeadjusting for exchanges). Also, Lincoln’s fixed annuity sales include the portionof variable annuity contracts allocated to fixed options whereas Nationwideincludes the fixed allocation in variable sales. The purpose of highlighting thesedifferences is not to conclude which disclosure is right or wrong, but rather toprove that subtle (but important) differences can make generalized comparisonspotentially misleading. Once the definition of sales is understood, investors canmove on to the more important issue of what this metric means for profitability.

� Don’t Get Caught up in Short Term Sales Swings

It may be tempting to extrapolate a strong quarterly sales performance to a moreenthusiastic outlook for profitability, but such a conclusion can be dangerous. Theprimary reason is that growth in sales does not translate into an equivalentpercentage increase in premium income. This phenomenon is driven by the factthat sales in any given period are a fraction of the total premiums in force. Formost life insurance lines of business, the bulk of collected premiums comes frompolicies that were sold years earlier. As a result, it takes time for sales tosignificantly impact premium growth. To illustrate this point, we have examinedAFLAC’s quarterly sales growth and premium growth in Japan for the years 2000and 2001 (Table 50). AFLAC is a good example because the products thecompany sells in Japan remain on the books for many years (i.e., low lapse ratesor high persistency).

Table 50: AFLAC Japan

1Q-00 2Q-00 3Q-00 4Q-00 1Q-01 2Q-01 3Q-01 4Q-01Summary AFLAC Japan:New Sales Growth 17.6% 5.1% 21.5% 16.0% 3.6% 0.6% -18.3% -15.8%Premium Growth 8.2% 7.7% 6.1% 6.5% 6.6% 4.9% 4.9% 4.3%Pre-tax Oper. Inc. Growth 9.0% 10.8% 9.0% 20.9% 19.3% 21.0% 22.5% 19.7%

Note: AFLAC Japan’s data is shown before currency translation.Source: Company Reports.

Understanding the differencebetween sales and premium iscritical in analyzing the group

Varying definitions don’t helpcomparability across companies

Short-term sales volatility haslimited impact on top line…



As shown in the table, Japanese sales growth decelerated from 3Q00 to 2Q01andactually declined significantly in the third and fourth quarters of 2001. During thisperiod, however, premium growth had fallen by only 180 basis points from 6.1%to 4.3%. So, while the near-term sales performance was poor, premium growth(albeit muted) continued to drive AFLAC Japan’s top line. In the table, we alsoincluded pretax operating income growth for this segment, which remainedbuoyant during the period of slowing sales. This may seem counter-intuitive, butis further evidence that sales volatility in the short run has little impact onprofitability. The decision for investors in this case was whether or not the salesdecline would continue over the next several quarters or years. If the conclusion isa secular decline or slowdown, the impact on premium growth could ultimately besevere, which would exert pressure on earnings. For AFLAC, the weak sales werebeginning to take a toll on the top line performance of the company, but asubsequent recovery has lessened the concern about top line growth.

For the example above, we suggested that investors must determine whether thedisappointing sales experience is a short or long-term phenomenon. Similarly, thistype of assessment is necessary when sales growth trends accelerate. Plus, wewould recommend that investors consider the risk that accelerating growth isoccurring at the expense of profit margins because rapid growth is often aprecursor to disappointing earnings (which we discuss in detail in Section 8).

� Consideration of Persistency a Must

Sales are typically emphasized as an indicator of future growth, but we believethat persistency of the existing book of business deserves at least equalconsideration. In other words, strong sales will not have a meaningful impact ifthe company does not retain the business that it has previously written. Todemonstrate this point, we have looked at Torchmark’s life insurance in-forcehistory from 1996 to 2000 (Table 51).

Table 51: Torchmark Life Insurance In-Force, 1996-2000

1996 1997 1998 1999 2000Beginning In-Force 80,391 86,948 91,870 96,339 101,846New Issues 18,718 20,268 21,448 22,846 25,754Lapses & Surrenders (14,305) (14,742) (16,028) (16,857) (18,744)Other 2,143 (603) (951) (481) (538)Ending In-Force 86,948 91,870 96,339 101,846 108,319Percentage ChangeNew Issues -3.3% 8.3% 5.8% 6.5% 12.7%Average In-Force 7.8% 6.9% 5.3% 5.3% 6.0%As % of Beginning In-ForceLapses & Surrenders -17.8% -17.0% -17.4% -17.5% -18.4%

Note: Other includes business acquired, death benefits, and other increases and decreases.Source: Company reports.

As the table shows, Torchmark’s sales growth, which is the year/year change innew issues, almost doubled in 2000 (+12.7%). However, a 90 basis point declinein the persistency of the existing business (1 – lapses and surrenders) absorbedmost of the strong sales performance (insurance in-force grew 6.0% versus 5.3%in 1999). The table illustrates that Torchmark’s persistency has slowly declinedsince this period’s high point in 1997. If persistency had remained flat with 1997,average in-force would have increased at a compound annual rate of 5.9%, whichcompares to actual annual growth of 5.5%. Putting flat persistency into thecontext of sales gives some sense for the importance of this metric. For example,if persistency had remained unchanged in 2000 versus 1999, lapses and surrenderswould have been approximately $920 million less than actual experience, or theequivalent of four percentage points of sales growth. From an economic

perspective, it is probably reasonable to assume that a dollar of persistent business

…and may have noimpact on profitability

Changes in productpersistency can mean at least asmuch as sales to top line growth

Economically, a dollar ofpersistency is probably worth

more than a dollar of sales



is worth more than a dollar of new business given the significant up-frontacquisition costs that are incurred when a new sale is made.

� Seasonality Can Determine Importance of Sales Growth

Another factor that should be considered when gauging the impact of an increaseor decrease in sales is seasonality. Many life insurers that serve the group markets(life, disability, health) experience significant swings in business activity duringcertain times of the year. In Table 52, we have illustrated UnumProvident’squarterly group short-term and long-term disability sales over the past year.

Table 52: UnumProvident Group Disability Sales

1Q02 2Q02 3Q02A 4Q02E 2002EGroup Disability Sales:Group Long Term Disability 79.3 79.5 63.0 221.9 443.7Group Short Term Disability 48.5 50.0 29.1 94.2 221.8Total Group Disability 127.8 129.5 92.1 316.0 665.4

Percentage Increase:Group Long Term Disability 13.6% 8.9% 16.9% 10.0%Group Short Term Disability 73.2% 30.9% 15.9% 10.0%Total Group Disability 30.7% 16.5% 16.6% 10.0%

Impact of 20% sales increase:Group Long Term Disability 15.9 15.9 12.6 44.4Group Short Term Disability 9.7 10.0 5.8 18.8Total Group Disability 25.6 25.9 18.4 63.2Total Impact on 2002 Sales 3% 9%

Sources: Company Reports and Merrill Lynch estimates.

As shown in Table 52, group LTD sales growth was at its highest level in 3Q02.However, the third quarter is typically seasonally depressed for sales activity, andtherefore the sales increase has only a modest impact on total sales for the year.To illustrate this point more clearly, we have shown the incremental sales thatwould have been generated if levels were 20% higher than reported in each of thefour quarters shown. Clearly, a strong sales performance in the fourth quarter hasa much more significant impact on total company sales for the year(approximately 3x) than is the case with strong third quarter sales.

� For Some Products, Sales Don’t Necessarily Mean Top-Line

We have discussed how sales impact the top-line over the longer term. However,we have not addressed how sales of asset accumulation products like variableannuities affect the top line. Much like a mutual fund company, variable annuitycompanies charge fees on average assets. Ultimately, the level of fees and thelevel of assets are the two primary variables that drive top line growth for anannuity company. Sales (which in this case are synonymous with premiums ordeposits) are an important contributor to asset growth, but they are not the onlyfactor that needs consideration. In fact, assessing the sales performance of acompany in isolation of other factors like market performance and surrenderactivity can lead to inaccurate conclusions. To illustrate this point, we haveincluded variable annuity asset roll-forward data for the years 2000 and 2001 forthree of the larger variable annuity companies in our coverage universe (Tables53, 54 and 55).

Good sales in seasonally strongperiods has bigger impact thanin seasonally depressed periods

Asset growth drives top line forannuity companies

Sales are only one factor thatdrive asset growth



Table 53: Lincoln National Variable Annuity Account Rollforward

1Q00 2Q00 3Q00 4Q00 1Q01 2Q01 3Q01 4Q01Beginning Balance 41,493 44,640 43,097 42,743 39,427 34,733 36,961 30,506Total Deposits 797 793 729 846 887 703 684 793Mkt. Apprec/(Deprec) 3,011 (1,511) (46) (3,175) (4,342) 2,291 (6,321) 3,944Transfer from/(to) Fixed 549 343 216 212 11 227 (23) 213Withdrawals and Deaths (1,210) (1,168) (1,253) (1,199) (1,250) (993) (795) (818)Ending Balance 44,640 43,097 42,743 39,427 34,733 36,961 30,506 34,638Percentage ChangeDeposits 25.5% 21.8% 15.0% 33.4% 11.3% -11.3% -6.2% -6.3%Average Balance 27.6% 22.9% 17.8% 6.6% -13.9% -18.3% -21.4% -20.7%% of Beg. Bal. (annual.)Withdrawals and Deaths -11.7% -10.5% -11.6% -11.2% -12.7% -11.4% -8.6% -10.7%Investment Performance 29.0% -13.5% -0.4% -29.7% -44.1% 26.4% -68.4% 51.7%Net Fund Flows -4.0% -3.4% -4.9% -3.3% -3.7% -3.3% -1.2% -0.3%

Sources: Company Reports.

Table 54: Nationwide Financial Variable Annuity Account Rollforward

1Q00 2Q00 3Q00 4Q00 1Q01 2Q01 3Q01 4Q01Beginning Balance 40,302 42,226 42,037 41,763 39,753 35,731 37,344 33,008Deposits 2,002 2,457 2,123 1,732 1,512 1,815 1,517 1,389Withdrawals / Surrenders (1,663) (1,476) (1,514) (1,330) (1,199) (1,160) (1,096) (1,124)Investment Performance 1,730 (1,025) 123 (2,277) (4,158) 1,085 (4,636) 3,193Policy Charges (145) (144) (147) (135) (128) (127) (120) (121)Benefits and Other - - - - (50) - - -Acquisitions - - (860) - - - - -Ending Balance 42,226 42,037 41,763 39,753 35,731 37,344 33,008 36,346Percentage ChangeDeposits 30.2% 34.2% 25.7% 10.5% -24.5% -26.1% -28.5% -19.8%Average Balance 26.1% 20.8% 16.8% 7.6% -8.5% -13.3% -16.0% -13.5%% of Beg. Bal. (annual.)Withdrawals / Surrenders -16.5% -14.0% -14.4% -12.7% -12.1% -13.0% -11.7% -13.6%Investment Performance 17.2% -9.7% 1.2% -21.8% -41.8% 12.1% -49.7% 38.7%Net Fund Flows 1.9% 7.9% 4.4% 2.6% 1.9% 5.9% 3.2% 1.8%


Table 55: Hartford Variable Annuity Account Rollforward

1Q00 2Q00 3Q00 4Q00 1Q01 2Q01 3Q01 4Q01Beginning Assets 80,588 85,264 82,264 83,009 78,174 70,649 78,415 68,545Sales and Other Deposits 2,437 2,261 2,250 2,058 2,303 2,530 2,102 2,054Acquisitions - - - - - 4,123 - -Market Appreciation 3,849 (3,449) 449 (5,085) (7,925) 3,101 (10,090) 5,927Surrenders / Benefits (1,610) (1,861) (1,978) (1,834) (1,949) (2,016) (1,899) (1,955)Net exchanges - 49 24 26 46 28 17 19Ending Assets 85,264 82,264 83,009 78,174 70,649 78,415 68,545 74,581Percentage ChangeSales and Other Deposits -4.8% -16.9% -13.1% -13.8% -5.5% 11.9% -6.6% -0.2%Average Assets 29.8% 22.9% 18.4% 7.9% -10.3% -11.0% -11.1% -11.2%% of Beg. Bal. (annual.)Surrenders / Benefits -8.0% -8.7% -9.6% -8.8% -10.0% -11.4% -9.7% -11.4%Investment Performance 19.1% -16.2% 2.2% -24.5% -40.6% 17.6% -51.5% 34.6%Net Fund Flows 4.1% 1.9% 1.3% 1.1% 1.8% 2.9% 1.0% 0.6%


Nationwide posted the worst1Q01 VA sales of these three

companies…

…but lower surrenders helpedNationwide’s asset growth

outperform both companies



There is a lot of information in these tables, but for this example we focus ourattention on the first quarter of 2001 for each company. During 1Q01, LincolnNational posted the strongest sales growth (+11.3) of any of the three companies.Hartford’s sales declined by 5.5%, while Nationwide’s sales were the weakestamong the three in the quarter (-24.5%). Considering only this data, however,provides an incomplete picture as it relates to top-line (asset) growth for thesethree companies in 1Q01. Asset growth is a better indicator of top line growthsince it considers withdrawals, market performance and other items. Looking atasset growth provides a very different picture of 1Q01 than was the case withsales. Due to the containment of contract surrenders by Nationwide, their assetgrowth was better than both Lincoln and Hartford in the quarter. Conversely,Lincoln’s withdrawals continued to increase (1Q01 proved to be the peak), whichcontributed to the lowest asset growth of the three companies in the quarter. Thisis one of the key reasons that we focus more on net fund flows than gross sales.

� Stock Market is Driver of Asset Growth for Variable Products

In the latter part of the 1990s, the growth in variable products was exceptional as aresult of strong customer demand and the tailwind provided by an unprecedentedbull market. During this time, 20%+ annual returns from the stock market andstrong net fund flows (deposits less withdrawals and benefit payments) combinedto produce approximately 25% asset growth. In 2000, 2001 and 2002, the stockmarket decline exerted pressure on assets, which, together with the deterioration ofnet fund flows, meant a challenging environment for variable companies. The netfund flows for ten top writers of variable annuities going back to mid 1998illustrate a major reversal of fortunes (Figure 68).

Figure 68: VA Net Flows as a % of Beg. Acct. Values, Industry Composite 3Q98 – 3Q02

0%

2%

4%

6%

8%

10%

12%

3Q98

4Q98

1Q99

2Q99

3Q99

4Q99

1Q00

2Q00

3Q00

4Q00

1Q01

2Q01

3Q01

4Q01

1Q02

2Q02

3Q02

Notes: Variable annuity composite currently consists of the following companies: Hartford Life, John Hancock, Lincoln,MetLife, Nationwide, Principal, Phoenix and Prudential. Data for Principal and Phoenix represents total annuity assetsunder management, which are predominantly variable. Prior years included AXA Financial and American General.Fund flows equal separate account (variable annuity) deposits (excluding transfers and exchanges) lesssurrenders/withdrawals, policy charges, and benefits.Source: Company reports.

We believe that a rebound in net sales is possible if equity market returns improve,but we think that 2% of assets may be the best that investors should hope for.Therefore, we believe that market performance will drive asset growth for variableannuity writers going forward. Given that the S&P 500 has produced an averageannual total return of 14% during the past 20 years, this may not seem like aproblem. However, these returns have not been predictable, as the standarddeviation of annual returns was 17% over the same period. Furthermore, thecurrent state of the equity markets remains uncertain (three consecutive downyears), and history suggests that returns over the next 20 years could very well fallmeaningfully short of the past 20 years.

Just looking at annuity salescan yield wrong conclusions

Weak net flows suggest thatequity market performance will

drive most asset growth

Both near-term and longer-term, reliance on equity marketperformance could be problem



8. The Potential Perils of Top-Line GrowthGrowth is not always good. This statement may be controversial for someindustries, and downright heresy for others. However, insurance analysts woulddo well to commit it to memory. In our opinion, there are too many examples ofinsurers that have stepped on the gas to produce rapid growth only to end upswerving off of the road (returns below the cost of capital) or going over the edgeof a cliff (a permanently impaired balance sheet). In our opinion, two leadingindicators of potential problems are top-line growth well in excess of the relevantmarket and unrealistic growth goals put forth by management. The latter isperhaps the earliest warning sign because it suggests that management may pushtoo hard for organic growth and/or consummate an uneconomic acquisition. InFigure 69 we show the differences between our long-term growth expectation andthe consensus forecast for each of the companies on our coverage list.

Figure 69: Long-term EPS Growth – Difference between Merrill and Consensus Est.

-3.50%

-3.00%

-2.50%

-2.00%

-1.50%

-1.00%

-0.50%

0.00%

NFS LNC JHF SFG MET HIG AFL PNX PRU JP PL PFG UNM TMK

Sources: First Call and Merrill Lynch estimates.

Be Wary of Growth in Excess of the Market

In many businesses, the winners are often defined by their ability to gain marketshare. Unfortunately, it is not so clear cut in insurance because the company thatunder-prices the product will find more than enough willing buyers (i.e., marketshare gains can be a precursor to bottom line difficulties). As we have discussedin a preceding section, because profits are an estimate, a large book ofunsatisfactory business could build up before the realization that margins are wellbelow targeted levels.

In our view, analysts and investors should be very skeptical of top-line growth thatis well in excess of the industry average. We believe that it is helpful to review afew recent examples of companies that produced strong top-line growth only tosubsequently suffer from unacceptable (and in two cases debilitating) bottom-lineperformance. This is by no means an exhaustive list. Without thinking too hard,we conclude that at least half of our coverage universe has at some point paid theprice for irresponsible growth.

Top-line growth is not anunambiguous positive

Always consider an insurer’stop-line performance vs. growth

in the relevant markets



� General American and Funding Agreements

The latter half of the 1990s was not kind to insurers that sold primarily generalaccount products because equity-based alternatives (variable or separate accountproducts) enjoyed rapid growth. Overall, general account reserves for the industrygrew at only a 3% annual rate from 1994 through 1999. Therefore, the substantialgrowth in General American Life’s general account reserves was an anomaly.

General American was not a public company, but a key reinsurance partner –ARM Financial – was a NYSE-listed insurer. Although we did not officiallycover ARM, we observed it from a distance and had difficulty understanding thewisdom of its growth strategy. A closer look at General American Life wouldhave raised similar concerns because the company was growing at a 34% annualrate in a business that was not growing at all for the industry (Table 56). Whatexplained this differential? In hindsight, the answer was that General Americanwas selling a type of funding agreement that had substantial cash flow risk.Specifically, the contract had a seven-day put feature that allowed the holderalmost instant liquidity yet ARM/General American was investing the funds insecurities that could not be counted on to meet a short-term demand for cash(Figure 70). Ultimately, General American placed itself under voluntaryregulatory supervision and ARM Financial went to zero.

Perhaps the most sobering aspect of the General American/ARM Financialdebacle is that people close to the situation did not recognize the severity of theproblem. For example, one large rating agency stated that “asset and liability cashflows are closely matched” within one month of the company going undervoluntary regulatory supervision because of a liquidity shortfall. Perhaps theconclusions would have been different if someone had stepped back and asked,“Why are they growing when no one else is?”

Table 56: Extreme Case of Unprofitable Growth - Regulatory Supervision

Group Annuity Gen’l Account Reserves: 1994 1995 1996 1997 1998 General American Life 684 814 1,020 1,456 2,198 Industry 196,398 199,376 198,157 193,576 190,623Growth in Reserves: 95/94 96/95 97/96 98/97 General American Life 19.0% 25.3% 42.8% 50.9% Industry 1.5% -0.6% -2.3% -1.5%

Source: A.M. Best.

Figure 70: General American Life Operating Cash Flow, 1995-1999 ($ in Mils.)

(2500)

(2000)

(1500)

(1000)

(500)

0

500

1000

1500

1995 1996 1997 1998 1999

Source: A.M. Best.

General American paid theultimate price for unprofitable

growth



� ReliaStar and Reinsurance

ReliaStar’s performance in reinsurance is another recent example of extraordinarysales growth leading to disappointing performance. The company generated rapidgrowth in reinsurance premiums at the same time that the related primary marketsexhibited a much more modest increase (Table 57). Although we identified thishigh level of growth as a risk factor, we did not anticipate the extent of theearnings problem that would develop in 1999 (Figure 71). Fortunately forshareholders, the earnings troubles became a less pressing issue as the companywas acquired in 2000 at a meaningful premium.

We did not know the whole reinsurance story before it was too late, but we wouldhave been well served to heed the numerous lessons of the past. In hindsight, it isclear that ReliaStar pushed too hard for growth, which ultimately led the companyto loosen underwriting standards. At the time of the earnings woes during 1999, itwas revealed that one managing general underwriter (MGU) accounted for two-thirds of ReliaStar’s total medical reinsurance premium. Essentially, managementhad given the “underwriting pen” to a third party, an occurrence that hashistorically been a precursor to loss ratio problems for other companies.

Table 57: Disconnect between Primary and Reinsurance Market Growth

Premiums: 1996 1997 1998 1999 ReliaStar reinsurance 184 222 320 463 Group life – primary industry 20,585 25,582 24,698 25,387 Health – primary industry 88,059 87,519 88,775 93,215Growth in Premiums: 97/96 98/97 99/98 ReliaStar reinsurance 21% 44% 45% Group life – primary industry 24% -3% 3% Health – primary industry -1% 1% 5%

Sources: Company reports and A.M. Best.

Figure 71: ReliaStar Reinsurance Operating Income, 1996-1999 ($ in Mils.)

0

5

10

15

20

25

30

35

40

45

1996 1997 1998 1999


� UNUM and Group Disability

The troubles of UNUM (and UnumProvident) were perhaps the biggest recentdisappointment for investors in insurance names because the company wasperceived to be a growth story (disability) within a mature industry (life and healthinsurance). At the peak of its popularity with analysts and investors, the long-termprojected EPS growth rate for the company was 14%. In hindsight, it was thesehigh growth expectations and management’s unwillingness to back away fromaggressive growth targets that led the company to sacrifice price for volume.

Disconnect betweenreinsurance & primary market

growth was warningsign for Reliastar



As was the case with the previous two examples, UNUM’s sales growth was well inexcess of the peer group (Table 58) prior to its profit disappointments (Figure 72).However, it was less obvious that UNUM was sacrificing profitability for growth, inour view, because in 1995 the company had allowed long-term disability sales todecline when the market became overly competitive. At the time, we cited this displayof discipline as an indication that management would walk away from unprofitablebusiness. Unfortunately, history is not always a perfect guide to the future, and in thisinstance the company’s strategic focus was altered at some point during 1996-1997.

The UNUM story also highlights that bad news does not emerge quickly in theinsurance business. At a New York luncheon in November 1998 management setforth an annual top-line growth target of 13%-15% through 2002. Clearlymanagement was not yet aware that the rapid sales growth of the previous coupleof years would produce disappointing results. This is a great example of howprofitability problems can build at an insurer before it is apparent (both inside andoutside of the organization) because the income statement is an estimate.

Table 58: Perceived Growth Story and Market Leader in Disability

Long-term Disability Sales 96/95 97/96 98/97 CAGR 1995-98UNUM 10.5% 34.6% 10.4% 18.0%Industry excluding UNUM 4.6% 12.4% 3.2% 6.6%

Sources: Company reports, Disability RMS and Merrill Lynch estimates.

Figure 72: UnumProvident Group Disability Pretax Income (Loss), 1996-1999 ($ in Mils.)

-300

-200

-100

0

100

200

300

400

1996 1997 1998 1999

Note: UNUM merged with Provident in June 1999.Source: Company reports.

Unrealistic Goals are a Warning Sign

In our opinion, unrealistic performance targets are a “growth peril” that could leadto unprofitable top line growth and/or a low-return acquisition. If managementpromises more than it can deliver, it may feel the need to stretch to reach goalsthat have been articulated to the investment community. This could lead amanagement team to push for excessive top-line growth (like the examples listedabove) or attempt to acquire growth (which improves the odds of overpaying). Asubset of the latter common mistake is getting sucked in by the Siren’s song ofgrowth at a target company (i.e., bid based on recent high growth rates that proveto be artificial). This is the “worst case” scenario, in our opinion, because itsuggests that an already low expected return on the acquisition will prove to beoptimistic.

UNUM proved that the past isnot necessarily prologue

When unrealistic promises aremade, the risk of pushing

too hard increases



� Conseco and Green Tree

An important lesson that we learned from the problems at Conseco is that it isrisky to recommend a stock when management’s growth targets are in excess ofyour estimates (Table 59), even if the shares appear undervalued on the moreconservative assumptions. In the case of Conseco, this search for growth led to theacquisition of Green Tree Financial, which ultimately led to the company’sdownfall (currently trading at $0.04 per share). The rationale for the Green Treedeal was different from previous acquisitions because it was based on top-linegrowth (Table 60). In contrast, Conseco’s acquisitions of insurance companies inthe 1980s and early 1990s were driven by the cash flow produced by in forceblocks of business and expense savings. Little, if any, of the purchase price forthese transactions was associated with new business volume.

Table 59: Expectations for Conseco prior to Green Tree Acquisition, 2/98

Contributors to EPS Growth Management’s Target Our ForecastPremiums and in force 9-10% 6-8%Margin Improvement 4-6% 2%Use of excess cash flow 2-3% 2%Total EPS growth 15-19% 10-12%

Sources: Company presentations and Merrill Lynch reports.

Table 60: Conseco’s Top-Line Performance Trailed Targeted Levels

Year/year growth 98/97 99/98Collected Premiums 5.7% 4.9%Deposit Reserves 8.4% 0.1%


� Provident and UNUM

In hindsight, we believe that Provident management – which is the survivingmanagement of UnumProvident – also attempted to use a merger to “bridge thegap” between realistic and targeted growth expectations for their company. Priorto the announcement of the merger with UNUM in November 1998, Providentmanagement had articulated a long-term return on equity goal of 13% to 15%.Given that the return on equity for Provident in 1998 was approximately 11%, thissuggested earnings per share growth of 13% to 17% per year. Not surprisingly,the consensus long-term EPS growth forecast was 15% (Table 61).

Looking for top-line growthoutside its core competency

added to Conseco’s problems



These expectations could have been considered extremely optimistic given thetop-line performance of Provident going into the merger with UNUM (Table 62).Specifically, Provident had not generated any top-line growth pro forma for the1997 acquisition of Paul Revere. Therefore, EPS growth in the low to mid teenswas a tall order. In our view, Provident management did not perform the type ofdue diligence that made the Revere deal a success because they were captivated bythe top-line performance of UNUM. Again, in hindsight, that top-lineperformance was a profit mirage, as we have outlined in the previous section.

Table 61: Expectations for Provident Prior to UNUM Merger, 9/98

Management’s Target Consensus ForecastReturn on Equity 13-15% in 3-5 yearsEPS Growth 13-17% 15%

Note: Earnings per share target is derived by assuming ROE goal achieved in the fifth year.

Table 62: No Revenue Growth for Provident ex. Paul Revere Acquisition

Revenue: 1996 1997 1998 Pro Forma 3,930 3,958 3,904 Actual 2,301 3,538 3,904Growth in revenue: 97/96 98/97 Pro Forma 0.7% -1.4% Actual 53.8% 10.3%


Be wary of companies that tryto “bridge the growth gap”

with an acquisition



9. Think Single Digit Top LineWe have been (and continue to be) cautious about the long-term growth outlookfor the insurers that we cover. In our view, the strong demographic and under-penetrated market themes for certain lines of business are offset somewhat by: (1)the slow growth of traditional lines; (2) the maturation of the annuity business; (3)the negative impact of a less robust equity market; and (4) the diminished demandfor life products related to estate planning. In our opinion, top-line growth for thelife industry will remain well into the single-digits for the foreseeable future.

Seeing Downward Adjustments as Reality Sets In

We published “Thoughts on Growth” in late 2000, which outlined our moreconservative view of long-term growth rates. Since that time, some of ourconcerns have become a reality. The equity market has produced three years in arow of negative returns, sales of variable and estate planning-related products havedeclined sharply, and consensus estimates of long-term EPS growth have fallenslightly for several companies. Since the end of 2001, consensus long-termgrowth rates have been revised downward for five of the eleven companies thatremain in the Merrill Lynch Life Insurance Index. In addition, growth hasconsistently been among the top concerns of CEOs according to LIMRA surveys.

A detailed analysis of the five-year growth performance ended in 2001 (which wepublished last year) suggested that the normalized top-line growth rate for publiclytraded life companies was 7% (Figure 73). Reported top-line growth was slightlymore than 10% on an annual basis from 1996 to 2001, which is a more thanrespectable performance. However, consolidation activity was substantial in thelatter half of the 1990s, and based on a bottom-up analysis, we estimate thatorganic growth was approximately 8% per year (or two points below actualgrowth). Finally, we think that normalized growth is less than 8% per year if weremove the impact on variable product lines from the exceptional equity marketreturns registered during the 1990s. We think that an adjustment for this factorreduces the annual growth rate to 7%, and this could be slightly aggressive.

Figure 73: Top-Line Growth Analysis – Merrill Lynch Life Composite, CAGR 1996 - 2001

0%

2%

4%

6%

8%

10%

12%

Reported Organic Normalized Market

Note: Top-line growth measured based on assets or revenues depending on a company’s business mix.Sources: Company reports and Merrill Lynch estimates.

Analysis of History Provides Guide to Future

Although it is sometimes dangerous to rely heavily on existing trends, we believethat it is instructive to examine the historical top-line growth for U.S. life insurersto glean some understanding of what the future may hold. We will focus primarilyon the annuity and life segments of the business, and briefly discuss the outlookfor certain supplemental health insurance lines (disability income and long-term

Several factors remind us thatthis is a mature industry

Focusing on annuity and lifesegments as these businesses

have represented 60% to 70% ofearnings in recent years



care insurance). Health insurance is not an especially important business from ourperspective because all of the companies that we cover except for one have exitedthe group market, which accounts for 70% of total industry health insurancepremiums written. It is also appropriate to pay the greatest attention to the annuityand life segments because these businesses combined have accounted for 63% oftotal profits generated by U.S. stock life insurance companies from 1999 to 2001(Figure 74). We have taken an average because annuity earnings were unusuallydepressed in 2001.

Figure 74: Stock Life Insurance Industry Profit Mix, Average 1999 - 2001

16.5%

1.6%

1.9%

5.3%

3.7%

0.9%

6.7%

33.9%

29.3%

Annuities

Ordinary LifeSupplementary Contracts

Group Life

Credit insurance

Industrial

Group Accident & Health

Other Accident & Health

All Other

Note: Data is on a statutory basis.Source: A.M. Best’s Aggregates and Averages.

The first point of interest from the historical record, in our opinion, is the growthrate for the annuity business (group and individual combined). We estimate thatcompound annual growth in account balances was 6% from 1996 to 2001, whichis a slight deceleration from a 7% annual growth rate from 1991 through 2001.(Estimates are necessary to adjust for the distortion caused by codification ofstatutory accounting principles in 2001.) In our opinion, growth in accountbalances is the key top-line measure for the annuity business because assets driveearnings. Account balance growth was a function of equity market appreciationand variable product sales during the mid to late 1990s, and fixed annuity growthhas been the driver at the beginning of the new decade as principal preservationstrategies look appealing following a difficult period for the stock market. Thedivergent trends in individual fixed and variable annuity sales illustrate this point(Figure 75). Individual variable annuity sales increased at a 23% annual rate from1995 to 2000, but individual fixed annuity sales increased only 2% annually. Thesales trends from the mid- to late-1990s were driven largely by the exceptionalreturns generated by the equity market, in our view. The story changed in 2002 aswe experienced the third consecutive year of negative stock market returns. Weestimate that variable annuity sales have declined at a 7% annual rate from 2000 to2002 while fixed annuity sales have increased at a 43% annual rate. In our view,it is clear that the variable annuity business will not repeat the impressiveperformance of the mid- to late-1990s barring an exceptional rebound in thecapital markets. We think that overall annuity growth (deposits and assets) will bein the mid to high single-digits for the industry going forward.

Growth rate in annuities maybe less than you think



Figure 75: Individual Annuity Premiums, 1988-2002E ($ in Mils.)

$0

$20

$40

$60

$80

$100

$120

$140

$160

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002E

Variable Fixed

CAGR: Variable Fixed 1996-2002E 6% 23%1991-2002E 14% 10%


According to Cerulli Associates, 401(k) plan assets increased at a 17% annual rateduring the 1990s, but assets declined in both 2000 and 2001 as a result of the bearmarket. The outlook for the 401(k) market remains relatively favorable, in ourview, but asset growth over the next decade will most likely trail the performanceof the 1990s. Cerulli Associates forecasts that 401(k) assets will grow at a 10.5%annual rate from 2001 to 2005. We think that this expectation is perhaps slightlyaggressive and believe that the ability of the 401(k) business to drive overallgrowth for the life industry is questionable. First, a large portion of 401(k) salesfor life companies (60% to 70% recently) relates to takeover business (i.e.,existing plans moving assets to another provider). Although growth from takeoverbusiness could continue for some carriers, there is reason to be concerned aboutthe outlook for overall asset growth when a large portion of sales relates toturnover of existing plans. Second, the potential for increased market penetrationin the small employer market is appealing, but it is sometimes easy to get tooexcited about “small employer” growth stories (e.g., disability insurance), in ourview. Third, the most recent data available from the American Council of LifeInsurance (ACLI) suggests that the 401(k) business accounts for less than 20% oftotal industry annuity premiums and deposits. Finally, we are somewhat dubiousabout the profit potential of the 401(k) business for most players in the lifeinsurance industry given the high level of competition and increased demand forservice/technology-based solutions.

Another interesting statistic from the historical record is the slow (3% to 5%) butstable annual growth in life insurance premium income. Although there have beenpockets of growth in the life market in recent years (e.g., variable life, estateplanning), the demographic story does not suggest reason for optimism. Morethan 75% of life insurance policies are sold to individuals under 45 years of age,and this segment of the population is not expected to grow through 2010.Individual (or ordinary) life insurance accounts for more than three-quarters oftotal life insurance premiums. More importantly, individual life has accounted formore than 80% of total profits for shareholder-owned life insurers in recent years.

The industry’s individual life sales during the past couple of years do not suggestreason for optimism about future top-line growth (Figure 76). Life sales are aleading indicator of growth in total premium income – which includes both newand renewal business – because it is probably reasonable to assume that lapse ratesof existing policies will remain fairly stable (not necessarily a realistic assumptionfor annuities). Following a 3% decline in total individual life sales in 2001, theindustry recorded a 3% increase through the first nine months of 2002. Theincrease was driven by growth in sales of universal life, term life and whole life(up 32%, 16% and 12% respectively), which was almost entirely offset bydeclines in variable product sales. So, similar to the annuity business, the

401(k) market may be a goodstory for some, but not driving

overall industry growth.

Don’t count on meaningfulacceleration in the lifeinsurance growth rate

Rapid growth rates in certainlife products have reversed



performance of fixed versus variable product lines may vary substantiallydepending on the market and economic environment, but the overall growthperformance is relatively unexciting.

It is worthwhile to discuss developments in the term insurance market in recentyears, which we believe were independent of the overall fluctuations in demandfor fixed and variable product lines. In our view, demand for term insurance from1997 through 2000 benefited from a decline in premium rates (a function of cheapreinsurance) and the proposal/adoption of Regulation XXX (threat of rising ratesrelated to more onerous reserving standards). In 2001, sales of term insurancedeclined 9%, which followed the adoption of Regulation XXX in 2000.

Figure 76: Individual Life Insurance Sales Growth Rates, 1995-9mos02

-60%

-50%

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

1995 1996 1997 1998 1999 2000 2001 9mo ’02

VUL VL Term Universal Whole Total

Source: LIMRA.

Another factor affecting growth in overall life sales is the lack of demand forestate planning-related coverage. In 2001, Congress passed estate tax reform thatgradually lowers the top estate tax rate from a peak 55% level to 39% by 2010with total elimination of the estate tax in 2010 (Congress must vote to extend therepeal in order for the tax to be eliminated beyond 2010). Some industryobservers argue that the one-year repeal is a non-issue given that extension in2011 is highly uncertain. However, recent survivorship sales suggest that themarket is at least considering the possibility that estate taxes are gone forever(Figure 77), which also seems to be a more realistic assessment given the shift toRepublican control of Congress. We still believe that there is an opportunity forsome insurers to provide value to the estate planning market, but the passage ofthis legislation could make the growth opportunity more elusive.

Figure 77: Individual Life Insurance Growth Rates, 1Q99-3Q02

-50%

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

1Q99

2Q99

3Q99

4Q99

1Q00

2Q00

3Q00

4Q00

1Q01

2Q01

3Q01

4Q01

1Q02

2Q02

3Q02

Total Individual Life Sales Survivorship Life Sales

Source: LIMRA.



Many individual health insurance products (e.g., Medicare supplement insurance)have relatively modest growth prospects, in our view. Companies that aregrowing at an attractive rate in these lines are probably gaining market share as aresult of compelling distribution strategies. The markets for disability income andlong-term care insurance, on the other hand, are theoretically substantial, but bothhave been slower to develop than many expected. Although these lines ofbusiness have not met bullish expectations, group disability income and long-termcare insurance have generated respectable top-line growth. According to JohnHewitt & Associates, group disability in-force premium increased at a compoundannual growth rate of approximately 10% over the past ten years (through 2001).In 2002, we believe that growth was 7% to 8%. In long-term care, sales havecompounded at a 13% annual rate in recent years, with growth of approximately10% in 2002. The argument for accelerating growth is that the market is less than10% penetrated, but the challenge is getting the remaining 90% to recognize theneed for coverage and display a willingness to pay what some may view assubstantial annual premiums for a product with no cash value feature. This is thesame challenge faced in the individual disability income market, where earnedpremium growth has been in the low single-digits in recent years.

Where Could We Be Wrong?

We acknowledge that there are many moving parts in analyzing the growthprospects of the U.S. life insurance industry, and therefore realize the potentialshortcomings of our assessment. Many macro factors favor financial companies,and in particular those selling tax-advantaged savings products. For example,insurers offering savings-oriented products should continue to benefit fromdemographic trends in the U.S. It is estimated that the number of pre-retirementsavers will grow at an annual rate of 2.5% from 2000 through 2010, providing aconstant flow of demand. The question is whether this will have an incrementalpositive impact on the demand for savings-oriented life and annuity products,especially given that this growth is similar to what we have witnessed during thepast five years. In addition to demographics, the conversion of defined benefitpension plans to defined contribution plans in the public sector could be a sourceof steady demand for insurance products and advice-driven insurance services.We may be conservative in our estimate of the impact from this shift in retirementplans. In the disability and long-term care markets, the population remains highlyunder-penetrated. Any catalyst that could drive increased recognition of theimportance of these products could prove our estimates to be low. And asdistribution channels change, so could the penetration levels for certain products.For example, approximately 70% of the middle market will never see a traditionalinsurance agent, and instead are prime targets for worksite marketing efforts.

Waiting for the under-penetrated market story in

supplemental health



10. A Comprehensive Approach to ValuationIn our opinion, it is useful to employ a somewhat sophisticated approach tovaluation when investing in life insurance stocks because several “valuation traps”exist. For example, above-average growth does not necessarily warrant a premiumvaluation, and a high growth company may in fact deserve a discount valuation. Aswe discussed in the previous section, the life insurance industry consistentlyproduces a return on equity that is only modestly above the equity cost of capital.Therefore, there appears to be a fine line in the life insurance industry betweenearnings growth that creates shareholder value and earnings growth that destroys it.Because growth that is a function of investing at returns below the cost of capital isundesirable, we easily could justify paying a higher price-earnings multiple for a lowgrowth, high marginal return company than we could for a high growth, lowmarginal return company. We strongly believe that the pursuit of earnings growthfor its own sake does not create value for shareholders.

Our Valuation Methodology

Our valuation model computes the present value of an estimated future stream ofinternally generated excess capital – not simply dividends per share. Thismethodology includes the following steps:

1. We determine whether the current level of earnings is indicative of a“normalized” ROE. For example, if a company has completed an acquisitionthat will produce expense savings in the future, we probably will consider“normalized” earnings to be something in excess of latest 12-month earnings.

2. We forecast marginal return on equity, the return generated by eachincremental dollar invested in the business. It is necessary to make thedistinction between average and marginal ROE largely because it is themarginal return that determines the amount of capital that is needed to fundgrowth. There is limited information available on marginal returns, so ourgoal is to be at least directionally correct with our forecast. Given the highlevel of competition in the fastest growth product lines, we typically assumethat marginal returns are lower than average returns. For example, we believethat heightened competition in the variable annuity business (e.g., aggressiveinterest rates offered on dollar-cost averaging options) suggests that returnsare lower at the margin.

3. We estimate the long-term or secular earnings growth rate by considering thecompany’s business mix and its competitive position in each market segment.Our growth forecast relates to earnings, not earnings per share.

4. The fourth step involves a modified use of the sustainable growth rate formula(return on equity multiplied by the earnings retention rate equals growth).Instead of solving for growth (the traditional use of the formula), we inputmarginal return on equity and our secular growth forecast to solve for thepercentage of earnings that must be retained to fund future growth. We thenassume that the remaining percentage of earnings (“excess capital”) can beused to pay dividends, repurchase stock, or make acquisitions. We check thereasonableness of our cash distribution assumption by comparing it tostatutory operating earnings, which are indicative of the cash flow that can bemost easily up-streamed to the holding company.

5. We calculate the present value of the stream of “excess capital” to computeour estimate of intrinsic value. We tend to use similar discount rates for alllife insurers, but there are a few companies for which a higher risk premiumseems appropriate. We utilize discount rates between 10.25% and 11.25% formost of the companies on our coverage list.

There is much more tovaluation than P/E

In our model, we consider…

Normalized earnings

Marginal ROE

Long-term growth rate

Capital required to fund growth

Discounted excess capital



6. As a reality check, we look at the projected price-earnings multiple for thestock based on our fair value estimate and compare it to the stock’s historicalP/E ratio on expectations relative to the S&P 500. If our fair value estimatesuggests a P/E that is above or below the historical range, we will revisit (butnot necessarily change) our assumptions.

Approach May Facilitate Cross-Border Comparisons

Our modified dividend discount model methodology may help facilitate cross-border valuation comparisons. We believe that embedded value – the presentvalue of in-force business plus the capital supporting the business – is aworthwhile tool to gauge the relative attractiveness of life insurers in differentcountries. At this point, U.S. companies do not disclose embedded value figures.However, by using the dividend discount model, we believe it should be possibleto generate a rough measure of embedded value. Specifically, if we set themarginal return on equity assumption equal to the cost of capital estimate (thediscount rate), our model would theoretically compute a value that is only basedon in force business.

Earnings Yield Shows Relative Attractiveness

It is reasonable to be at least a little skeptical about the usefulness of relative price-earnings multiples for the valuation of life company shares. Earnings for themarket are more sensitive to the economy, which can distort the relative multipleanalysis because life company earnings do not deviate as much from a normalizedlevel. For example, a low relative multiple may not be particularly meaningful ifearnings are well below trend for the S&P 500. As a check on the relative P/Eanalysis, we think that it makes senses to directly compare the valuation of lifecompany shares with interest rates (Figure 78).

Figure 78: ML Index - Ratio of Earnings Yield to 10 Year Treasury Yield, 1990 – 2002

80%

100%

120%

140%

160%

180%

200%

220%

240%

260%

280%

12/89 12/90 12/91 12/92 12/93 12/94 12/95 12/96 12/97 12/98 12/99 12/00 12/01 12/02

UNDERVALUED

OVERVALUED

Note: Horizontal lines represent the mean and one standard deviation above and below the mean.Sources: Company reports, I/B/E/S and Merrill Lynch estimates.

We look at the ratio of the earnings yield (or inverse of the absolute price-earningsmultiple on forward earnings calculated using consensus estimates) to the 10-yearTreasury yield. The idea is that the spread between the earnings yield and therisk-free rate should be wide enough to compensate investors for owning aparticular life insurance stock or the life group in general. We show one standarddeviation above and below the mean to illustrate unusual divergences from theaverage. This measure has proven to be predictive of relative stock priceperformance since the end of 1989, and especially for longer holding periods(Figure 79).

Use P/E as a check

Special case of modified DDMyields similar results to

embedded value calculation

The ratio of earnings yield tointerest rates can identify

attractive relative valuationopportunities



Figure 79: Distribution of Life Index Relative Total Return, 12/31/02

-20%

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0%

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20%

30%

40%

50%

60%

70%

> 1 std deviation belowthe mean (overvalued)

0 to 1 std deviationbelow the mean

0 to 1 std deviationabove the mean

> 1 std deviation abovethe mean (undervalued)

6 Month 12 Month 24 Month


Focus on Both Average and Marginal ROE

The historical 12% to 14% return on equity for the stock life insurance industryindicates that average returns are not exceptional. More important, however, isour concern that heightened competition in the industry has driven marginalreturns on equity below average returns. For example, in our valuation model wetypically assume that marginal returns on equity are equal to or lower than averagereturns. It is necessary to make the distinction between average and marginalreturn because marginal return on equity should determine price-earningsmultiples over the long term. It is easy to prove this notion mathematically usingthe dividend discount model (Table 63).

Table 63: Marginal (Not Average) ROE Determines P/E Multiple

Company X Company YBook value per share 10.00 10.00Earnings per share 1.50 1.00Average return on equity 15% 10%Dividends per share 0.75 0.50Payout ratio 50% 50%Marginal return on equity 10% 10%Earnings and dividend growth 5% 5%Cost of capital 11% 11%Intrinsic Value 13.13 8.75Price/earnings ratio 8.8 8.8

Note: Earnings and dividend growth = marginal ROE x earnings retention. Earnings retention = (1 - payout ratio).Source: Merrill Lynch.

We also find it instructive to use the dividend discount model to disprove thenotion that a higher growth rate necessarily warrants a higher price-earningsmultiple. Table 64 illustrates that earnings growth achieved by investing at returnsbelow the cost of capital destroys value. In our example, if the management ofCompany Z pursues the low growth, high dividend payout strategy, the stockshould sell at a 60% higher multiple than if management pursues the high growth,low dividend payout strategy.

Average ROE tells onlypart of the story



Table 64: Faster Growth Does Not Necessarily Mean Higher P/E Multiple

Alternative Strategies for Company Z

Low Payout/High Growth High Payout/Low GrowthBook value per share 10.00 10.00Earnings per share 1.20 1.20Average return on equity 12% 12%Dividends per share 0.12 0.60Payout ratio 10% 50%Marginal return on equity 10% 10%Earnings and dividend growth 9% 5%Cost of capital 11% 11%Intrinsic Value 6.54 10.50Price/earnings ratio 5.5 8.8


P/E-to-Growth Valuation Methodology is Flawed

To test our view that investors need to know more than just projected earningsgrowth to determine the appropriate price-earnings multiple for life insurance stocks,we examined the relationship between P/E and both near-term (one year) and long-term projected earnings growth during 1987-1996 using I/B/E/S data. The outcomewas that near-term and long-term growth expectations – on average – explained only15% and 9%, respectively, of life insurance company price-earnings multiplesduring this period. The low correlation between valuation and growth suggeststhat the market assigns substantial weight to the other factors that determinevaluation (return on equity and risk). Clearly, a high return company with goodgrowth prospects deserves a substantial valuation premium to a high returncompany with limited growth prospects. Our point is that the simplistic approachof ranking companies by earnings growth rates in isolation does not work well inthe life insurance industry.

Shortfalls of Price-to-Book versus ROE Model

Price-to-book versus return on equity is a common valuation methodology used toassess the attractiveness of insurance stocks. Although this approach is more usefulthan the P/E-to-growth method, we believe that investors need to know more than justaverage return on equity to determine the appropriate price-to-book multiple for lifeinsurance stocks. Conceptually, this approach is incomplete because it does notconsider marginal return on equity, growth, and risk. The “valuation trap” associatedwith ignoring future growth prospects is illustrated in Table 65. In this example, thecompany generating faster earnings growth deserves a substantially higher (greaterthan 50%) price-to-book multiple than the slower growth company – even though bothare producing the same return on equity.

Table 65: Price/Book vs. ROE Model Does Not Consider Future Growth

High Growth Low GrowthBook value per share 10.00 10.00Earnings per share 1.20 1.20Average return on equity 12% 12%Dividends per share 0.20 0.40Payout ratio 17% 33%Marginal return on equity 12% 12%Earnings and dividend growth 10% 8%Cost of capital 11% 11%Intrinsic Value 22.00 14.40Price-to-book ratio 2.20 1.44


Low correlation between P/Eand growth limits

usefulness of PEG ratio

The relationship betweenaverage ROE and P/BV

doesn’t incorporatefuture growth, returns and risk



The “valuation trap” associated with ignoring marginal return on equity isdepicted in Table 66. In this example, both companies are generating a 12%return on equity. However, let’s assume that one company is in the highlycompetitive term insurance business (a 10% marginal ROE), while the other isrealizing the benefits of scale economies (a 14% marginal ROE). Under theserealistic assumptions, the higher marginal return company deserves to sell at 1.6times book value, while the lower marginal return company deserves to sell at amodest discount to book. Using the price-to-book versus average return on equitymodel, the erroneous conclusion would be that each stock deserves to sell at thesame multiple of book value.

Table 66: P/BV vs. ROE Model Does Not Consider Marginal Returns

High Marginal ROE Low Marginal ROEBook value per share 10.00 10.00Earnings per share 1.20 1.20Average return on equity 12% 12%Dividends per share 0.63 0.40Payout ratio 52% 33%Marginal return on equity 14% 10%Earnings and dividend growth 7% 7%Cost of capital 11% 11%Intrinsic Value 15.53 9.85Price-to-book ratio 1.55 0.98Note: Earnings and dividend growth = marginal ROE x earnings retention. Earnings retention = (1 – payout ratio).Source: Merrill Lynch.

Thoughts on Catalysts and Perception

If the stock market taught life insurance investors anything during the late 1990s,it was that undervalued stocks can remain below intrinsic value for an extendedperiod. A catalyst for improving investor sentiment is critical. In our opinion, themost frequently discussed catalysts historically for life insurance stocks arerelative earnings, earnings estimate revisions and interest rates. Another catalystthat has received more attention in recent years is consolidation. We believe thatall of these factors drive investor sentiment.

� Relative Earnings Growth

In our opinion, strong relative earnings performance helped explain theoutperformance of the life group in 2000 and 2001(Figure 80). However, relativeearnings is not a perfect predictor of stock price performance, in our view. Forexample, the group outperformed the market in 2002 even though earnings growthcompared unfavorably to the S&P 500.

Figure 80: Operating EPS Growth Comparison, 1990-2003E

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30%

91/9

092

/91

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294

/93

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/95

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698

/97

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800

/99

01A/0

0

02E/0

1A

03E/0

2E





� Revisions to Near-Term Earnings Expectations

In our view, there is little doubt that earnings estimate revisions are important forstock price performance. Revisions to expectations reflect new information and, notsurprisingly, often produce a reaction in the stock price. The relationship betweenrelative total return and relative earnings estimate revisions for the Merrill LynchLife Insurance Index has been meaningful over time (Figure 81), with correlationcoefficients of 63% for the past ten years and 73% for the past five years.

Figure 81: Relative Total Return vs. Relative EPS Estimate Revisions, 1985-2002

60

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160

180

200

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240

12/85 12/86 12/87 12/88 12/89 12/90 12/91 12/92 12/93 12/94 12/95 12/96 12/97 12/98 12/99 12/00 12/01 12/0260

80

100

120

140

160

180

200

220

240

Relative Total Return Index, 12/85 = 100 (Left Axis)

Relative EPS Estimate Revisions Index, 12/85 = 100 (Right Axis)

Correlation Coefficients10 years = 63% 5 years = 73%

Note: The revision indices are based on current-year estimates from January through June and on following-yearestimates from July through December. Total return and revisions are relative to the S&P 500.Sources: Compustat Monthly PDE Database and I/B/E/S.

Even though equity-sensitive business lines have created more earnings volatility forthe life industry, the group still generates a reasonably predictable earnings stream.Therefore, it is often what is going on with earnings expectations for the S&P 500that will determine the degree of interest in life insurance stocks (Figure 82). In1999, earnings revisions were positive for the market, which led to a relatively lessexciting outlook for the life group. To illustrate, operating EPS growth wasapproximately 14% for the Merrill Lynch Life Insurance Index in 1999, which wasdown modestly (perhaps two percentage points) from our estimate at the beginningof the year. In contrast, the growth in S&P 500 operating earnings per share was21% in 1999, which compared to Merrill’s forecast at the beginning of 1999 thatEPS would decline 4.5%.

Figure 82: Earnings Per Share Estimate Revisions, 1988-2002

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12/87

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/89

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012

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212

/93

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412

/95

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2


Note: The revision indices are based on current-year estimates from January through June and on following-yearestimates from July through December.Source: I/B/E/S.

Relative earnings revisions area timing tool and fundamental

indicator



Of course, the correlation between revisions and stock performance is not perfect,proving stronger in some market environments and weaker in others. For example,in 2000 S&P 500 earnings expectations were revised upward by 11% from thebeginning to the end of the year while the revisions for the Merrill Lynch Life Indexwere negative 2% during the same period. Despite these revisions, the life groupdramatically outperformed the market during 2000. We attribute this apparentinconsistency to the historic low valuations that the life insurance group reached inMarch 2000, combined with the dramatic market rotation that occurred throughoutthe year. As with any other metric used in determining future stock priceperformance, revision trends cannot be used in isolation of other factors. Forexample, in 2000 the volatility and decline in the NASDAQ led investors to look forsafe haven groups. Later in the year, the markets’ concern broadened to include theearnings outlook for the S&P 500 (a flat growth expectation for 2001, which provedto be optimistic). These factors, in our view, contributed to substantialoutperformance for the life insurance group despite negative relative revision trendsduring 2000.

If we have a high degree of conviction that a life company’s earnings will exceedexpectations, we probably will stick with the stock longer than valuation mightjustify. For example, we remained positive on SunAmerica’s shares (until thecompany entered into a merger agreement with American International Group)despite a full valuation because we had a high degree of confidence that thecompany would continue to deliver positive earnings surprises. We will not,however, become aggressive on a name that we perceive to be fully valued.

� Interest Rates

Life insurers’ earnings have been relatively stable despite a variety of interest rateenvironments since the mid 1980s, suggesting that the industry’s fundamentals arenot as sensitive to interest rates as some might think. In addition, the argumentthat life insurance companies are “leveraged bond funds” is at least somewhatflawed because it only considers the change in the value of assets when interestrates change, and ignores the change in the value of liabilities. Therefore, eventhough most insurers probably have assets of longer duration than their liabilities,the economic effect on equity is not as pronounced as commonly perceived.However, we still believe that the perception of the industry as “interest sensitive”will lead to stock price reactions when interest rates change by a substantialamount or reverse direction versus expectations. From a fundamental standpoint,the worst interest rate environments for insurance companies probably include oneor more of the following: (1) a flat yield curve; (2) substantial volatility; (3) veryhigh rates; and (4) very low rates.

� Consolidation

Prior to 2000, the last big year for the life insurance group from a stock marketperspective was 1997, when the Merrill Lynch Life Insurance Index outperformedthe S&P 500 by more than 17 percentage points. The strong relative showingoccurred despite a negative trend in earnings estimate revisions. In our opinion,the absence of positive earnings revisions – or a “traditional catalyst” for highervaluations – was overlooked by investors, who instead focused on a new catalyst,consolidation.

Consolidation became a major theme for the life insurance group beginning in1995, when the dollar amount of activity was more than double the level of theprevious year. During 1996-1997, four stocks in the Merrill Lynch Life InsuranceIndex were acquired. The acquisition landscape in 1998 and 1999 was marked byfewer, but very large deals (AIG acquired SunAmerica in 1998, Aegon boughtTransamerica in 1999). During this period – particularly in 1999 – life stockvaluations languished. In 2000, consolidation in the sector again accelerated. Theprimary catalyst for acquisitions during this period was the depressed valuation(single digit multiple) that the group reached in early 2000. It was this substantial

Stock price reaction torate changes may be

a function of perception –not necessarily reality

Consolidation has been apositive catalyst in recent years,

which should continue



gap between public and private market values that ultimately sparkedconsolidation in the spring of 2000. During that year, Hartford Financial boughtin the share of Hartford Life that it did not already own, AXA Group purchasedthe public interest in its U.S. life insurance and asset management unit AXAFinancial, and ING acquired ReliaStar after several years of takeout speculation.The increased activity fueled investor enthusiasm, and consolidation was yet againa theme for the group. For the full year (which included dreadful relativeperformance in 1Q00), the Merrill Lynch Life Insurance Index outperformed theS&P 500 by 60%. Deal activity has been limited recently, however, as the lastmajor transaction was AIG’s purchase of American General in 2001.

Non-U.S. companies had been a driving force behind the upsurge in consolidationactivity in the U.S. market, but have been silent during the last couple of years, asvaluations have fallen dramatically for European insurers. Since the mid-1990s,European insurers were the acquirers in six of the ten largest U.S. life companytransactions. As a result of these deals, companies like Aegon and ING emergedas leading players in the U.S. life market from relatively small positions in themid-1990s (Table 67). Although we still believe that Europeans are interested inthe U.S. market, the declines in their share prices have made it virtuallyimpossible to pay the premiums that were common during the late 1990s. Forexample, Aegon paid 21 times forward earnings for Transamerica in 1999, but itsstock price was four times the current level.

Table 67: Europeans are Now a Force to be Reckoned with in the U.S.

1995 2001Assets Market Share Assets Market Share

Aegon $32,662 17 $135,047 5ING 9,295 51 123,247 7

Note: Assets are in $ millions.Source: A.M. Best

We do not believe that North American life companies are particularly interestedin developed markets in Europe, but have been active in Japan and emergingmarkets. For example, after building a presence in the U.K. through acquisitions,Lincoln National’s operation in that market is essentially in a runoff mode becausethe company was unable to sell it. In Japan, North American companies havepurchased failed life insurers where a restructuring of assets and liabilities (e.g.,interest rate guarantees) has allowed for high returns on investment. In mostcases, however, these types of acquisitions have been more financial in nature thanstrategic. General Electric, AIG, Manulife and Prudential have all completedacquisitions of this type in Japan. Finally, we see most U.S. life companies withan interest in expanding internationally focused on smaller acquisitions inemerging markets, with the top-end of deal size probably $1 billion. For example,in May 2002, MetLife announced that it has successfully bid for the privatizationof Aseguradora Hidalgo, S.A. (Hidalgo), Mexico’s largest life insurer. Theacquisition price was $965 million. MetLife has operated in Mexico since 1992,but this acquisition made the country the largest single contributor within theInternational segment, and dramatically increases this segment’s earningscontribution to MetLife’s bottom line. We estimate that the International segmentwill account for 7% of MetLife’s total earnings in 2003, which compares tomanagement’s long-term goal of 20% of total profits from outside the U.S.

Since 2000, the valuation of the group has improved and consolidation has beenmore targeted. Aside from American International Group’s acquisition ofAmerican General, much of the M&A activity has been focused on filling gaps ordivesting non-core businesses (e.g., Lincoln National’s sale of its reinsurancebusiness to Swiss Re, Aegon’s purchase of JC Penney’s Direct Marketingbusiness, Prudential’s announcement to acquire American Skandia). We believethat recent developments support the notion that, at the very least, consolidation

Europeans show big interest inU.S. market

No reciprocation from U.S.companies

Consolidation may create a floor for the valuation

of the group



puts a floor on the valuation for the group over the long term. We believe that anunderperforming life insurance company cannot remain an underperformerindefinitely (i.e., it eventually will be acquired). Also, when a good or averagecompany loses favor with investors, it may make sense to risk “being early” in thename because most publicly traded life insurers could be potential takeovercandidates.



11. Some Basics

What Is Insurance?

Conceptually, insurance is a mechanism by which risk is transferred from anindividual person to a large group of people. In return for a periodic payment,usually called a premium, the insurer agrees to compensate the individual if aninsured event occurs. The purpose of insurance is the reduction of the financialloss associated with the insured event. Essentially, the premium-paying groupshares the loss with the individual. In the world of life insurance, a typicalexample would involve the purchase of a life insurance policy and the subsequentdeath of the insured during the coverage period. For the beneficiary of the policy(usually a spouse), the receipt of the death benefit would temper the financial loss(typically related to the loss of future income) of the death of the policyholder.

Insurance is based on mathematical probability and depends heavily on theconcept of the law of large numbers, which states that the deviation from theexpected outcome will fall as the number of cases increases. Actuaries use thefollowing variables in the calculation of life insurance premiums:

• Mortality Rates: The relative frequency of death in a population is affectedby health, gender, socioeconomic status, occupation, smoking status and othervariables.

• Interest Rates: Current interest rates affect many factors including thecompany’s expected yield on investments and an appropriate discount rate forpresent value calculations.

• Loading: This component of premium is designed to cover operatingexpenses, provide an allowance for lost income from policy lapsation, create acontingency fund for unexpected events (e.g., a natural disaster) and build in amargin for profit. Some consider loading the most substantial differentiatingfactor among companies in terms of pricing strategy.

By way of definition, a policy’s gross premium is the sum of the loading and thenet premium. The net premium is the minimum amount necessary to cover thepolicy’s promised benefit, based only on mortality and interest rate assumptions.A policy lapse is the discontinuation of a policy as a result of the nonpayment ofpremiums. Lapses figure heavily into the calculation of the gross premium.

Types of Life Insurance Companies

There are two major types of life insurers – stock companies that are shareholder-owned and mutual companies that are policyholder-owned. In recent years, ahybrid structure has emerged called the mutual holding company. Also, fraternalbenefit societies (organizations whose members have a common religious, ethnic,or trade background) and a small number of banks can serve as insurers. By far,the most common structure is the stock insurance company. At the end of 2000,91% of all life insurers were stock companies. However, mutuals tend to be muchlarger than the average insurance company. According to A.M. Best, at year-end2000, 9% of all life insurers that were owned by policyholders controlled 26% ofthe total industry assets.

� Stock Company

A stock life insurer is owned by one or more shareholders. The shares may bepublicly traded or privately held. Shareholders have the right to vote on certaincompany issues and on the appointment of members of the board of directors, butgenerally do not get involved with the day-to-day management of the company.Benefits of the stock company structure include access to the capital markets andthe ability to use stock as a currency for acquisitions. Management is heldaccountable to shareholders via the oversight of the board of directors.

Insurance transfers the riskof loss from an individual

to a large group

Most insurers are stockcompanies, but those that are

mutual are generally very large



� Mutual Company

In the mutual form, the insurer is operated for the sole benefit of the policyholders,thus the policyholders are the “owners” of the company. Each policyholder hasthe right to vote on certain company issues. Unlike stockholders, policyholderscannot trade their ownership interest in the mutual company to otherpolicyholders/investors. Although mutual policyholders theoretically haveproprietary rights (e.g., control of the board of directors), these rights are not oftenexercised.

A demutualization is the conversion of a mutual insurer to a stock company form.Under the traditional demutualization structure, eligible policyholders receivestock or cash in exchange for their membership rights. Essentially, it is a“buyout” of the policyholders (who, as the “owners” of a mutual insurer, becomeshareholders in the stock insurance company). An actuarial valuation of existingpolicies is required for allocation of the equity to individual policyholders. Inaddition, a full demutualization typically involves (it may be mandatory) an initialpublic offering of the stock holding company’s common shares. For a morecomplete discussion of demutualization, please see our report, Shootin’ Fish in aBarrel, September 17, 1998.

� Mutual Holding Company

A mutual holding company (MHC) is a hybrid of the stock and mutual structures.Under the MHC structure, the mutual is converted into a stock life insurancecompany. An intermediate stock holding company owns 100% of the formermutual life insurer. In turn, a newly created MHC (which contains thepolicyholder membership rights associated with the mutual insurer) controls thestock holding company. The MHC must retain 50.1%-100% voting control of thestock holding company, although the economic interest may fall to lower levels insome instances. The remaining 0%-49.9% voting interest of the stock holdingcompany may be held by potential new shareholders (i.e., buyers in an IPO).Subject to the voting interest limitation, the stock holding company may issueequity periodically after the conversion. Also, the MHC structure allows for a fulldemutualization at a later date. Approximately 30 states (including New York) donot allow the formation of mutual holding companies.

Tax Advantages of Life Insurance Products

Besides being a mechanism by which risk is transferred from an individual to agroup (a way to ameliorate financial loss when insured events occur), lifeinsurance products also offer purchasers important tax advantages.The key tax benefits of life and/or annuity products in the U.S. are as follows:

� Death Benefits

Death benefits from a life insurance policy are not subject to income taxes, ingeneral. This is true even though the proceeds likely will exceed the premiumspaid for the insurance. The exceptions to the general rule include:

1. The circumstance in which the policy is transferred to another individual forconsideration. In this case the death benefits less the premiums paid would betaxable.

2. The failure of the policy to meet the IRS definition of life insurance. Thiswould happen if the IRS determined that the policy is more investment thanprotection oriented. The protection portion would not be taxed, while theinvestment portion would be subject to taxation.

3. Other situations such as the payment of the proceeds to a creditor of theinsured; the receipt of the proceeds as alimony; or the lack of an insurableinterest at the time the contract was established, reducing the policy status tothat of a wager.

Mutual companies areowned by policyholders

MHCs are a cross betweenstock and mutual companies

Tax advantages are among thetop benefits of life insurance



4. Interest earned on the death benefit is taxable. Death benefits can accrueinterest from the date of death, but the distribution to the beneficiary can bedelayed or even spread out in installments. The interest income that accruesis taxable.

� Policy Loans

In general, policy loans are not taxable. Therefore policyholders can borrowagainst the cash value of the policy without incurring a tax. However, interestpaid on policy loans generally is not deductible.

� 1035 Exchanges

This tax-free exchange of one policy for another is subject to stringentrequirements. If executed properly, the tax basis of the contract does not changeand does not subject the holder to capital gains taxes that might otherwise occur.

� Inheritance Taxes

Some or all of the death benefits are not subject to state inheritance taxes,provided the proceeds go to certain beneficiaries.

� Tax Deferral

Taxes are deferred on the inside buildup (interest credited, investment income andcapital gains) of life insurance products and annuities. In tax-qualified plans,contributions are also on a pretax basis.



12. A Highly Regulated IndustryRegulation of life insurance companies exists to ensure solvency of the insurers aswell as the fair treatment of customers. Regulation generally is the responsibilityof the individual states, as per the McCarran-Ferguson Act of 1945. The U.S.Congress rarely has intervened in the regulation of insurance companies, althougha change is possible if financial services’ reform legislation is passed. Stateregulators’ responsibilities reach across the spectrum of life insurance activities –licensing companies and agents to do business in a state, examining a company’sfinancials, handling complaints, and closing operations of insurers that are not incompliance with state codes.

All life insurance companies are corporations; sole proprietorships and partnershipsare prohibited from issuing life and health insurance. Once an insurance companyestablishes domicile in its home state, it must apply to the insurance departments inother states to obtain a license to operate there. Once licensed in a state, the lifeinsurer must comply with the insurance laws of that jurisdiction. Each state has itsown minimum financial criteria for insurance companies.

Problems in Early 1990s Led to Risk-Based Capital

One of the primary goals of insurance regulation is to promote solvency within theinsurance industry. During the last few decades, competition from other financialservices industries and the interest rate and capital markets environment havefostered intense competition for the consumer savings dollar. This intensecompetition has stimulated innovation and has caused the development of interestsensitive products, such as universal life, and variable insurance products, such asvariable life and variable universal life. Unfortunately, it also led a number ofcompanies to promise exceedingly high returns to the consumer. To guaranteethese returns, insurers invested in higher returning, and riskier, assets such as junkbonds and real estate. As these assets declined in value or defaulted in the late1980s and early 1990s, a number of insurers became insolvent, including somelarge companies (e.g., First Executive and Mutual Benefit Life).

To combat this problem, the NAIC developed risk-based capital (RBC). Risk-based capital is a measure of the capital an insurer should have on hand to assureits solvency. The idea is that, as an insurer exposes itself to more risk, it shouldhave more capital. Regulators use this concept to assess whether an insurer’sstatutory capital and surplus is adequate.

In order to calculate an appropriate level of RBC, the NAIC classified risk intofour categories.

• Asset Risk: The risk of investments defaulting or decreasing in market value.This is also known as C-1 risk, and accounts for nearly 75% of total RBC.

• Insurance risk: The risk of a product being priced poorly and thesusceptibility to adverse mortality or morbidity. This is also known as C-2 risk.

• Interest Rate Risk: The risk of loss associated with a change in interest rates.Adverse interest rate movements can materially affect both asset performanceand obligations to the policyholders. This is also known as C-3 risk.

• General Business Risk: The risk of fraud, mismanagement, competition, etc.This is also known as C-4 risk.

Regulators analyze these four risks to derive an authorized control level RBC, aquantitative measure of the risk inherent in the particular insurer’s business. Thenthe insurer’s total adjusted capital is calculated. The total adjusted capital is thesum of: (1) the insurer’s capital and surplus; (2) the AVR; (3) half of the dividendliability; and (4) the insurer’s ownership share of the AVR and dividend liabilityof any subsidiaries. The risk-based capital ratio is the ratio of total adjustedcapital to the authorized control level RBC. The magnitude of the RBC ratio

Regulation of life insurers issubstantial, and resides at the

state level

Risk-based capital is designedto measure (and manage)

solvency in the industry



determines what action, if any, is required. For RBC ratios greater than 250%, noaction is required, even if the ratio has been trending downward. If the RBC ratiois between 200% and 250%, no action is required, unless a trend test uncovers ameaningful deterioration of the ratio over time.

• Level 1: Company Action. For RBC ratios of 150%-200%, the insurer mustsubmit a plan to the insurance commissioner regarding bringing the RBC ratioback into compliance. Also, in the case of an unfavorable trend test and a200%-250% RBC ratio, an insurer would be deemed to be at the companyaction level.

• Level 2: Regulatory Action. For ratios of 100%-150%, the insurancecommissioner begins the rehabilitative process for the insurer.

• Level 3: Authorized Control. At 70%-100%, the insurance commissionerhas the authority to either take corrective actions for the insurer or liquidatethe company.

• Level 4: Mandatory Control. For RBC ratios below 70%, thecommissioner must seize the insurer and can elect either to take correctivemeasures or to liquidate the insurer.

In the real world, when insurers talk about risk-based capital ratios, thedenominator is typically the company action level. Therefore, when a stockcompany states that the RBC ratio is 200%, this is the equivalent of 400% in thestatutory filings.

The NAIC Seeks Homogenization

The National Association of Insurance Commissioners (NAIC), although notaffiliated with the federal government, exercises considerable influence in theregulation of insurance companies by the individual states. The purpose of theNAIC is the homogenization of regulations across the states through thedevelopment of recommended standards and “model laws”. Although the NAIChas no official authority, states often adopt its recommendations. However, thereare several critical model laws that have not been adopted.

� Understanding Codification

In 1994, the NAIC began what turned out to be a seven year process (and stillgoing) to replace the old guidance for statutory accounting (Accounting Practicesand Procedures Manuals) with a new, more comprehensive and consolidated setof interpretations (NAIC Accounting Practices and Procedures Manual – effectiveJanuary 1, 2001). This “codified” statutory guidance amends some historicalapplication of the rules and adds guidance where no statutory rules previouslyexisted. Codification is intended to provide users of statutory financial statementswith greater comparability between companies and to give companies moreexplicit instruction for preparing their financial statements. We could probablyspend the next 100 pages outlining the specific issues addressed in these newrules, but such an exercise would be beyond the scope of this report (not tomention unnecessarily tedious for the reader). Instead, we list the impact that thenew guidelines had on the statutory capital and surplus of each company we coveras of 12/31/02 (Table 68).

The NAIC helps makeregulatory requirements

consistent across state lines

Codification providescompanies with new, clearer

statutory accounting guidance



Table 68: Impact of Codification on Statutory Capital & Surplus ($ in 00s)

12/31/01 SAP C&S Impact of Codification Impact as % of SAP C&SPrudential 6,420,194 1,000,000 16%Hartford 6,169,000 400,000 6%Torchmark 766,328 46,500 6%AFLAC 2,162,000 130,000 6%Nationwide 1,760,000 80,000 5%Jefferson-Pilot 1,548,000 42,000 3%MetLife 5,358,000 84,000 2%UnumProvident 3,378,700 45,600 1%StanCorp 641,900 6,100 1%Phoenix 1,149,800 (66,400) -6%John Hancock 3,513,600 Did not have a material impact NALincoln National 3,517,000 Was not significant NAPrincipal 3,483,800 Net impact was not significant NAProtective Life 775,138 No material impact NA

Note: Does not reflect positive impact for New York domiciled companies (MetLife and Phoenix) expected at 12/31/02.Sources: Company filings.

As the table illustrates, the adoption of the codified rules increased the capital andsurplus for all but one of the companies that quantified the impact of the newstandards. The experience was similar for the industry as the risk-based capitalratio increased from 287% in 2000 to 346% in 2001. New York companies willrealize a further benefit from codification in 2002. Effective December 31, 2002,New York domiciled insurers will recognize deferred tax assets on a statutorybasis, which brings this state’s regulation closer to the NAIC guidelines. Weestimate that both MetLife and Phoenix should see an increase in statutory capitaland surplus of between 5% and 10% in 2002 as a result of the changes to NewYork regulation.

The Bottom Line for Insurance InvestorsWe have discussed the impact that the new rules have on capital and surplus, but itmay not be clear what a higher level of statutory capital and surplus means toinvestors. Risk-based capital (RBC) is compared to actual capital and surplus todetermine capital adequacy. All things being equal, a favorable adjustment tocapital could mean that the RBC ratio is higher than previously, and that theincrease theoretically amounts to “freed-up” capital that could be re-deployed. Arelated topic is the ability of a life insurance company to pay dividends to theholding company. Depending on the state, dividend capacity is determined byeither the level of statutory operating earnings or capital and surplus (in somestates the lower of the two, in others the higher of the two).

Aside from the financial implications of Codification, some of the new disclosurerequirements can also add to an analyst’s overall understanding of the company.For example, the new guidelines required that companies following state regulationin lieu of NAIC guidelines must reconcile net income and surplus to the NAICpresentation. This reconciliation allows for apples-to-apples comparisons betweencompanies regardless of the insurers’ state of domicile. Also, the guidance seemsto make statutory financial statements more user friendly. There are severalamendments that incorporate GAAP-oriented treatment (e.g., premium income,income taxes, pension liabilities), which is the presentation that investors are mostfamiliar with. However, in some instances, Codification has made financialstatements more opaque, with the problem sometimes related to application ofGAAP concepts that have been modified slightly. For example, accumulationliabilities with insignificant mortality risk will be included in life reserves ratherthan be considered deposit liabilities. This presentation is less desirable, in ourview. Finally, codification has made year/year comparisons of industry data moredifficult to interpret. For example, top line trends are substantially distorted as aresult of the change in accounting for premiums and deposits.

Nearly all companies benefitfrom the codified rules

More capital maymean higher RBC ratio, which

could mean excess capital

Generally more disclosure, butnot always



The Watchful Eyes of Rating Agencies

A.M. Best (an agency dedicated to the insurance industry) and credit ratingagencies such as Moody’s Investors Service and Standard & Poor’s issue“financial strength” or “claims-paying ability” ratings on life insurers. Accordingto A.M. Best, the “objective of Best’s rating system is to evaluate the factorsaffecting the overall performance of an insurance company in order to provide ouropinion of the company’s financial strength, operating performance and ability tomeet its obligations to policyholders. The procedure includes quantitative andqualitative evaluations of the company’s financial condition and operatingperformance.” Depending on the product type and the distribution channel, aninsurance company’s ratings can be a very important marketing factor.

Quantitatively, rating agencies use an insurer’s profitability, capital structure andliquidity (the insurer’s ability to meet its obligations) as inputs for their ratingsmodels. Qualitatively, rating agencies consider many factors, including assetdiversification, reserve and surplus adequacy, management experience andpolicyholder confidence. Table 69 presents A.M. Best’s ratings categories fromthe highest rating to the lowest. Essentially every operating company owned by alarge, publicly traded life insurer has an A.M. Best rating in the A- to A++ range.

Table 69: A.M. Best’s Insurance Company Ratings Categories

Secure Ratings:A++ to A+ SuperiorA to A- ExcellentB++ to B+ Very GoodVulnerable Ratings:B to B- AdequateC++ to C FairC to C- MarginalD Very MarginalE Under State SupervisionF In Liquidation

Source: A.M. Best.

� Whether Agencies are Right or Wrong, They’re Right

In our opinion, the rating agencies are the de facto regulators of large publiclytraded life companies, and we believe that risk-based capital ratios support thisconclusion (Figure 83). Risk-based capital ratios for the life industry have beenwell above the minimum levels required by regulators, which suggests that capitallevels are driven by factors other than regulatory requirements. We believe thatthe rating agencies are the force behind the level of capital held by the industry,and that this is one of the significant challenges faced by publicly traded lifecompanies. Stockholder-owned life insurers are constantly striving to improvereturn on equity while rating agencies push for a capital cushion, which generallydepresses returns. Essentially, whether or not management believes that anagency is correct in its assessment of company and industry risk factors (whichdrive capital expectations), we believe that the expectations of rating agenciesmust be met if maintaining or improving credit ratings is a desired outcome.

Rating agencies impact insurersin capital raising (debt ratings)

and new business production(claims paying ratings)



Figure 83: Industry Risk-Based Capital Ratio, 1995 - 2001

0%

50%

100%

150%

200%

250%

300%

350%

400%

1995 1996 1997 1998 1999 2000 2001

Note: Ratio based on company action level, which is the most common presentation.Source: ACLI.

� Agencies Flex Their Muscles, not Always Predictable

The power of the rating agencies has been demonstrated during the past twelvemonths as concerns over credit risk and exposure to equity-sensitive businesseshave led to pressure on the ratings of some large publicly-traded life companies.We think that during times of stress for the economy and the market, thepredictability of rating agency actions is often difficult. For example, when onevariable annuity company was downgraded by a major agency, the analyst told usthat concern about a potential DAC charge was not the primary driver of the ratingaction. The next day, we heard a senior person from the same agency citeconcerns over DAC as a key reason for downgrading a different variable annuitywriter. In our opinion, it is difficult for life companies to meet the expectations ofagencies when, at least to some extent, those expectations are a moving target.



13. Two Main Product CategoriesFor GAAP financial reporting, two accounting standards (FAS 60 and FAS 97)prescribe the proper accounting treatment for most life insurance products. Priorto the adoption of FAS 97 in 1988, FAS 60 covered all life insurance producttypes. Now, FAS 60 applies to some products (mainly short-duration, accidentand health and traditional life insurance), and FAS 97 primarily applies to interest-sensitive life and investment products. We have included descriptions of lifeinsurance products of both basic types in Appendix B.

Prior to 1995, there was no GAAP accounting model for the participatinginsurance contracts sold by mutual life insurance companies. Participating lifeinsurance policies involve the payment of policyholder dividends, allowingpolicyholders to share in the financial results of the insurer. A participatinginsurance policy does not fit precisely with either FAS 60’s traditional contracts orFAS 97’s universal life-type contracts. In January 1995, the issuance of FAS 120provided a hybrid model for participating policies. FAS 120 applies to theparticipating policies of all mutual insurers. Stock companies may elect to applythe statement to their participating business. FAS 120 generally is more relevantfor mutuals because participating policies usually are not a major offering forstock companies. Because the purpose of this report is to provide a betterunderstanding of the financial results of stock insurers (particularly the publiclytraded ones), the discussion below focuses on FAS 60 and FAS 97.

The Difference Between FAS 60 and 97 Products

The starting point for understanding the classification of products as FAS 60 orFAS 97 is the duration of the contract (either short or long). According to FAS60, a short duration contract “provides insurance protection for a fixed period ofshort duration and enables the insurer to cancel the contract or to adjust theprovisions of the contract at the end of any contract period, such as adjusting theamount of premiums charged or coverage provided.” These products includeproperty and liability insurance and some term life insurance contracts. All shortduration contracts are FAS 60 products. A long duration contract, again accordingto FAS 60, “generally is not subject to unilateral changes in its provisions, such asa noncancelable or guaranteed renewable contract, and requires the performanceof various functions and services (including insurance protection) for an extendedperiod.” These contracts include, among others, whole life, some term life, andannuity contracts. A long duration contract can be either a FAS 60 or FAS 97product, with additional characteristics determining the classification.

Investment Contracts: If, according to the contract, an insurer is not subject tomortality or morbidity risk (in other words, it does not make payments contingenton the death, disability or continued survival of the policyholder), then thecontract is considered an investment contract. Mortality is the relative incidenceof death in a given time or place. Morbidity is the relative incidence of disabilitydue to disease or physical impairment. Investment contracts are FAS 97 products.

Universal Life-Type Contracts: According to FAS 97, a universal life-typecontract is one whose terms are not fixed and guaranteed. These terms include:(1) policy charges assessed by the insurer; (2) policyholder balances; and(3) premiums paid by the policyholder, which can be varied without the insurer’sconsent. This definition is not meant to include traditional participating or non-guaranteed premium policies. Universal life-type contracts are FAS 97 products.

Limited Payment Contracts: A limited payment contract is a long durationcontract whose payment period is shorter than the benefit period. Limitedpayment contracts are FAS 97 products.

Other: All accident and health contracts, as well as any contract whose premiumpaying period is the same as the benefit period or whose terms are otherwise fixedand guaranteed, are FAS 60 products.

FAS 60 applies to traditionalproducts & FAS 97 to

investment-oriented contracts

Short-duration products havefixed periods, can be cancelled,

and fall under FAS 60

Long duration contracts can beconsidered FAS 60 or FAS 97



Figure 84: Product Classification Flowchart

Insurance Policyor Annuity ProductInsurance Policy

or Annuity Product

FASB 60Short DurationPolicy

FASB 60Short DurationPolicy

LongDuration

?

LongDuration

?

FASB 60Long DurationPolicy




FASB 97InvestmentProduct

FASB 97InvestmentProduct

FASB 97UniversalLife-TypePolicy

FASB 97UniversalLife-TypePolicy

FASB 97Limited-PaymentPolicy

FASB 97Limited-PaymentPolicy

Mortalityor

Morbidity risk?

Mortalityor

Morbidity risk?

Accident and

health coverage

only

?

Accident and

health coverage

only

?

Adjustablepolicy charges or credits

-or-Nongauranteed policy values

-or-Flexible premium option

for policyholder?

Adjustablepolicy charges or credits

-or-Nongauranteed policy values

-or-Flexible premium option

for policyholder?

Premium

period shorter

than benefit

period

?

Premium

period shorter

than benefit

period

?

No

Yes

Yes

No

No

No

Yes

Yes

No Yes

Source: Accounting for Life Insurance and Annuity Products, Ernst and Whinney, 1988.



14. Understanding DistributionIn the second edition of our primer, we decided to enhance the section ondistribution for a variety of reasons. First, and perhaps most importantly, thedistribution issue is a wide-reaching topic that is a top strategic priority for most ofthe insurers we follow (Figure 85). Second, the changes in the distributionchannels and their increasing relative importance to the industry are creating newdemands on insurers. The response to these challenges is likely to be a factor indifferentiating between winners and losers in the industry, and therefore isimportant to study. Finally, we believe that distribution has historically been aconvoluted topic. In response to these points, this section highlights some of ourrecent findings on distribution, and provides some tools for investors to use in theinvestment decision-making process. Also, we have dedicated a portion toreviewing some basics on each channel, as well as important changes that areoccurring in each one.

Figure 85: Top Issues for Life Company CEOs

0%

10%

20%

30%

40%

Growth ImprovingProfitability

Distribution Sales ForceDevelopment

Strategic Issues GovernmentRegulation

All Companies Large Companies Midsize Companies Small Companies

Source: LIMRA , 2002.

Conclusions on Distribution Strategy

We have taken a very close look at many life insurers in our universe, andcombined their views on distribution with discussions that we had with many oftheir distribution partners. These individuals represented a wide cross-section ofdistributors including the companies’ own regional managers and producers(career), independent agents, independent financial planners, executives andbrokers at wirehouses and regional broker-dealers, as well as insurancedistribution managers at banks and independent broker dealers. As a result of ourmany discussions, the distribution picture crystallized, which led us to someimportant conclusions. A summary of these conclusions is presented below.

(1) In order to be successful in the new world, companies must have a clearlydefined strategy.

(2) There are two primary strategies that exist: (1) Advisor/Planning and(2) High Service/Low Cost. We believe that management must commit toone strategy in each relevant market, and the latter strategy cannot bebifurcated into two separate strategies.

(3) The demands on life insurance companies are increasing; the old days ofmanufacturing product and “pushing” it through an agency force are over.

(4) Flexibility on product and service are a prerequisite to gaining access andshelf space in alternative distribution channels.

(5) Although there have been many supporters of the “own to control” model, webelieve that it is possible to control without owning.

Distribution has become acritical issue for life insurers

A clearly defined strategy isessential, and it appears there

are two possibilities



(6) Technology is a critical part of a company’s strategy, and must become apervasive characteristic of the successful companies in the future.

Our bottom line is that although all companies are quick to suggest that they have“distribution”, we are not convinced that this is the case. We believe it is imperativethat companies have a focused strategy toward which they are working so they donot get “caught in the middle”. In the end, any company that wants to create afranchise in financial services must successfully tackle the distribution challenge.

� A Roadmap Might Help

In an effort to sort out the varied approaches to distribution, we developed adecision tree to help walk investors through the determination process of whethera company has a clearly defined strategy. (Please refer to the DistributionStrategy Decision Tree, a foldout located on the back cover of this report.) TheAdvisor/Planning Strategy route represents what we believe most traditionalcompanies will migrate toward, while the other strategy, High Service/Low Cost,is more likely for those companies pursuing alternative distribution channels.Although the decision tree is not designed to be all-inclusive, we believe it is agood start in evaluating where companies are in their strategic thought process.Additionally, the exhibit shows common questions that, when answered, can behelpful in assessing the clarity of a company’s direction.

Distribution: What It Is, Why It’s Important?

In the generally low margin, highly competitive life insurance industry, efficientand effective distribution is critical for success because it impacts many differentaspects of a life insurance company. First, distribution affects the market positionof an insurer. A good distribution system is instrumental in helping an insurer gainmarket share, which is necessary to generate attractive top-line growth given theslow-growth nature of the industry. Second, distribution affects the profitability ofthe business. If a distribution system is costly, product prices will be higher orinsurance margins will be lower. The more expensive the distribution system, thehigher the insurer’s overall acquisition costs. Given that acquisition costs aredeferred and amortized over the life of the policy, the actual cost of distribution canbe difficult for an investor to ascertain immediately. (For an in depth discussion ofDAC and its amortization, please see Section 17 of this report.)

Distribution is a top strategic priority for most of the insurers that we follow, atleast partially because there is a strong correlation between performance (asmeasured by growth and return on equity) and the quality and productivity of acompany’s distribution system. For example, stock companies generally havemore efficient distribution systems than do their mutual counterparts, a fact that isevident in the financial results. As seen in Table 70, stock life insurers havegenerally delivered better top-line growth and a substantially higher return onequity compared with their mutual company peers. We only considerperformance through 1999 meaningful because 2000 and 2001 results wereheavily influenced by large demutualizations, and 2001 data is further distorted bycodification of statutory accounting principles.

Distribution can determinethe success or failure

of a life insurer



Table 70: Statutory Premium and ROE Comparison

Premium Growth Operating ROE

Stock Mutual Stock Mutual1989 4.6% 8.2% 12.7% 7.6%1990 5.3% 15.0% 13.6% 10.6%1991 -0.7% 3.7% 12.6% 8.8%1992 7.0% 4.0% 11.8% 9.1%1993 13.0% 2.4% 12.4% 9.6%1994 7.1% 3.2% 12.2% 5.9%1995 6.8% 0.6% 12.3% 7.0%1996 7.0% 8.2% 12.8% 6.5%1997 10.1% 3.2% 13.6% 6.8%1998 13.6% 5.7% 10.1% 6.6%1999 9.3% 3.8% 10.8% 6.8%2000 28.0% -21.8% 12.1% 7.1%2001 -7.6% -33.2% 7.5% 6.5%

Note: Premium income increased for stock life companies and decreased for mutuals in 2000 and 2001 as a result ofdemutualizations. Premium income in 2001 is not comparable to prior years due to the exclusion of premiums ondeposit-type funds as a result of codification of statutory accounting principles.Source: Best’s Aggregates and Averages.

Reviewing the Channels, Discussing the Changes

Alternative distribution (e.g., banks and securities brokers) is a focus for most lifeinsurance companies because the offerings in the industry’s fastest growingproduct lines have been sold effectively through these channels. For example, themajority of variable annuity sales occur through non-traditional distributionchannels (Figure 86). Today, traditional agents produce only 35% of variableannuity sales, compared to 55% of sales as recently as 1995. According to themost recent data available from the American Council of Life Insurance (ACLI),variable annuities accounted for 26% of total industry premiums in 2000, whichcompares to less than 1% of industry premiums in 1988. (The bear market hasinterrupted the growth trend of variable products, but we think that these lines willgrow at a faster pace than traditional fixed products over the long term.) Incontrast, the product lines where agents remain dominant have not experiencedrapid growth in recent years. For example, agents account for approximately 63%of individual life insurance sales (Figure 87).

Figure 86: Variable Annuity Sales by Distribution Channel, 9/30/02

Regional InvestmentFirms13% Direct Response

2%

Bank/Credit Union12%

Independent NASDFirms25%

New YorkWirehouses

13%

Captive Agency35%

Source: VARDS.

Non-traditional channels havebecome a larger part of life

insurance distribution



Figure 87: Individual Life Sales by Distribution Channel

Career Agents40%

Unaffiliated B-Ds23%

Affiliated B-Ds5%

PPGA Agents23%

3rd Party Marketing1%

Banks1%

Other7%

Source: A.M. Best Review/Preview, January 2003.

We believe that direct insurance sales will account for a larger portion of totalsales but will remain a small percentage overall. To date, a very small portion oflife insurance and annuities (less than 5%) is sold on a direct basis. Life insuranceproducts have not sold well through direct channels because they are “sold, notbought”. In other words, it often is necessary for someone (an agent or financialplanner) to remind an individual about the need for life insurance. In contrast,direct selling has been more successful in personal auto insurance because whenan individual buys a car, he or she knows that it is necessary to buy insurance(a demand product). Also, life insurance and annuities can be complicatedproducts, making direct sales difficult. Although there is experimentation takingplace on the Internet, we do not envision online channels as a substantial lifeinsurance distribution mechanism in the near future. Longer term, we believe thatthe Internet could account for a meaningful portion of term insurance sales, andother relatively easy to understand products (perhaps a simplified annuity). In theshort term, it appears more likely that the Internet will become an effective meansof communicating with, understanding the needs of and servicing bothpolicyholders and agents.

Given the increased importance of alternative distribution channels and thedemand for higher productivity from agency channels, the traditional structure oflife insurance distribution is clearly under stress. For this reason, we thought itwould be instructive to elaborate on the structure of the different selling systems(Figure 88), and discuss some of the changes that are occurring in each channel.

First, however, we think it is important to clarify one source of confusion relatedto captive and independent agency structures. Specifically, the role of the generalagent, we believe, warrants some discussion. A general agent is a generic termused to describe an intermediary between an insurance carrier and a producingagent. Many companies refer to general agencies in an independent structure;however, the identification of the type of general agent is needed to make thedistinction more clear. For example, a brokerage general agent (BGA) is anindependent intermediary between the insurer and independent insurance brokers.This individual is usually responsible for a particular geographic area, andfacilitates recruiting and provides marketing, training and other support to brokersin his region. Similar general agencies in the independent structure includeindependent marketing organizations (IMO) and independent general agencies(IGA). Conversely, a managing general agent (MGA) provides all the servicesthat a BGA or IMO would, but works with a career agency force. MGAs aretherefore considered a part of the captive agency structure. With that clarification,definitions and changes within each channel are appropriate to discuss.

The motivation to buy andcomplexity within many life

products determines effective-ness of certain channels

BGAs are independent, MGAsare part of a captive structure



Figure 88: Distribution Channels

Career Agents

Exclusive Agents

Salaried Sales Agents

Captive Agents

Independent Agents

Personal Producing General Agents

Insurance Brokers

Independent Producers

Financial Planners /Independent Broker Dealers

Banks

Broker Dealers (Wirehouses and Regionals)

Worksite Marketers

Alternative Distributors

Personal Selling Direct Response

Sources: Life Management Institute and Merrill Lynch.

� Captive Agency System

Agents within a captive system market the products of very few insurers, usuallyonly one. In exchange for representing only its products, the agent may receiveinitial financial support, training, administrative and back-office support and/oremployee benefits from the insurer. This type of structure affords the insurer themost influence over the distribution of its product, however that control comes at acost. Generally, a captive agency system is the most expensive structure aninsurer can use, given the associated overhead costs of supporting the agents.There are three primary categories within the captive structure.

Career agentsA career agent is a full-time, commissioned salesperson who is often an employeeof the insurance company. In practice, a career agent typically places most of hisor her business with one company. Historically this has been one of the mostfrequently used structures for life insurance companies.

Exclusive agentsAn exclusive agent is contractually obligated to sell the products of only onecompany and is paid on a commission basis. Exclusive agents are also sometimesknown as direct writers.

Salaried sales agentsThese are employees of the insurer who are, as the title implies, compensated on asalary plus bonus structure. These agents have the latitude to market productsdirectly to the consumer or through intermediaries. These agents are usuallyresponsible for marketing group and pension products.

Quantifying the CostsIn 1999, LIMRA revised a study originally completed in 1985 in an effort toquantify just how expensive it is for an insurer to hire and train an agent. Table 71illustrates these costs and how they have changed over the past 15 years.

Table 71: Estimated 3-Yr. Cost to Train / Finance an Inexperienced Agent

1985 1999Average cost per agent- Variable financing $75,000 $140,000Average cost per agent- Salary based financing $120,000 $250,000Number of agents surviving for three years per 100 25 23

Source: LIMRA

Captive – or career – agents areexclusive to one insurer in

exchange for financial andoperational support



Of the two types of financing illustrated in the study, variable financing is themost commonly used today, a reversal from when the first study was done in1985. Variable financing sets a targeted earnings level which is supplemented ifcommissions fall short of that level, assuming a minimum commission level isgenerated. Although this is clearly the more cost-effective system of the two,there is still less than a 1 in 4 chance that it will produce a successful outcome(i.e., a productive agent). Considering the drive to lower expenses and increasedprofitability in the industry, it is easy to see why insurers have switched financingmethods.

The cost to hire and train an agent is only one component of the cost ofdistribution. An even more important determinant of how expensive an agent canbe to an insurer is the productivity level of that agent. In the table below, LIMRAsummarizes the distribution of net investment with agent retention andproductivity as factors.

Table 72: Total Three Year Investment Per Surviving Agent

Excellent Productivity Average Productivity Poor ProductivityExcellent Retention $65,000 $100,000 $145,000Average Retention $100,000 $140,000 $185,000Poor Retention $130,000 $170,000 $215,000

Source: LIMRA

As shown in Table 72, the level of agent productivity can severely alter the overallprofitability of an insurance carrier. Throughout our research process, we foundthat productivity is increasingly defined as managing a client relationship asopposed to efficiently selling products into a client base. It appears to us that intoday’s competitive environment, which is likely to become even morechallenging in the future, productivity means planning, and planning is the onlyway to justify the costs of a career force.

� Independent Agency Structure

The independent agency structure has also traditionally been a common way todistribute life insurance products. These agents are contractors who representdifferent insurance companies and search the market for the best place for aclient’s business. The independent agent is not controlled by any one company,and pays agency expenses and employee benefits costs out of the commissionsearned. Given that this type of agent is self-sufficient, this structure represents amuch lower cost of distribution to the insurance carriers. There are several typesof independent agents, which are listed below.

Independent agentsAn independent agent (general contractor) typically represents a handful ofcompanies. This is not a captive distribution channel, but there is some level ofloyalty to what are considered primary companies.

Personal producing general agents (PPGA)PPGAs hold general agency contracts with several insurers. These agents aretypically sole proprietors that are unaffiliated with an agency, and as a result donot work through a general agent. These agents also have some level of loyalty towhat they consider primary companies.

Insurance BrokersA broker is an insurance salesperson who represents the customer, not theinsurance company. A broker does not have an agency contract with anyinsurance company, and generally has little or no loyalty to any company.

Productivity is critical tojustifying career agency costs

Independent agents are self-employed and sell the products

of many companies



� Worksite Marketing

Worksite marketing refers to marketing insurance products to the employees ofparticipating firms on a voluntary payroll deduction basis. It is difficult tocategorize worksite marketing as either a captive or independent distributionchannel as both channels are used to sell the product.

Group and IndividualThere are two types of policies typically sold through worksite marketingprograms: group and individual. These policies primarily differ in three ways.First, with a group policy the employer has a master contract with the insurer. Allemployees who sign up for the insurance are covered by this contract. On theother hand, with an individual policy the contract is between the insurer and theemployee only. Second, insurance policies under the group concept are not“portable”. In other words, if the employee leaves the firm, he loses coverageunder that contract. Under an individual policy, the employee has the option tokeep the insurance regardless of where he is currently employed. Last, under agroup policy, the employer often makes a contribution towards the premium,which lowers the cost to the employee. Individual policy premiums, on the otherhand, are the sole responsibility of the employee and are usually more expensivethan group policy premiums.

Why market products at the workplace?Although it is usually specific to certain types of insurance, worksite marketingoffers advantages to the insurer, employer and the employee. From the insurer’sperspective, worksite marketing allows for broad customer access at a low cost.With benefits costs rising, employers need a way to provide benefits to employeeswhile still containing costs. Providing a worksite program for supplementalcoverage to employees can keep their costs low, and help defray the costs to theemployee. Finally, employees get the convenience of a payroll deducted premiumplan, while benefiting from group-type premium rates, which are usually lower.

� Banks & Broker Dealers

The bank and broker-dealer channels have become increasingly important to theinsurance industry in recent years as a result of the mix shift toward investment-oriented products. For example, banks accounted for approximately 35% of theindustry’s total fixed annuity sales, and 12% of the industry’s variable annuitysales in the first nine months of 2002. Life insurance sales through banks,however, have been slower to expand than many expected. While some estimatesfor ordinary life sales growth through the bank channel exceed 20%, the level ofsales remains low. However, there is clearly potential for the product, especiallyif banks figure out a way to tap the underpenetrated middle-income marketplace.

Securities brokers have been an even larger source of insurance sales, drivenpredominantly by variable annuity volume in recent years. As Figure 86 displays,through the first nine months of 2002, national and regional broker dealersrepresented 26% of the variable annuities sold. In addition, brokerages (affiliatedand unaffiliated) have had more success in distributing ordinary life productsthrough their systems, representing 28% of the first year individual life directpremium (Figure 87).

We view both channels as likely growth opportunities for the insurance industry,with one qualification. The growth in these channels will be dependent on theability of insurance companies to accommodate the specialized requirements ofthese alternative distributors. For example, the needs of both large and smallbroker dealers are very specific, and don’t fit well with the traditional model of thelife insurance industry. We spoke with two of the largest bank-distributors ofannuities, and found that both have very specific sets of needs, which don’tinclude back office servicing or training. While the large banks are unbundlingthe product, putting more pressure on carriers to meet needs in a customized,

Worksite marketing can be avery cost-effective way to reach

a large number of prospectivepolicyholders

The shift toward investmentoriented products has playedinto the hands of banks and

broker-dealers



flexible way, regional broker dealers require very different support. One largeregional broker dealer, for example, relies heavily on its insurance partners notonly for product, but also for technological capability that complies with theirpaperless systems. We believe that the long-term success of insurers distributingall insurance products through these channels will rely heavily on carriers’ abilityto move from the traditional “product-push” model to a “distribution-friendly”(pull) orientation.

� Direct response

Although direct response represents a fairly small portion of the market, webelieve there are two primary reasons this segment is important to consider. First,changes in demographics (i.e., aging population) support an expected increase indemand for product sold on a direct basis. Second, the Internet has become aburgeoning alternative to the traditional direct methods. We believe this could bean important source of volume for certain products and higher-probability leadsfor personal selling systems. Background on direct systems is important, in ourview, to understanding the role that this channel might play in the future.

The BasicsA direct response distribution channel eliminates the middleman, allowing theinsurer and customer to transact business directly. The mediums for theseexchanges include advertisements, magazine inserts, telephone solicitations andthe Internet. Products distributed through this channel usually have a fewcharacteristics in common. They are easy to understand, purchase, manufactureand deliver. The products are generally designed to serve very broad markets thatcover a wide range of ages and income. Two examples are graded benefit wholelife and term life.

Perhaps the most attractive characteristic of the direct channel is its cost relative tomore traditional personal selling systems. Direct response, by its definition, hasno agents involved with the sales process. This saves the insurer a tremendousamount of money on training inexperienced agents.

The potential downside to direct response distribution relates not to the amount, butrather to the type of costs that are incurred. Unlike agency channel costs that, aftertraining, are largely variable to the insurance carrier, the majority of a directresponse system’s costs are incurred well before the sale. Even though the insurerdoes not incur training costs, the insurer still must complete marketing studies,product development and utilize a delivery system to put the information in front ofconsumers. At that point, the insurer must wait for the inquiries from customers,and hope that there are enough sales to justify the costs already incurred.

Who Buys Direct?There have been numerous studies completed on the profile of the typical directresponse system buyer. According to a LIMRA study on direct response, buyersattracted to the direct system are generally less affluent than average, come fromnon-traditional homes, and are older and less well educated. Table 73 showsselected results from this LIMRA study.

Direct response remains a smallmarket, but has potential

Direct buyers tend to be older,less educated



Table 73: Purchases by Channel with Buyer Characteristic as Factor

All Purchasers Purchased from Agent Purchased DirectAge<30 23% 24% 17%30-44 41% 43% 41%45-64 27% 25% 24%65+ 9% 8% 18%CollegeNone 46% 42% 52%Some 54% 58% 48%OccupationWhite Collar 45% 48% 35%Blue Collar 36% 36% 36%Unemployed/Retired 16% 13% 26%Other 3% 13% 3%

Source: LIMRA

What Sells Direct?Products purchased through direct response channels tend to be fairly simple.Term life is the product of choice, outselling cash value products by ninepercentage points (Table 74). It is also interesting to note that 21% of therespondents do not know what type of policy they purchased. That statistic helpsconfirm the point that, as a group, people who purchase through direct responsechannels tend to be less financially savvy.

Table 74: Characteristics of Policies Purchased

Type of Policy% of

PurchasersMedian

face Value% Replacement

Policies% PrimaryInsurance

Cash Value 35% $10,000 9% 80%Term 44% $10,000 7% 62%Don’t Know 21% NA NA 76%

Source: LIMRA

Low Face Value, but IncreasingThe face value of the policies purchased is fairly low as well, with a median valueof only $10,000. The low face value helps explain why agents rarely focus on thissegment of the insurance market. By our estimates, a first year commission froma $10,000 face value term policy is only about $50. With so little reward it is easyto understand why the agent would choose to focus on more lucrative business.The average face amount sold direct should increase, however, as a result of salesover the Internet. For example, $400,000 is the average face amount of lifeinsurance sold through Quicken, an Internet aggregator site.

� Financial Planning Channel

The financial planning channel is important to discuss for two reasons. First, theindependent broker dealer channel (which is also known as a financial plannerchannel) already accounts for a substantial portion of insurance product sales(primarily annuities). Second, the high growth of the channel is having a broaderimpact on the way life insurance companies are looking at their businesses. Weexpect that future editions of this life insurance primer will contain longer andmore encompassing discussions of this channel as the changes evolve to includemore directly the life insurance industry.

Face values on direct policiesare generally low, but the

Internet could change that



What is Financial Planning?In broad terms, financial planning is the process of identifying a client’s financialneeds and objectives, and establishing a plan to achieve the goals. This includesidentification and analysis of a client’s current and probable future situation, andintegrates personal discipline with financial products in order to meet the futureobjectives. Approaches vary from comprehensive, identifying every aspect of aclient’s financial life (e.g. monthly cash flow, investment, tax and educationplanning) to more specialized approaches such as estate planning. The industry isstill evolving, and will likely continue to do so over the next decade.

Financial planning has become a loose way to describe the activities of a multitudeof financial professionals. In an effort to clarify roles, we surveyed several groupsof financial planners and talked with many executives involved in financialplanning to more clearly define the market. Our conclusion is that there are threetypes of financial planners, classified by how they are compensated: fee-based(fee-offset), fee-only, and commission-based. Fee-based planners derivecompensation from a combination of product commissions and fees. Generally,these planners charge a fee for the plan, and earn commissions on product sales.Fee-only planners rely solely on asset, income or flat fees, and neither sellproducts nor earn commissions or trailers. Commission-based planners can begrouped into two sub-segments. The first consists of planners who historicallyhave been product specialists (insurance agents, securities brokers) and havebroadened their offering of advice, but continue to receive the bulk of theircompensation through commissions. The second consists of re-branded sales-people, who have not truly embraced the planning approach. We believe the lattergroup will shrink over time as they migrate toward planning or are displaced.

Why It’s Important?The financial planning movement is becoming intertwined with the insuranceindustry, and we believe that the impact of planning will become even morepronounced in the future. Competition has become intense for the “control” of, orinfluence on, customers’ financial decisions. What historically has been a captivemarket for insurance ‘specialists’ is under assault from independent advisors whounderstand insurance and are intimately in tune with their client’s needs. Thispotential for displacement of the traditional career agent has made many in theindustry re-think their field force strategies. So, while the explosion in plannershas created a threat, it has also served as a catalyst for many companies to increasethe productivity of traditionally inefficient channels.

Some industry players have argued that selling insurance through financialplanners can result in better returns and more consistent performance over the longrun. The argument is that the planner’s long-term focus and deep clientrelationship will keep policies from lapsing during temporary market dislocationsor adverse circumstances. Also, this longer-term perspective should meansmoother sales patterns as planners focus less on the current market environmentand more on the client’s long-term needs. However, a glimpse into the annuitymarket during the past couple of years suggests that this assertion may not becompletely accurate. For example, American Skandia distributes heavily throughindependent broker dealers (whose producers are “financial planners”). In 1999,American Skandia was the third largest seller of variable annuities. Through thefirst nine months of 2001 – after the S&P 500 had lost 29% of its value and theNASDAQ was less than one-third of its peak level – American Skandia had fallenout of the top ten. Also at that time, Nationwide Financial – a leader in thefinancial planning channel – experienced a 34% decline in variable annuity salesthrough independent broker dealers, which compared to an overall decline invariable annuity sales of 16%.

Although the planning channel may experience challenges, we think it is here tostay. Today, some formidable national platforms like American Express FinancialAdvisors, with more than 9,900 advisors, and HD Vest, a tax-focused planningoutfit with over 6,000 affiliates, already focus on specific markets to provide their

Financial planning broadlyincludes advising on the basis

of fees, commissions or acombination of both

Distributing through thischannel may not provide

benefits expected on paper

Lots of resources have beenallocated to tap this market



advice-driven services. Other companies like Merrill Lynch, with 12,000Financial Consultants, AXA Financial, with over 7,400 career agents, AIG, withan exclusive agency force at VALIC, and Lincoln Financial Group, with 2,000LFA agents, are moving in this direction. Still other companies have chosen notto establish their own planning platforms, and instead provide product toindependent financial planners. To date, this has been done with relative successthrough independent broker dealers, with Nationwide being a good example of aleader with this strategy.

Independent Broker DealersThrough the first nine months of 2002, 25% of all variable annuities was soldthrough independent broker dealers firms, according to VARDS (Figure 86). Justas wirehouses provide the infrastructure for their ‘captive’ brokers to sellinvestment products, independent broker dealers offer that function to affiliated,but independent, financial planners and investment advisors. These firms sponsorthe advisor/planner’s NASD securities license and provide a menu of investmentproducts, back-office service and support and technology to help advisors managetheir businesses. In fact, in order to attract new planners, some independentbroker-dealers bear the cost for office supplies, business cards, and even computerhardware. As the financial planning community has grown, these independentbroker dealers have increased their attractiveness to financial productmanufacturers as a good source of potential product distribution. Examples of thelarge independent broker dealers include LPL Financial Services, Royal Alliance(AIG subsidiary), and Nathan and Lewis. Royal Alliance and LPL alone representmore than 7,000 financial advisors nationwide.

Independent broker-dealersprovide products and services

for financial planners



15. Two Accounting Systems – SAP & GAAPAll life insurers report their financial results to the regulators of the states in whichthey are licensed in accordance with permitted or prescribed Statutory AccountingPrinciples (SAP). State insurance commissioners prescribe statutory reportingrequirements and use the financial reports to gauge the financial health of insurers.The goal is to assess the insurer’s ability to satisfy its obligations to thepolicyholders. SAP generally is more conservative than Generally AcceptedAccounting Principles (GAAP) because the primary goal is the assessment ofsolvency. Statutory earnings are analogous to cash flow because earnings on thisbasis determine the amount of cash that is available for distribution to owners ofthe company.

In addition to SAP financial statements, all stock life insurers and some mutualsalso prepare another set of reports in accordance with GAAP. The FinancialAccounting Standards Board (FASB) prescribes GAAP, which is required forfilings made with the Securities and Exchange Commission. GAAP is moreliberal than SAP, but it gives a better idea of the insurance operations as a “goingconcern” because the goal is the proper matching of revenues and expenses.Within GAAP, there are some fundamental differences in accounting for FAS 60,FAS 97 and FAS 120 products.

We have limited our discussion of SAP in this report because of equity investors’focus on GAAP results. Despite the sometimes difficult-to-understand nature ofstatutory accounting, investors can use the highly standardized SAP financialstatements for comparisons of certain individual line items or ratios (e.g., generalexpenses as a percentage of premium income) between two companies or betweena company and the industry average. Furthermore, equity investors can usestatutory statements for: (1) calculating a reasonable proxy for free cash flow;(2) assessing capital adequacy through risk-based capital ratios; and (3) gaugingearnings quality (See Section 2).

Differences Between Statutory and GAAP

The cash flow focus of SAP and the accrual methodologies of GAAP give rise toseveral marked differences between the two accounting systems. Thesedifferences, several of which are described in greater detail in subsequent sectionsof this report, include:

1. Policy acquisition costs are expensed as incurred in statutory accounting.These items generally are deferred and amortized under GAAP.

2. Premiums from FAS 97 products are considered revenue in statutoryaccounting. Under GAAP, they are considered deposits only.

3. Reserves are calculated using conservative assumptions, and without givingconsideration to withdrawals, in statutory accounting. In GAAP, assumptionsreflect current and expected experience.

4. The statutory balance sheet includes an asset valuation reserve and an interestmaintenance reserve, while the GAAP balance sheet does not.

5. Statutory accounting requires bonds and preferred stocks to be recorded atamortized cost, while GAAP requires either amortized cost or market value,depending on the insurer’s classification of the fixed income securities.

6. Statutory accounting requires the exclusion of certain assets from the balancesheet, while GAAP generally requires the inclusion of all assets.

7. Costs associated with employee pension benefits are recognized when thecontributions are made under statutory accounting. Under GAAP, these costsare recognized when incurred during the service lives of the employees.

Statutory accounting isgenerally more conservative

than GAAP accounting

Standardized reporting makesthe use of SAP data moreappropriate for companycomparisons than GAAP



8. Statutory accounting requires post-retirement benefits to be recognized forvested employees and current retirees. GAAP requires the obligation to beaccrued over the service period for all eligible employees.

9. Statutory accounting does not allow majority-owned subsidiaries to beconsolidated on the parent’s financial statements.

10. Assets and liabilities are reported net of reinsurance balances in statutoryaccounting. Under GAAP, assets and liabilities are grossed up, and the assetis typically a reinsurance recoverable (FAS 113).

Tables 75 and 76 illustrate some of the basic differences between statutory andGAAP financial statements for life insurers.

Table 75: Balance Sheet Reconciliation, Statutory to GAAP

AdjustmentStatutory for GAAP GAAP

ASSETSInvestments:Bonds and Other Debt Securities XXX + XXXMortgage Loans XXX = XXXPolicy Loans XXX = XXXTotal Investments XXX + XXXCash XXX = XXXDeferred and Uncollected Premiums XXX + XXXDeferred Policy Acquisition Costs None + XXXFurniture and Equipment None + XXXSeparate Account Assets XXX = XXXTOTAL ASSETS XXX + XXXLIABILITIES AND SHAREHOLDER EQUITYReserves for Future Policy Benefits XXX - XXXClaims Payable XXX = XXXPolicy Dividends Payable in the Following Year XXX - NoneTotal Policy Liabilities XXX - XXXAccounts Payable XXX = XXXExpenses Due and Accrued XXX = XXXCash Dividends Payable to Stockholders XXX = XXXInterest Maintenance Reserve XXX - NoneAsset Valuation Reserve XXX - NoneIncome Tax- Current XXX = XXXIncome Tax- Deferred XXX = XXXSeparate Account Liabilities XXX = XXXTOTAL LIABILITIES XXX - XXXSTOCKHOLDERS’ EQUITYCapital Stock XXX = XXXAdditional Paid in Capital XXX = XXXUnrealized Gain (Loss) XXX + XXXRetained Earnings None + XXXSurplus XXX - NoneTotal Stockholders’ Equity XXX + XXXTOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY XXX + XXX

Sources: Accounting and Financial Reporting in Life and Health Insurance Companies (Mulligan and Stone) andMerrill Lynch.

On a statutory balance sheet, the “equity” section is known as capital andsurplus. As it relates to “equity”, differences between SAP and GAAP are fairlylimited. Obviously, “equity” is the difference between assets and liabilities underboth of the accounting methods. However, the concept of invested capital isdifferent under SAP and GAAP. For example, quasi-debt (e.g., surplus notes) isconsidered statutory equity. As a rule of thumb, GAAP equity generally is largerthan statutory capital and surplus by a factor of 150%-300%.

GAAP equity is usually 1.5 to3.0 times larger than SAP

capital and surplus



� Unrealized Gains and Losses

Unrealized gains and losses (URGL) is an equity account that generally reflectsvaluation changes to invested assets. One of the differences between SAP andGAAP is that statutory accounting generally requires invested assets to berecorded at amortized cost while GAAP requires marking to market for certainclassifications of assets. Under statutory accounting, only common and preferredstocks are marked to market. The aggregate unrealized gain or loss from theinvestments that are marked to market is shown, net of deferred acquisition costsand taxes, as accumulated other comprehensive income in the GAAPshareholders’ equity section of the balance sheet. (Deferred acquisition costs areadjusted for realized and unrealized gains and losses related to FAS 97 productsbecause ongoing updates to the DAC amortization schedule are required to reflectrevised expectations for profit.)

For our analysis, we exclude the impact of the marked to market adjustment forfixed income securities from book value (and therefore return on equity) becauseit distorts the true economics of the balance sheet. Specifically, changes in interestrates affect the left- and right-hand sides of the balance sheet, but accountingconvention only dictates that the asset side is marked to market.

� Surplus vs. Retained Earnings

Surplus (statutory) and retained earnings (GAAP) are similar in they bothrepresent accumulated profit. The difference is that surplus has several reserveitems subtracted from it (such as AVR and IMR) and has more conservativeaccounting for related assets and liabilities (e.g., a larger benefit reserve understatutory). Hence, an insurer’s GAAP retained earnings account tends to be largerthan its statutory surplus.

Table 76: Income Statement Reconciliation, Statutory to GAAP

AdjustmentStatutory for GAAP GAAP

REVENUE:Premium Income XXX - XXXNet Investment Income XXX = XXXFees and Other XXX = XXXTotal Revenue XXX - XXXBENEFITS AND EXPENSES:Policy Benefits XXX - XXXCommissions XXX = XXXDeferral of Commissions None - XXXDAC Amortization None + XXXGeneral Expenses XXX = XXXTotal Expenses XXX - XXXPretax Income XXX - XXXTaxes XXX + XXXNet Income XXX + XXX


SAP carries invested assets atamortized cost, GAAP marksmany investments to market



16. Accounting for AssetsIn order to be conservative, insurance commissioners do not allow every asset ofan insurer to be included on a SAP balance sheet. Based on the asset type, assetsare either admitted (allowed on the SAP balance sheet) or nonadmitted (excludedfrom the balance sheet). A prime example of a nonadmitted asset is furniture andequipment. This fixed asset is completely disallowed on statutory balance sheetsbecause, in case of a liquidation of the business, the historical value listed on abalance sheet could be in excess of what the company would actually realize fromthe sale of the items. Under GAAP, there is no such concept as admitted versusnonadmitted assets, although GAAP includes various asset valuation rules.

Invested Assets

Investments are the most important assets of an insurance provider because thespread between income from invested assets and interest credited to policies is amajor driver of revenue and profit. Given the characteristics of a life insurancepolicy, fixed income products best match the duration of an insurer’s obligations.Hence, bonds and mortgages make up the bulk of an insurance company’sinvested assets, as shown in Figure 89.

Figure 89: Composition of Investment Portfolio, Year-End 2001

Fixed maturities73%

Other 5%

Real estate1%

Policy loans5%

Mortgage loans14%

Equity securities2%

Note: Based on an investment portfolio composite including AFLAC, Hartford Life, Jefferson-Pilot, John Hancock, LincolnNational, MetLife, Nationwide Financial Services, Phoenix Companies, Principal Financial Group, Protective Life,Prudential Financial, StanCorp Financial, Torchmark and UnumProvident.Source: Company reports.

� Bonds

In statutory accounting, all bonds are carried on the books at their amortized costexcept for those investments that are in or near default. If a bond is in or near default,it is carried on the balance sheet at the lower of cost or market. Amortized cost is thehistorical cost of the bond adjusted for the amortization of the premium or discount asthe bond matures and approaches par value. Under GAAP, bonds are carried at eithermarket value or amortized cost depending on the insurer’s classification of theinvestment as either “held to maturity”, “available for sale”, or “trading”.

� Stocks

Stocks represent a much smaller portion of an insurer’s portfolio than do bonds.Since stock returns are normally not guaranteed and insurance providers have toearn a certain investment return to meet their obligations, stocks are used muchless frequently than bonds. Nonetheless, stocks often are used as investments forexcess surplus because of the potential for high returns and the benefits ofportfolio diversification. Common stocks are carried on the books at market valuein both statutory and GAAP accounting. There are two exceptions to these

In the spirit of conservatism,SAP excludes some assets

altogether



guidelines in statutory accounting. First, the NAIC determines the value of stocksthat are not publicly traded. Second, stock ownership of subsidiaries or affiliatesis valued using the equity method, which is also prescribed by the insurancecommissioner. Insurance subsidiaries are valued on a statutory basis and non-insurance subsidiaries are valued on a GAAP basis.

In statutory accounting, preferred stocks in “good standing” are reported at cost.“Good standing” means that the stock is investment grade and has appreciatedsince the time the company bought it. If this is not the case, the preferred stock isreported at market value. In GAAP, preferred stocks are reported at market value.

� FAS 115

FAS 115 “Accounting for Certain Investments in Debt and Equity Securities” wasadopted in 1993 and 1994. This GAAP accounting standard established threecategories of securities. The first category, “held-to-maturity”, is composed of debtsecurities which a company has the positive intent and ability to hold-to-maturity.The second category, “available-for-sale”, may be sold to address the liquidity andother needs of a company. Debt and equity securities classified as available-for-saleare carried at fair value on the balance sheet with unrealized gains and lossesexcluded from income and reported as a separate component of shareholders’ equity.The third category, “trading”, is for debt and equity securities acquired for thepurpose of selling them in the near term with unrealized gains and losses recognizedon the income statement as net investment gains (losses).

Most insurance companies classify fixed income securities as available-for-sale,so the bulk of the fixed income portfolio is carried at market value. We excludethe marked to market adjustment when we analyze the equity account, but it isuseful to compare the change in market value of fixed income securities for agiven change in interest rates to get a sense for the duration of the portfolio. Forexample, if the bond portfolio of a fixed annuity writer declined by 10% wheninterest rates increased by 100 basis points, this would suggest portfolio durationof approximately 10 years. This hypothetical investment strategy suggests that thecompany is taking serious interest rate risk because liability duration for a fixedannuity writer is typically 5 to 6 years. The market value adjustment can also beused to assess the credit risk of the bond portfolio by analyzing the change thatoccurs during periods of widening credit quality spreads.

� FAS 133

After nearly a decade of deliberations, in June 1998 the FASB issued FAS 133“Accounting for Derivative Instruments and Hedging Activities.” For allcompanies, compliance with the new standard was required as of January 1, 2001.The standard requires that all derivative instruments are carried on the company’sbalance sheet at market value, reflecting mark-to-market adjustments in earningsor comprehensive income (direct impact on equity), depending on the type ofhedge. There are three types of hedges defined in the standard: Fair Value Hedge,Cash Flow Hedge, and Foreign Currency Hedge. In the case of a fair value hedge,the gain or loss is recognized in earnings along with the offsetting gain or loss onthe item being hedged. In other words, to the extent that there is a difference(which is defined as the ‘ineffective’ portion of the hedge), earnings are impacted.For all hedges, each company must perform an effectiveness assessment, unlessrequirements for a shortcut are met. If the company is hedging the variability ofcash flows related to a variable rate asset, liability or transaction, this hedge isconsidered a cash flow hedge. In this instance, the effective portion of thederivatives gain or loss is initially reported in other comprehensive income (directimpact on equity), and reclassified (in earnings) when the forecasted transactionaffects earnings. The ineffective portion of the hedge hits current-period earningsimmediately. The third type, a foreign currency hedge, requires that gains andlosses be reported in other comprehensive income as part of the cumulativetranslation adjustment.

The mark-to-market adjustmentof fixed income securities can

be used to gauge interestrate and credit risk

FAS 133 – which requires thatderivatives are carried at

market value – effective 1/1/01



For all companies, the implementation of FAS 133 carried the risk of increasedearnings volatility. Critics of the new accounting requirement have argued that thepotential for volatility could reduce a company’s motivation to hedge risks thatotherwise would be prudent to minimize. An example is an option, of which itsincome statement impact has been historically limited to the amortization of theoption premium over its life. Under FAS 133, the value of the option must bemarked-to-market, which given the time value of an option, will not move inperfect tandem with the hedged position. The result is higher potential earningsvolatility over the life of the option regardless of the economic benefit realized atthe expiration of the option (the hedge). How often economic decisions aremodified because of the accounting treatment is probably a longer-termassessment that analysts and investors will need to make. We believe that mostcompanies are including the impact of FAS 133 in realized gains and losses, notoperating income.

In addition to its impact on general industries, FAS 133 requires life insurers (andother financial companies) to account separately for ‘embedded derivatives’ thatexist within certain life insurance contracts (or other financial products). Forexample, an equity-indexed annuity that credits interest based upon an externalindex must be ‘bifurcated’, or split from the policy from an accountingperspective. Also, a variable annuity contract that offers guaranteed minimumaccumulation benefits (GMAB) or a guaranteed account floor is considered tohave an embedded derivative. Not all life products require FAS 133 treatment, asa traditional variable annuity contract that allows the holder to earn the returns ofselected investment options offered in the contract with no special guaranteeswould be excluded under FAS 133.

� EITF 99-20

EITF 99-20, “Recognition of Interest Income and Impairment on Purchased andRetained Beneficial Interests in Securitized Financial Assets”, became effective onApril 1, 2001. The EITF (Emerging Issues Task Force) is a group of publicaccountants, industry executives and professional organization leaders thatidentify areas where FASB direction may be needed. EITF 99-20 addresses rulesfor recognizing interest income on credit-sensitive mortgage and asset backedsecurities. EITF 99-20 also determines when these securities must be writtendown to fair value because of impairment. The impairment provisions bring theseassets much closer to a lower-of-amortized cost or fair value approach.

� Mortgage Loans

Insurance companies invest in mortgages either as an issuer of mortgage loans, or asa purchaser of securitized loans such as collateralized mortgage obligations (CMOs).Mortgage-related investments are desirable for a couple of reasons. First, they areconsidered highly rated securities by the NAIC. Second, they pay monthly, whichprovides a predictable cash flow for the insurer. Even variable mortgages typicallyhave a floor rate, providing downside protection for the insurer. In statutoryaccounting, mortgage loans are recorded at the amount of the outstanding principalbalance or net book value if acquired. In GAAP, mortgage loans are also reported atthe outstanding principal balance if purchased at par. If they are purchased at adiscount or premium, then they are reported at amortized cost.

� Policy Loans

Policy loans are loans made to the policyholder by the insurer and are based on thecash surrender value of the policy. Since the funds otherwise would be invested toprovide future benefits for the policyholder, the insurer charges interest on theloan. If there is a loan outstanding when the policy is surrendered or whenbenefits are paid, then the loan plus interest is deducted from the payment. Policyloans are considered admitted assets in statutory accounting and are recorded atbook value. The loans are also recorded at book value under GAAP.

FAS 133 risked an increasein earnings volatility, butwe have seen little impact

Certain insurance productscontain contracts that also

require mark-to-marketadjustments



� Real Estate

In statutory accounting, real estate is reported at book value or appraised value,whichever is lower. Under GAAP, real estate is reported at cost less accumulateddepreciation and an impairment allowance.

Thoughts on the Quality of Invested Assets

The role of a life insurance analyst has changed dramatically in the last decade(especially for us as we moved from the buy-side to the sell-side), but perhaps thebiggest difference today versus the early 1990s is the priority that we assign to thevarious financial statements. Specifically, everything we did from an analyticalstandpoint started with the balance sheet ten years ago, which contrasts with anincome statement-driven approach today. When we were analyzing the group inthe late 1980s/early 1990s it was easy to stump us with a question aboutdistribution or product type. However, if you wanted to know a company’sexposure to commercial office properties in the Northeast and a further breakdownbetween performing and non-performing mortgages in the region, we could oftenrecite this information from memory. Given recent market events and the currentstate of the economy, we believe that we have already begun to see the beginningof a shift in focus back to the balance sheet. (For a detailed discussion of assetquality and equity market sensitivity, see Potential Cracks in Safe Haven Story?,February 12, 2001.)

The industry does not seem to have the same level of credit exposure today as itdid in the early 1990s (Figure 90). Investors should keep in mind, however, that ifthe market becomes concerned about asset quality, good operating earnings wouldlikely have little or no impact on stock prices. To illustrate this point, we can lookto 1990 as a guide to what to expect when balance sheet troubles are evident(Figure 91). Although growth in operating earnings per share for the MerrillLynch Life Insurance Index substantially outpaced the growth in S&P 500operating EPS in 1990, life stocks still performed poorly relative to the market.We can tell you first hand that strong earnings did not impress investors duringthis period, as they were too busy focusing on the deterioration in asset quality tocare about the bottom line of the income statement. In a 1990-type environment,book value takes center stage.

During the depths of concern about the industry’s asset quality problems in theearly 1990s, the Merrill Lynch Life Insurance Index traded at its lowest point everon the basis of book value. Specifically, the Merrill Life Index traded at a slightdiscount to its book value in October 1990 for the first and only time since theIndex was created in 1985. Book value has been considered a floor for valuationin the past because more than 95% of the average life company’s assets aremarketable securities. Today, the valuation is 1.3x book value, or on theconservative side and similar to the level during the early 1990s. It seems that tosome extent attention has shifted from the income statement to the balance sheet,which is not surprising during a period of credit deterioration and uncertaintyabout the appropriate carrying value of deferred acquisition cost assets.

Ignoring balance sheet qualityis a perilous strategy



Figure 90: Total Life Insurance Industry – Risky Assets as a % of Statutory Equity

0%

100%

200%

300%

400%

500%

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Note: Risky assets defined as below investment grade bonds, mortgages and real estate. Statutory equity defined ascapital, surplus and the asset valuation reserve (AVR).Source: A.M. Best.

Figure 91: A Look at 1990: If Balance Sheet Questions Emerge, Market Ignores EPS!

-15%

-10%

-5%

0%

5%

10%

15%

20%

MER Life Index EPS Growth S&P 500 EPS Growth Relative Total Return MER LifeIndex vs S&P 500

Sources: Compustat and I/B/E/S.

� Rank Companies by Total Exposure to Risky Assets

As a starting point, it is helpful to think about a company’s total exposure to riskyassets relative to equity. We used this measure earlier to assess the overall creditrisk profile of the industry today versus a decade ago. Below, we show the ratioof speculative grade bonds, mortgages and real estate to statutory equity (Figure92) and the ratio of risky assets to GAAP equity (Figure 93) for the companieswithin our coverage universe. Although not illustrated below or in subsequentsections, we also think that it is useful to look at the trends in risky assets on allmeasures. For example, we might be particularly concerned if a companydramatically increases the exposure to private placement junk bonds becauseexperience in managing this risk is an important consideration, in our view.

Frame the issue by looking atcredit risk exposure to equity



Figure 92: Risky Assets as a % of Statutory Equity, 2001

0%

100%

200%

300%

400%

500%

AFLHIG TMK

PNXUNM LNC PL

ML Composite JPPRU

PFGSFG

METJHF

NFS

Note: Data for HIG is life company only. Risky assets defined as below investment grade bonds, mortgages, real estate.Source: Sheshunoff Information Services.

Figure 93: Risky Assets as a % of GAAP Equity, 9/30/02

0%

50%

100%

150%

200%

250%

300%

350%

AFLTMK HIG

UNMPNX

PRU JPLNC

ML Composite PLSFG

PFGMET

NFSJHF

Note: Data for HIG is life company only. Risky assets defined as below investment grade bonds, mortgages, real estate.Source: Company reports.

� Obvious (and Not So Obvious) Ways Assess Credit Risk of Bonds

As a result of recent experience, analysts and investors have begun to spend moretime looking at the credit quality of bond portfolios. To the extent that this type ofanalysis has been performed, it has probably been limited to the standard measuresof exposure such as the ratio of below investment grade (BIG) bonds to statutoryequity (Figure 94) or the ratio of BIG to GAAP equity (Figure 95). (We definestatutory equity as capital, surplus and the asset valuation reserve.) In our opinion,it is useful to consider other more obscure measures to get a sense for the creditrisk in the bond portfolio. To this end, we turn to Schedule D of the statutoryfinancial statements, which provides exceptional detail on insurers’ bond portfolios.

Schedule D from statutoryfinancial statements contains a

lot of valuable information



Figure 94: Speculative Grade Bonds as a % of Statutory Equity, 2001

0%

20%

40%

60%

80%

100%

120%

AFLSFG HIG PL

PNXNFS

PFGLNC

TMK JP

ML CompositeUNM

METPRU JHF

Note: Statutory equity defined as capital, surplus and asset valuation reserve, data for Hartford is life company only.Source: Sheshunoff Information Services.

Figure 95: Speculative Grade Bonds as a % of GAAP Equity, 9/30/02

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Extended Maturities in Lower Quality HoldingsIn our opinion, it is possible to add value to the fixed income security selectionprocess through credit analysis. However, we also believe that the longer thematurity of a fixed income security, the less certain that the fundamentalassessment will prove to be correct (the “cloudy crystal ball” issue). Moody’sindicates that over a nearly 80 year period the vast majority of issues that havedefaulted were marginally at or below investment grade five years prior to default.In our view, the potential for extreme deterioration in credit quality has beenparticularly evident recently as several well-known, formerly high quality “blue-chip” companies have fallen from the investment grade category.

Given the tendency for fundamentals to change over time, we believe that it isuseful to analyze the composition of life insurers’ triple-B and below investmentgrade bond holdings by maturity. Specifically, we believe that analysts andinvestors should look at the ratio of triple-B bonds with maturities greater than 10years to total invested assets (Figure 96) and the ratio of BIG bonds withmaturities greater than 10 years to statutory capital, surplus and AVR (Figure 97).In our view, this analysis not only highlights the potential for longer-term risk butalso provides an indication of management’s overall attitude toward theassumption of credit risk.

Long maturity means morepotential for fundamental

change



Figure 96: Triple-B Rated Fixed Income Holdings > 10 Years as a % of Invested Assets

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Figure 97: BIG Fixed Income Holdings > 10 Years as a % of Statutory Equity

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Need to Look at Lowest Quality BIGWe believe that an analysis of credit risk that simply considers the allocation tospeculative grade securities is incomplete because the default characteristicswithin the junk category vary materially. According to Moody’s, the highest ratedsecurities within the speculative grade category (Ba rating) have an average one-year default rate that is almost 20% of the experience for the next rating within thecategory (B). The lowest-rated speculative grade securities (Caa-C) have anaverage default rate that is 3.8 times the experience for B-rated bonds and morethan 20 times the experience for Ba-rated bonds (Table 77).

Default rates increasedramatically as you move

through speculativegrade category



Table 77: One-Year Default Rates, 1970-2001

Mean MaximumAaa (NAIC Class 1) 0.00% 0.00%Aa (NAIC Class 1) 0.02% 0.69%A (NAIC Class 1) 0.01% 0.27%Baa (NAIC Class 2) 0.15% 1.36%Ba (NAIC Class 3) 1.21% 5.43%B (NAIC Class 4) 6.53% 22.78%Caa-C (NAIC Class 5) 24.73% 100.00%

Source: Moody’s Investors Service.

To assess the exposure to the lowest quality speculative-grade securities, wesuggest computing the ratio of total NAIC Class 4 and Class 5 bonds to statutoryequity (Figure 98). The Securities Valuation Office (SVO) of the NationalAssociation of Insurance Commissioners (NAIC) classifies the bond holdings ofinsurance companies. A Class 4 bond is equivalent to the rating agencydesignation of B, and a Class 5 bond is equivalent to the rating agency designationof Caa and lower.

Figure 98: Lowest Quality BIG as a % of Statutory Equity

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Note: Data for Hartford is life company only. Lowest quality BIG defined as NAIC Class 4 and 5 bonds.Source: Sheshunoff Information Services.

Less Clarity with Private Placements, so Assume More RiskMany insurers argue that a private placement bond could entail less risk than apublic bond because of the ability to influence the structure of the obligation atorigination. We, on the other hand, believe that the illiquidity of this type ofsecurity and the lack of public information on the exposure suggest that a higherrisk premium is appropriate. This is not a controversial view. For example,commitments to private placements (and mortgages and real estate) arehighlighted in SEC filings as risk factors because of the lack of liquidity. The lackof liquidity also suggests that defaults could have a more pronounced impact onearnings. If a publicly traded bond defaults, there is the option of selling thesecurity at a depressed value and reinvesting the proceeds. With a private bond, asale may not be feasible, which suggests that lost net investment income could bemore substantial. To assess this type of risk, we suggest looking at the portion oftotal triple-B rated fixed income holdings that are private bonds (Figure 99) andthe percentage of total BIG holdings that are private bonds (Figure 100).

Insurers may disagree, but webelieve default assumption is

more risk in privates



Figure 99: Private Triple-B Rated Fixed Income Holdings as a % of Total Triple-B

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Figure 100: Private BIG Fixed Income Holdings as a % of Total Below Investment Grade

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� Use History as a Guide for Mortgage & Real Estate Analysis

The combination of high exposure to mortgages and real estate with the economicslowdown in early 1990 served as a catalyst for a material increase in credit costsfor the industry and substantial losses for individual companies. In 1989,mortgages (primarily commercial) accounted for 24% of the life insuranceindustry’s total invested assets, and companies that received the most attentionfrom investors related to this topic – Travelers, Aetna and Equitable – had anaverage of 32% of invested assets committed to mortgages. From thesehistorically high levels, the exposure to this asset class has declined materially inboth absolute terms and as a portion of total invested assets (Table 78).

Lack of good data makesmortgage assessment

more difficult



Table 78: Life Insurance Industry Mortgage Exposure, 1989-2001 ($ in thousands)

Performing Non-Performing Total Mortgages

90 Days Overdue In Process Foreclosure % of Invested$ Amount % Total $ Amount % Total $ Amount % Total $ Amount Assets

1989 260,997,061 97.7% 3,045,462 1.1% 3,148,069 1.2% 267,190,592 24.0%1990 271,196,508 97.0% 4,377,441 1.6% 4,088,734 1.5% 279,662,683 23.2%1991 255,945,289 95.0% 7,641,896 2.8% 5,956,917 2.2% 269,544,102 21.1%1992 235,870,181 94.9% 5,985,416 2.4% 6,628,937 2.7% 248,484,534 18.3%1993 219,644,913 96.4% 3,992,683 1.8% 4,191,025 1.8% 227,828,621 15.7%1994 209,074,180 97.0% 2,532,635 1.2% 3,841,803 1.8% 215,448,618 14.0%1995 208,218,672 98.1% 1,489,941 0.7% 2,645,162 1.2% 212,353,775 13.1%1996 203,085,732 98.5% 1,050,041 0.5% 2,094,041 1.0% 206,229,814 12.3%1997 203,536,406 99.3% 569,747 0.3% 958,244 0.5% 205,064,397 11.6%1998 210,236,673 99.5% 378,807 0.2% 642,302 0.3% 211,257,782 11.5%1999 224,698,691 99.7% 411,421 0.2% 313,877 0.1% 225,423,989 11.9%2000 229,360,452 99.7% 330,691 0.1% 348,674 0.2% 230,039,817 11.8%2001 236,347,082 99.8% 302,453 0.1% 225,961 0.1% 236,875,496 11.3%

Source: A.M. Best.

We find it more difficult to pinpoint early indicators of potential credit problemsin commercial mortgage portfolios than we did when analyzing fixed incomeportfolios. Perhaps the most obvious reason for this difficulty is the limiteddisclosure of detail on mortgage holdings by quality. Although statutory filingsinclude every mortgage loan held by insurers, a standard quality rating system isnot applied as it is to the bond portfolio. We can argue about the efficacy of therisk classification of bonds by the SVO, but we still believe that it is better thannothing. For those companies that provide us with specific data on mortgageholdings, we also found that the information is not standardized, making cross-company comparisons challenging. Finally, both performing and non-performingloans are difficult to value because market prices are not readily available.

Because of these impediments, we have defaulted to an insurer’s historical trackrecord and exposure ratios to assess the potential risk. (The American Council ofLife Insurance (ACLI) is a good source for industry problem loan data.)

Figure 101: Mortgage Loans as a % of Statutory Equity, 2001

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Figure 102: Real Estate as a % of Statutory Equity, 2001

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Figure 103: Mortgage Loans as a % of GAAP Equity, 9/30/02

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Figure 104: Real Estate as a % of GAAP Equity, 9/30/02

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Thoughts on Interest Rate Risk & Business Mix

We believe that credit quality is a key consideration, but also think that it isunadvisable to judge the risk of an insurer solely based on credit considerations.One company may have substantially more junk bond exposure than another, butwhat if the company with a smaller commitment to high yield bonds has materialexposure to interest rate risk? An insurer may invest slightly more heavily in longdated, lower quality private placements than the average insurer, but does thismean an unreasonable level of risk if this company’s insurance liabilities are longduration and highly predictable?

� A Rule of Thumb on Interest Rate Risk

There are two primary risks that insurance companies’ assume in order to achieveadequate investment spreads: credit risk and interest rate risk. All of thecompanies that we cover have investment strategies that combine both risks, butmany insurers favor one over the other. In general, we would prefer thatcompanies take credit risk because we believe that fundamental analysis addsvalue to the security selection process (I guess we have to believe this, or elsewe’d turn off the lights).

One potential screen to assess the appetite of an insurance company for interestrate risk is the commitment to residential mortgage-backed securities (MBS).Residential MBS have high credit ratings (typically triple-A), but can exhibitunpredictable cash flow characteristics when interest rates change by a substantialamount. A company could be duration-matched for a small change in interestrates, but a large movement in rates could cause a residential MBS portfolio toshorten or lengthen materially as prepayments speed up or slow down (i.e.,negative convexity). As a result, a mismatch could develop between assets andliabilities for what was seemingly a “matched” book of business. We stress thatthe portion of invested assets allocated to residential MBS is a “rule of thumb” tomeasure rate risk. For example, the types of securities (i.e., the priority of theclaim on the cash flows from the underlying mortgages) are a critical factor thatdetermines the level of interest rate risk.

We have ranked the companies in our coverage universe based on exposure toresidential mortgage-backed securities (Figure 105). In most cases, we had accessto the detailed breakdown of the mortgage-backed holdings, but in some instanceswe had to estimate the allocation to residential MBS. (We have focused onresidential mortgage-backed securities because commercial mortgage-backedsecurities do not entail meaningful prepayment risk.)

We’d rather see credit risk thaninterest rate risk



Figure 105: Residential Mortgage-Backed Securities as a % of Invested Assets, 9/30/02

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� Mix Considerations Should Not be Ignored

The business mix of an insurer will have a material impact on the investmentstrategy. This is a key factor that limits somewhat the comparison of companiesbased only on the left-hand side of the balance sheet, which is the approach thatwe will generally adopt throughout this section. Using data from Schedule D ofthe statutory financial statements, we have listed the breakdown of fixed incomeinvestments by maturity groupings for each company in our coverage universe(Figure 106). The order of the companies in Figure 106 was determined by theimportance of the major product categories to overall results (asset accumulation,individual life insurance and supplemental health). In general, the data indicatesthat asset accumulators have shorter duration portfolios than life insurers, andsupplemental health companies have the longest duration portfolios. In our view,asset accumulators have perhaps the most unpredictable cash flows, so the risk-reward from investing long is probably unfavorable. (Table 79 provides detail onthe amount of fixed annuity reserves for each company we cover.) Lifecompanies have longer-dated liabilities and more predictable cash flows than assetaccumulators, which allow for a slightly more aggressive posture. Finally,supplemental health insurers typically generate enough cash flow from operationsto pay claims, so there is the ability to invest long term to add incremental yield.

Investment portfolio strategywill differ materially

by line of business



Figure 106: Bond Maturity Schedule for Companies in Merrill Lynch Life Ins. Composite, Grouped by Major Lines of Business, 2001

Less Than More ThanBusiness Lines 1 Year 1-5 Year 5-10 Year 10-20 Year 20 Years

Short Individual and group annuities, ordinary

Nationwide Financial and variable life insurance, asset 16.1% 45.1% 28.8% 7.4% 2.6%

management.Individual annuities, variable and

Phoenix Companies interest sensitive life and 8.0% 31.8% 34.5% 16.2% 9.5%

managed accounts.Pensions, annuities, individual life and

Principal Financial disability, group life and health, residential 12.2% 44.6% 25.6% 10.7% 6.8%

mortgages and international pensions.Individual annuities, individual and group

Hartford Life life insurance 9.1% 34.8% 26.4% 15.6% 14.2%

Individual annuities, ordinary life

Lincoln National and health insurance, life 9.2% 27.9% 33.1% 13.3% 16.5% Asset Accumulation

reinsuance, asset management.Individual life, annuities, mutual funds,

Prudential Financial property-casualty, securities brokerage, 16.2% 23.9% 23.1% 17.0% 19.8%

group life and international insurance.Ordinary life insurance, annuities,

John Hancock Financial GICs and mutual funds. 8.1% 29.4% 35.3% 19.2% 8.0%

DurationIndiv. and group life insurance and

MetLife annuities, non-medical health insurance 7.6% 27.2% 27.9% 13.2% 24.1%

asset mgt., auto and homeowners insurance.Individual life insurance, dental insurance, Individual life

Protective Life commercial mortgages, investment 16.5% 31.3% 15.7% 13.6% 22.9%

products.Individual ordinary life insurance,

Jefferson Pilot individual and group annuities, 7.6% 31.9% 34.3% 17.7% 8.5%

communications.Individual and group life, health, and

Torchmark Corp. annuities. 3.5% 20.3% 45.6% 17.5% 13.0%

Group life and disability,

StanCorp Financial individual disability income and 10.8% 37.4% 33.2% 8.2% 10.5%

retirement plans.Individual and group short-term and long-

UnumProvident term disability, group life, accident, and 3.5% 9.9% 22.3% 30.7% 33.7% Supplemental Health

long-term care insurance.Life and supplemental health

AFLAC insurance including cancer, 4.1% 7.0% 18.6% 34.3% 36.1%

Long accidental death and disability.

ML Life Insurance Index Average 10.1% 27.0% 27.4% 16.8% 18.8%

Life Insurance Industry Average 9.1% 27.9% 30.0% 14.5% 18.5%

Maturity of Total Bond Portfolio, 2001

Sources: Sheshunoff Information Services and Merrill Lynch.



Table 79: Fixed Annuity Reserves as a % of General Account Reserves

Nationwide Financial 90%Principal Financial 69%Hartford Financial 60%John Hancock 51%MetLife 48%Protective Life 46%Lincoln National 40%Jefferson-Pilot 35%Prudential Financial 31%StanCorp Financial 30%Phoenix Companies 10%Torchmark 10%AFLAC 0%UnumProvident 0%

Notes: Hartford reflects life company only. Data as of 3Q02.Source: Company reports and Merrill Lynch estimates.

Other Assets

� Due and Deferred Premiums

Deferred premium assets are intended to adjust an overly conservative statutoryreserve. The line item applies to policies whose premium payments are made moreoften than annually. Uncollected premiums are simply premiums that are due buthave not yet been collected as of the Annual Statement date. In statutoryaccounting, these assets are recorded at the net premium amount. Under GAAP, duepremiums are a recoverable and deferred premium is an adjustment to reserves.

� Reinsurance

Reinsurance is the transfer of insurance risk from one insurer to another inexchange for some form of compensation. The company that transfers the risk iscalled the ceding company, and the company that accepts the risk is called thereinsurer. This is an asset account that may or may not be broken out separately.It includes amounts recoverable from reinsurers, commissions and expenseallowances due and experience ratings and other refunds due.

� Separate Account Assets

Held and managed separately from the company’s other assets, separate accountassets generally are used for products in which policyholders themselves acceptthe investment risk. Examples of these products are variable and universal lifeinsurance, variable annuities, pension contracts and other employee benefits. Theseparate account is distinguished from the general account in that a generalaccount is a pool of assets for the insurer’s guaranteed products. The separateaccount asset is matched almost dollar for dollar against a separate accountliability. Separate account assets are reported at market value in both statutoryand GAAP accounting.

� Deferred Policy Acquisition Costs

For the proper matching of revenue and expenses, GAAP permits the insurer tocapitalize certain up-front costs and amortize them over time. The deferral helpsto alleviate surplus strain as well as give a better indication of the actualprofitability of a block of policies. The capitalized costs are called deferred policyacquisition costs (DPAC or DAC).



17. Understanding DACOne of the life insurance industry’s more important and complex accounting topics,the amortization of deferred acquisition costs has a “black box” quality from anoutsider’s perspective. Even if an investor understands the mechanics of theamortization process (which we explain below), the lack of disclosure of the necessaryassumptions makes the assessment of life insurers’ earnings quality difficult.

Insurance companies incur heavy costs associated with the initial sale of lifepolicies. The up-front outlays (acquisition costs) include sales commissions forthe agents or other intermediaries and processing costs. The benefits and expensescan easily exceed the revenue the insurer will receive during the first year that thepolicy is in force. This statutory loss leads to a situation known as surplus strain.Surplus strain occurs when the cost of writing new business (including the reserverequirement) actually outweighs the cash inflow associated with the same newbusiness, causing the surplus of an insurer to decrease with the addition of thepolicies.

Despite the possibility of surplus strain, statutory accounting – in keeping with itsconservative nature – requires the insurer to expense acquisition costs as they areincurred. Statutory accounting rules alleviate surplus strain somewhat through themodification of reserves as opposed to the deferral (capitalization) of costs. Forthe proper matching of revenue and expenses, GAAP requires the insurer tocapitalize the up-front acquisition costs and to amortize this balance over time.The deferral helps to alleviate the GAAP equivalent of surplus strain as well asgive a better indication of the expected profitability of the block of policies. Thecapitalized items are called deferred policy acquisition costs (DPAC or DAC).

To demonstrate a surplus strain scenario, the example in Table 80 assumes the saleof policies that generate $300 million in first-year premiums and require $200 millionof acquisition costs and $200 million in reserves. After the payment of the up-frontcosts and the establishment of the reserve, surplus must fall by $100 to keep theaccounts in balance. Without the capitalization of expenses, assets only include the$100 million in cash ($300 million in collected premiums less the $200 million incosts paid). By contrast, the example in Table 81 assumes that 75% of the up-frontcosts are capitalized and amortized over time. In this scenario, assets include the $100of cash and $150 of DAC, and the surplus has a net gain of $50 instead of a decreaseof $100. Thus, the surplus strain has been eliminated.

Table 80: Example of Surplus Strain (Statutory Balance Sheet)

ASSETS: LIABILITIES:Cash $100 Policy Reserves $200

CAPITAL:Surplus ($100)

TOTAL $100 TOTAL $100


DAC refers to thecapitalization of up-front

policy acquisition costs

No DAC concept understatutory accounting



Table 81: Effect of Capitalization on the GAAP Balance Sheet

ASSETS: LIABILITIES:Cash $100 Policy Reserves $200Deferred Acquisition Costs $150 CAPITAL:

Equity $50TOTAL $250 TOTAL $250


Amortization Differs By Product Type

The amortization method for DAC depends on the classification of the relatedproduct as either FAS 60 (traditional contracts) or FAS 97 (investment contracts).

� FAS 60 Products – Amortization Relates to Premium Income

For traditional products, DAC is written off as a constant percentage of premiumincome. Although it sounds relatively simple, the calculation can be a little tricky.We illustrate FAS 60 DAC amortization with the example shown in Table 82. Wehave assumed that the block of business generates $1 million in premium in yearone, and in subsequent years the premium income declines by $100,000 per yearbecause of policyholder deaths and surrenders. Assuming a discount rate of 8%, thepresent value of the premiums is $4.44 million. Although the insurer continues tocollect premiums, no new policies are sold, so the company incurs no additionalacquisition costs after the first year. We also have assumed that acquisition coststotaling $1.5 million are deferred and that there are no renewal expenses or otherongoing expenses related to the block of business. The steps required for thepreparation of the amortization schedule include:

1. Calculate the rate at which DAC is to be amortized by dividing the total DACby the present value of the expected stream of premiums. In this example, thepercentage is 33.77%.

2. Calculate the gross DAC amortization schedule by multiplying each year’sexpected premium income by the DAC amortization percentage (33.77%).

3. Calculate the end-of-year DAC balance, which is the quantity of thebeginning-of-year DAC balance less gross amortization (Net DAC to Accrue)increased by the discount rate.

4. Finally, the charge to earnings (i.e., net amortization) is the differencebetween the beginning-of-year and end-of-year DAC balances. After tenyears, the cumulative earnings charge equals the original acquisition cost of$1.5 million.

Under FAS 60, insurers perform DAC calculations using the original mortality,morbidity, surrender, and interest rate assumptions that were made when thepolicies were sold, plus a provision for adverse deviation (a built-in cushion forthese assumptions). The assumptions do not change (called a “lock in”) unlessactual experience deviates from what was expected by such a large amount that apremium deficiency exists. A premium deficiency occurs when the grosspremium (the amount the policyholder pays) is less than the net premium (theamount necessary to provide coverage). In the event of a premium deficiency, theinsurer adjusts the DAC asset balance and reserves to reflect more realisticassumptions. The first step would be to reduce the DAC asset balance, and then –if necessary – accrue a liability for the deficiency.

DAC assumptions for FAS 60products are fixed at the time

the policy is written



Table 82: Amortization of Deferred Acquisition Costs for FAS 60 Products

Premium Discounted DAC Gross Net DAC DAC EarningsYear Income @ 8% Beg of Yr. Amort. to Accrue End of Yr. Charge1 1,000,000 1,000,000 1,500,000 337,732 1,162,268 1,255,249 244,7512 900,000 833,333 1,255,249 303,959 951,290 1,027,394 227,8563 800,000 685,871 1,027,394 270,186 757,208 817,785 209,6094 700,000 555,683 817,785 236,412 581,372 627,882 189,9035 600,000 441,018 627,882 202,639 425,243 459,262 168,6206 500,000 340,292 459,262 168,866 290,396 313,628 145,6347 400,000 252,068 313,628 135,093 178,535 192,818 120,8108 300,000 175,047 192,818 101,320 91,498 98,818 94,0009 200,000 108,054 98,818 67,546 31,271 33,773 65,04510 100,000 50,025 33,773 33,773 0 0 33,773TOTAL 4,441,390 1,500,000Discount Rate 8%Present Value of Premiums 4,441,390Capitalized Acquisition Costs 1,500,000DAC Amortization Percentage 33.77%


� FAS 97 Products – Amortization Relates to Gross Profit

The DAC amortization calculation for FAS 97 products is similar to the FAS 60method, but it is based on different assumptions. Under FAS 97, DAC is writtenoff as a constant percentage relative to the stream of expected gross profit from theblock of policies versus a percentage of premium for FAS 60 products. Thisapproach makes sense because FAS 97 products typically do not generate a steadyflow of premium income. According to FAS 97, gross profit includes all of thefollowing:

1. Amounts expected to be assessed for mortality (sometimes referred to as thecost of insurance) less benefit claims in excess of related policyholderbalances released. This could be referred to as the mortality spread.

2. Amounts expected to be assessed for contract administration less costsincurred for contract administration (including commissions that are notdeferred). This could be thought of as the expense margin, although it is notunusual for it to be a negative number.

3. Earnings from the investment of policyholder balances less interest credited topolicyholder balances, which often is referred to as the investment spread,and/or retained fee income earned on separate account policyholder balances.

4. Other expected assessments and credits (e.g., surrender charges).

On a GAAP basis, gross profit can also be thought of simplistically as pretaxoperating profit before the amortization of acquisition costs.

We illustrate FAS 97 DAC amortization with the example shown in Table 83. Wehave assumed that this block of FAS 97 business will generate the estimated streamof gross profit shown in the first column. The present value of the expected grossprofit is $88,799, based on a discount rate of 5% (the same as the crediting rate forthe policies). We have assumed that the capitalized acquisition costs are $60,000.

1. To calculate the rate at which DAC is amortized, divide the total DAC assetby the present value of the stream of expected gross profit. In this example,the percentage, which is sometimes referred to as the k-factor, is 67.57%.

2. Calculate the gross DAC amortization schedule by multiplying each year’sexpected gross profit by the DAC amortization percentage (67.57%).



3. Calculate the end-of-year DAC balance by increasing the beginning-of-yearbalance by the policy crediting rate and subtracting the period’s gross DACamortization.

4. Finally, the charge to earnings (net amortization) is the difference between thebeginning-of-year and end-of-year DAC balances. After ten years, thecumulative earnings charge equals the original acquisition cost of $60,000.

Table 83: Amortization of Deferred Acquisition Costs for FAS 97 Products

Gross DAC Gross Accretion DAC EarningsYear Profit Beg of Yr. Amort. to DAC End of Yr. Charge1 19,000 60,000 12,838 3,000 50,162 9,8382 16,480 50,162 11,135 2,508 41,535 8,6273 14,292 41,535 9,657 2,077 33,955 7,5804 12,391 33,955 8,373 1,698 27,280 6,6755 10,742 27,280 7,258 1,364 21,386 5,8946 9,309 21,386 6,290 1,069 16,165 5,2217 8,066 16,165 5,450 808 11,523 4,6428 6,987 11,523 4,721 576 7,378 4,1459 6,051 7,378 4,089 369 3,658 3,72010 5,685 3,658 3,841 183 0 3,658TOTAL 60,000Crediting Interest Rate 5.0%Present Value of Gross Profit 88,799Capitalized Acquisition Costs 60,000DAC Amortization Percentage 67.57%


� FAS 60 and FAS 97 DAC Methodologies Compared

The DAC amortization methodologies for FAS 60 and FAS 97 include three basicdifferences:

1. The calculation is based on premium income under FAS 60 versus grossprofit under FAS 97;

2. The interest rate used for the present value calculation, as well as the annualaccretion of the DAC balance, is the policy reserving rate (the expectedinvestment earnings rate less a provision for adverse deviation) for FAS 60versus the crediting rate for FAS 97; and

3. DAC amortization is a considerably more dynamic process for FAS 97 productsthan it is for FAS 60 products, as described in greater detail below. The FAS 60amortization schedule does not provide for retroactive restatements.

An important difference between the two accounting standards with respect toDAC is FAS 97’s prohibition of the use of a cushion in the assumptions versus theFAS 60-style provision for adverse deviation. Because of the difference inapproach to initial assumptions, the FAS 60 amortization schedule does notprovide for retroactive restatements (except in the extreme case of a premiumdeficiency), which stands in contrast to FAS 97’s ongoing updates to the DACamortization schedule for revised expectations. FAS 97 requires the insurer toreview its expectations of gross profit regularly, recalculate the DAC amortizationschedule using past experience and new expectations, and use the incomestatement in the current accounting period to make any necessary adjustments tothe DAC asset balance. An actual result that is different from the expected releaseof DAC from the balance sheet is called an unlocking. The unlocking process isnormal and inevitable because actual gross profit virtually will never preciselyequal the forecasted amount. This characteristic of FAS 97 has become noticeablerecently because the DAC unlocking experienced by some variable annuity writershas been unusually large driven by the steep decline in the equity market. One by-

Unlike FAS 60, FAS 97 requiresregular adjustments to DAC

asset

For FAS 97, DAC unlockingoccurs when profits differ from

original expectations



product of “static” DAC amortization under FAS 60 versus “dynamic”amortization under FAS 97 is that the full positive or negative effect fromexperience that differs from expectations affects the income statement under FAS60 but not under FAS 97. Under FAS 97, in the event that a gross profit forecastproves to be wrong, there is a concomitant adjustment to DAC amortization,reducing the effect on the bottom line. This “DAC offset” does not occur for FAS60 products. Unlocking also is the term used to describe an insurer’s adjustmentof one or more of the basic assumptions of the entire schedule of gross profitforecasts. By directing insurers to use “best estimate” assumptions going forward,FAS 97 may have forced some insurers to adopt more disciplined practices.

To demonstrate how unlocking works, we present in Table 84 an example thatuses the FAS 97 DAC amortization schedule from Table 83 as a base. In ourrevised scenario, we assume that during year 2 the insurer determines that grossprofit in years 2 through 10 will be slightly lower than originally expected. Wehave kept all other assumptions the same, including that the gross profit in year 1was consistent with the original expectation. Making the change for expectedgross profit in years 2 and beyond leads to a present value of gross profit that isslightly lower than the base case ($85,264 versus $88,799). As a result, the DACamortization percentage increases to 70.37%, compared to 67.57% in the basecase. To properly account for the changes in gross profit expectations for years 2through 10, the insurer must recalculate the entire DAC amortization schedule(including the figures for year 1) using the new amortization percentage, as shownin Table 85.

With the entire amortization schedule revised during year 2 for the lower grossprofit assumptions, the insurer is prepared to calculate the effect of the newassumptions on the financial statements. Table 85 is a worksheet for thecalculation. The Original Estimate column shows the progression of the DACasset balance using the original expectations for year 1 and the revisedexpectations for year 2. The Revised Estimate column shows the progression ofthe DAC asset balance for both year 1 and year 2 as if the revised expectations hadbeen in place from the start.

The required earnings charge (or net DAC amortization) for year 2 is the differencebetween the actual year 1 ending DAC asset balance of $50,162 and the targetedyear 2 ending balance of $41,094. The $9,068 expense includes the required,“catch-up” adjustment of $559 (as shown in Table 86). The adjustment is thedifference between the values for the year 2 ending DAC balance shown in theOriginal Estimate and the Revised Estimate columns ($41,653 and $41,094,respectively). In this case, the adjustment involved an “earnings hit” because thedownward revision of the gross profit estimates forced an acceleration in the write-off of the DAC asset. Our example is analogous to Lincoln National’s 2Q02 DACunlocking, which related to actual equity market returns that were substantiallybelow the levels management had assumed to derive estimates of future grossprofit. Lincoln’s reduced gross profit expectations caused a large unlockingadjustment – proportionately less profit in the future meant that the companyshould have been amortizing DAC more quickly in the past. Yet, we note that,based on the particulars of the changes in a company’s assumptions, DACunlocking can have either a negative or a positive effect on the income statement.

Large unlocking adjustmentsare an indication thatpast profitability wasover- or under-stated



Table 84: Revised Amortization of Deferred Acquisition Costs for FAS 97 Products

Gross DAC Gross Accretion DAC EarningsYear Profit Beg of Yr. Amort. to DAC End of Yr. Charge1 19,000 60,000 13,370 3,000 49,630 10,3702 15,656 49,630 11,017 2,481 41,094 8,5363 13,577 41,094 9,554 2,055 33,595 7,4994 11,772 33,595 8,284 1,680 26,990 6,6045 10,204 26,990 7,181 1,350 21,159 5,8316 8,844 21,159 6,223 1,058 15,994 5,1657 7,663 15,994 5,392 800 11,401 4,5938 6,638 11,401 4,671 570 7,300 4,1019 5,748 7,300 4,045 365 3,620 3,68010 5,401 3,620 3,801 181 0 3,620TOTAL 60,000Crediting Interest Rate 5.0%Present Value of Gross Profit 85,264Capitalized Acquisition Costs 60,000Amortization Percentage 70.37%


Table 85: DAC Unlocking for Change in Gross Profit Assumptions

Original Estimate Revised EstimateASSUMPTIONS:PV of Estimated Gross Profit 88,799 85,264Capitalized Acquisition Costs 60,000 60,000Amortization Rate 67.57% 70.37%YEAR ONE:Beginning DAC Balance 60,000 60,000Interest Accrual @ 5% 3,000 3,000Gross Amortization (Gross Profit = $19,000) (12,838) (13,370)Ending DAC Balance, Year One 50,162 49,630YEAR TWO (Revised Scenario):Beginning DAC Balance 50,162 49,630Interest Accrual @ 5% 2,508 2,481Gross Amortization (Gross Profit = $15,656) @ New Amortization Rate (11,017) (11,017)Ending DAC Balance, Year Two 41,653 41,094

Source: Merril Lynch.

Table 86: Income Statement Impact

Year 1 Year 2Gross Amortization (12,838) (11,017)Interest Accrual 3,000 2,508DAC Unlocking (559)Earnings Charge (9,838) (9,068)


� Understanding Difference between Unlocking and Recoverability

There is some confusion among investors about the difference between DACunlocking and recoverability. For example, Lincoln National recorded ameaningful DAC unlocking in 2Q02 because of the weak equity market,penalizing earnings by 15%, but management also stated that the stock marketwould need to decline by another 50% before there is a DAC recoverability issue!Although there may seem to be an obvious disconnect between the 2Q results andmanagement’s comment, that would be an incorrect conclusion. Unlocking refers

Unlocking does not mean thatthe DAC asset is unrecoverable



to a retrospective restatement of DAC that occurs when the current expectation ofthe present value of gross profits is less than or greater than initially contemplated,but still in excess of the DAC asset. For example, Lincoln National managementstated that the k-factor for the company’s annuity business remains 50%-55%. Inother words, the DAC asset is approximately half of the present value of expectedgross profits. Recoverability is an issue when the DAC asset is greater than thepresent value of expected gross profits (i.e., a k-factor above one).



18. Accounting for ReservesIn general, reserves are provisions for liabilities that have a high probability ofoccurrence but can be uncertain in amount or in dispute. Life insurance companiesare required to maintain many different types of reserves, the most important ofwhich relate to policyholder benefits. Insurers vary in the conservatism of theirreserving practices. Because of this and the high importance of actuarialassumptions in the determination of the liabilities, reserves are another element oflife insurance accounting that makes the assessment of earnings quality difficult.

Life insurers establish policy reserves to provide for the future benefits andexpenses related to the in-force policies. In theory, to cover expenses and profit,an insurer should collect more in premiums over time than it pays in benefits. Tocalculate reserves, most insurers use the net level premium approach, whichassumes that net premiums are a constant percentage of gross premiumsthroughout the life of the policy. Insurers use this approach two different ways –the prospective method and the retrospective method.

Prospective Method for FAS 60 Products

For FAS 60 products, the prospective method bases the reserve calculation on theanticipated stream of future net premium. The net premium is the minimumnecessary to provide a policy’s promised benefit, based only on the mortality,persistency and interest rate assumptions. Specifically, policy reserves arecalculated as the present value of future benefits (PVFB) less the present valueof future net premiums (PVFNP). This definition seems fairly straightforward,but the calculation can get a little tricky.

� Variables and Equations

PVFNP = the present value of future net premiums

PVFB = the present value of future benefits

PVFGP = the present value of future gross premiums

Int = Interest rate

T = Time. Initially set at 0.

At any time in the future, the PVFNPT+X should be the ratio of the beginningPVFB to PVFGP multiplied by PVFGPT+X. Applying the ratio PVFBT/PVFGPT

to gross premiums will give you net premium received in a period. Therefore:

PVFNPT+X = (PVFBT/PVFGPT) * PVFGPT+X

When insurance policies are priced, the PVFNP should just cover anticipatedbenefits of the policy. The extra premium the insurer collects (which, togetherwith the net premium, comprises the gross premium) covers other expenses andthe insurer’s profit.

PVFBT = PVFNPT when T = 0.

At the beginning of a policy’s term (time T), there are no reserves. One periodlater (T+1), the reserve will reflect the initial calculations of PVFB and PVFNP, aswell as an interest accretion related to the passage of time, the payment of anybenefits during the period (so no longer part of “future benefits”) and the receiptof the first net premium (so no longer part of “future net premiums”). We haveassumed that the net premiums are received at the beginning of the year, thereforethe net premium receives a full year’s interest income.

Net level premium reservingprovides prospective andretrospective approaches

Reserves = PV future benefits –PV future net premiums



ReserveT = PVFBT – PVFNPT = 0

ReservesT+1 = PVFBT+1 – PVFNPT+1

PVFBT+1 = PVFBT * (1+Int) – Benefits PaidT+1

PVFNPT+1 = PVFNPT * (1+Int) – Net PremiumsT+1 * (1+int)

Substitution into the first-year reserve formula produces:

ReserveT+1 = (PVFBT – PVFNPT) * (1+Int) + Net PremiumsT+1 * (1+Int) –Benefits PaidT+1

For our numerical example in Table 87, we have assumed values for the PVFGP,PVFB, yearly premium and yearly benefits paid. Also, we have assumed that allpremiums are collected on the first day of the year, and that all benefits are paid onthe last day of the year. Because PVFB = PVFNP at the beginning of the policyterm, the ratio of PVFB/PVFGP is applied to gross premiums received.

Table 87: Calculation of Policy Reserves for a FAS 60 Product

Yr. 1 Yr. 2 Yr. 3 Yr. 4 Yr. 5Gross Premiums Received 20,000 18,000 16,000 14,000 12,000Reserve Rollforward:Beginning Reserve Balance 0 8,920 17,582 25,564 33,013Plus: Liability Increase (Premium x 45%) 9,000 8,100 7,200 6,300 5,400Plus: Interest 720 1,362 1,983 2,549 3,073Less: Benefits 800 800 1,200 1,400 1,400Ending Reserve Balance 8,920 17,582 25,564 33,013 40,086Reserve Increase (Expense Item) 8,920 8,662 7,983 7,449 7,073PV of Gross Premiums 100,000PV of Future Benefits 45,000PVFB / PVFGP 45%Interest Rate 8%


Retrospective Method FAS 60

The retrospective method considers historical results in the estimation of reserves.Under this method, the reserves equal the accumulated value of net premiumsless the accumulated cost of insurance. The accumulated value of net premiumsis the sum of the net premiums received plus interest, and the accumulated cost ofinsurance is the total amount of benefits paid plus interest. Insurers use theretrospective method much less frequently than the prospective method.

FAS 97

For FAS 97 products, insurers do not treat premiums as revenue. Instead,premiums are deposited into an account from which policy charges are deducted,forming the basis for the generation of the policy’s revenue. This deposit accountis analogous to a savings account, as deposits are made, interest is credited andfees and withdrawals are deducted. Typical fees for a FAS 97 product aremortality assessments to cover the insurance risk and charges for administering thecontract. According to FAS 97, the policy reserve includes:

• The account balance as of the balance sheet date;

• Amounts the insurer assesses for services to be performed in future periods;

• Amounts the insurers assesses that are refundable upon termination of thecontract; and

• Any probable loss such as a premium deficiency.

In the circumstance that the policy does not have an account balance, the cashsurrender value should be used to calculate the reserves.

Reserves = Accumulated netpremiums – accumulated cost

of insurance



Surplus Strain

Large first-year policy acquisition costs often lead to a statutory loss, whichproduces a decline in surplus. This reduction in equity is known as surplus strain.Under GAAP, the DAC asset is used to alleviate surplus strain. For statutoryaccounting, surplus strain is reduced by modified reserving methods. Onecommonly used method is the full preliminary term method. It states that thefirst year reserve is equal to the end-of-year reserve of a one-year term policy,which equals zero. Basically, insurers are not required to establish statutoryreserves for a block of policies during the first year the policies are in force.

Difference Between Statutory and GAAP

Statutory reserves are more conservative than their GAAP counterpart. UnderSAP, reserves are calculated using:

• Conservative mortality tables, which have a cushion;

• A lower-than-expected interest rate;

• An assumption of no withdrawals; and

• An assumption that future benefits are limited to death benefits.

On the other hand, GAAP reserves use:

• Realistic mortality tables, with a provision for adverse deviation;

• A realistic interest rate assumption, reduced by a provision for adversedeviation;

• A realistic withdrawal assumption; and

• Future benefits that can include surrenders, dividends and maintenanceexpenses, in addition to death benefits.

� How Much is Enough?

Insurance companies have considerable discretion in the decisions regardingreserving levels. Conservative reserving practices lead to higher reserves and,typically, higher ratings from the rating agencies. However, by being tooconservative, the insurer could eventually price itself out of the market. This isbecause, given consistent profitability targets, the insurer must charge more for apolicy for which it maintains relatively higher reserves.

Other Types of Reserves

� Premium Deficiency Reserves

The need for a premium deficiency reserve arises when a policy’s gross premiumis less than its net premium. This situation can result from the sale of acompetitively priced product, such as term insurance. The premium deficiencyreserve is a statutory concept only because, under GAAP, the similar deficiencywould result in a charge to adjust the policy reserves and DAC.

� Contingency Reserves

Under SAP, contingency reserves are established to protect against unusual risks,such as very large damage awards from litigation. These reserves are consideredsurplus accounts, not liabilities. Again, this is solely a statutory concept, asGAAP specifically prohibits contingency reserves.

Under SAP, full preliminaryterm method gives a one-year

reprieve from surplus strain

Regarding reserving, there is afine line between conservatism

and competitiveness



� Interest Maintenance Reserves

Under SAP, insurers establish interest maintenance reserves (IMR) to capturerealized capital gains and losses on fixed income securities caused by a change ininterest rates. The gain or loss is added to the IMR and then is amortized intoincome over the life of the investment. This is a statutory concept only.

� Asset Valuation Reserves

The asset valuation reserve is similar to the interest maintenance reserve, but theasset valuation reserve (AVR) absorbs both realized and unrealized gains andlosses due to credit issues, such as a bond default or the bankruptcy of a stockissuer. Although the AVR is a liability on the statutory balance sheet, changes inthe AVR are charged directly to surplus. Again, this is a statutory concept only.

� Guaranteed Minimum Death Benefits

There is currently no guidance on reserving for the GMDB benefit on a GAAPbasis, so most companies have little or no reserves. Lincoln National is the onlycompany that we cover that has established meaningful reserves for this exposure.With the July 31, 2002 issuance from the AICPA of an exposure draft SOP on thistopic, we expect that reserving will become the norm under GAAP, perhaps in2004. Unlike GAAP, companies are already required to establish reserves forGMDB exposure on a statutory basis, and the formulaic nature of statutory(regulatory) accounting suggests that the reserves reflect a consistent (albeitimperfect) approach to assessing the death benefit exposure. We believe it isunlikely that GAAP reserves will ever be the equivalent of statutory reserves, butit is useful to look at statutory reserves for a conservative view of exposure.

Hartford provides a lot of detail on guaranteed minimum death benefits in itsfinancial supplement, so this is a good company to use as an example of how toestimate the ultimate GAAP reserve requirement and assess the conservatism builtinto the statutory reserve calculation (Table 88). At the end of 3Q02, Hartford’snet statutory reserve for guaranteed minimum death benefits was $366 million andthe company has not established a reserve for this exposure on a GAAP basis. Webelieve that the statutory reserve is a conservative assessment of the ultimateexposure, and the disclosure from Hartford seems to support this notion. (Wethink that the mortality assumptions – not the capital appreciation assumptions –explain the conservatism of the statutory reserve.) First, the expected deathbenefit payments are $184 million on a present value basis or approximately halfof the statutory reserve (line two in Table 88). Second, the statutory reserve isnear the tail of the distribution of possible death benefit payments on a presentvalue basis (line three in Table 88). Finally, we believe that the GAAP reservecalculation will be based on the present value of death benefits offset by thepresent value of future fees associated with this guarantee. As a result, weestimate that the GAAP reserve will be approximately two-thirds of the presentvalue of death benefits under the new SOP.

The establishment of GAAP reserves for GMDB would seem to have a minorimpact on equity for the large variable annuity writers that we cover, and Hartfordis a good example. We estimate that a GAAP reserve for this exposure would havereduced GAAP book value by less than 1.5% at September 30, 2002. The impactwould be even less today given that the equity market has rebounded sinceSeptember. Finally, the hit to book value for Hartford would have been modest atthe end of 3Q02 even if the statutory reserve was held on a GAAP basis. We donot think that GAAP will move toward a statutory reserving methodology.



Table 88: Hartford Financial Services – GMDB Exposure ($ in Mils.)

09/30/2002GMDB net statutory reserve 366Present value of unreinsured guaranteed death benefits 18495% confidence interval of PV of death benefits (91-378)

Estimated GAAP GMDB reserve under new SOP 123Current GAAP GMDB reserve 0Increase in reserve related to new accounting standard 123Impact per share (after-tax) 0.48Impact on book value excluding FAS 115 1.3%

Sources: Company financial supplement and Merrill Lynch estimates.

� Other VA Guarantees with Limited or No SAP or GAAP Reserves

In our opinion, other guarantees on variable annuity products could be a source ofdisappointment for the industry, and while there is guidance for establishingstatutory reserves (Actuarial Guideline MMMM, which is a temporary measure),it is unclear that reserving for these guarantees will be required on a GAAP basisin the near future. Guaranteed minimum income benefits (GMIB) and guaranteedaccumulation benefits (GMAB) both fall under the category of “living benefits”.Insurers charge high fees for these features (perhaps 30 to 100 basis points) andutilize conservative annuitization rates (i.e., low interest and mortality rates) toformulate the guaranteed payments in the case of GMIB, which is the morepopular of the two. However, we still worry about the potential for correlatedrisks to lead to unexpected outcomes in some cases. For example, a GMIBproduct guarantees a minimum periodic payment if a policyholder chooses toannuitize rather than take a lump sum payout. In some instances, we think thatinsurers have probably looked at historically low annuitization rates (i.e., themajority of policyholders have taken lump sum withdrawals over time) andthought of this guarantee as a gimmick more than anything else. However, webelieve that if this option is substantially “in the money”, annuitization rates couldexplode on the upside. Unlike guaranteed death benefits where the two primaryrisks are uncorrelated (performance of the stock market and mortality), incomebenefits have two primary risk factors that appear highly correlated (performanceof the stock market and the percentage of policyholders electing to annuitize).



19. Income StatementIn previous sections of this report we discussed the accounting methodologies fordeferred acquisition cost amortization and the maintenance of policy reserves –two of the more complex items that affect a life insurer’s income statement.Presented below are the basics of the life insurance revenue and expenserecognition mechanisms, including the differences between SAP and GAAP.

Revenue Recognition

� Premiums – Short Duration

According to FAS 60, with respect to short duration contracts, premium isrecognized as revenue over the period of the contract in proportion to the amountof insurance protection provided. For example, if an insurer receives $1,200 inpremium for a one-year term policy, the company recognizes $100 per month inrevenue. This is the same in both statutory and GAAP accounting. Premiumrecognition for short duration contracts is not an issue for FAS 97 since all shortduration contracts are classified as FAS 60 products.

� Premiums – Long Duration

Premiums from FAS 60-type long duration contracts are recognized as revenuewhen due from policyholders. This is true for both SAP and GAAP. However,SAP and GAAP have different revenue recognition rules for FAS 97-type policies.In statutory accounting, FAS 97 premiums are recognized as revenue to the insurerjust like any other policy. However, under GAAP, premiums for FAS 97 productsare not recognized as revenue to the insurer. The source of revenue for FAS 97products (either fees or investment income) depends on the type of policy.

� Investment Income

Investment income is recognized as revenue when due from the issuer.

Expense Recognition

� Benefit Expenses

Changes in reserves and benefits paid to policyholders are recognized as expensesas incurred. This is true for both statutory accounting and GAAP. Just aspremiums are not treated as revenue for FAS 97 products, benefits are notincluded in expenses. The only benefit expenses shown on the income statementare those that exceeded their respective reserves. Most of the expenses incurredand shown in FAS 97 are policy maintenance expenses.

� Policy Acquisition Costs

Policy acquisition costs are expensed as incurred for statutory accounting. UnderGAAP, a large portion of these costs are deferred and amortized based on eitherpremiums or gross profit.

� Earnings

GAAP earnings tend to be larger than statutory earnings. From our analysis of thecompanies we follow at Merrill Lynch, we found that statutory earnings areroughly two thirds of GAAP earnings.

Short duration premiumrecognition is the same under

GAAP and SAP, while...

...recognition of long durationpremium differs



20. How to Think About Life ReinsuranceReinsurance is the transfer of insurance risk from one insurer to another inexchange for some form of compensation. The company that transfers the risk iscalled the ceding company (primary insurer), and the company that accepts therisk is called the reinsurer. One of the attractions of reinsurance is that it can helpreduce the variability of earnings for primary insurers that can result, for example,from unexpected mortality swings. This volatility is not eliminated, however, asit is absorbed by the reinsurance capacity. One of the conceptual challenges thatwe have with reinsurance, in general, is the notion that it absorbs unacceptablevolatility or eliminates a drag on returns for a primary company and still producesan adequate rate of return for the reinsurer. The majority of reinsurance premiumsceded are for property/casualty exposures, but our discussion will focus on the lifereinsurance market.

Divergence in Primary & Reinsurance Markets

Typically, if we leave a company’s investor conference with two or threeincremental pieces of useful information, we consider the meeting a success. Onthe topic of life reinsurance, we remember being struck by comments made byLincoln National management at the insurer’s 1998 Investor Conference. Thehead of the life insurance business showed a slide with the subtitle “ExponentialGrowth in Term In-force” to illustrate Lincoln Life’s rapid growth in term lifeinsurance and commented that profitability was acceptable on a primary basislargely because Lincoln was reinsuring the bulk of the mortality risk. Later in theday, the head of the reinsurance operation expressed optimism about the futuredriven by Lincoln Re’s rapid growth in life reinsurance in force. These commentsseemed extremely contradictory to us at the time. How could profitability beacceptable as a primary writer largely because of attractive reinsurance pricing yetprofitability also be acceptable as a reinsurer in the same market? In our view, thedeterioration in actual to expected mortality at Lincoln Re in 2000 and 2001 andLincoln’s decision to sell this operation suggest that perhaps it was inconsistent toassume that strong profits would emerge on both a primary and reinsured basis.Overall, we believe that the reinsurance industry has been counting on thecontinuation of mortality improvement while primary companies are assumingstabilization in mortality trends. To the extent that we do not continue to livelonger lives, we believe that the inherent returns in the life reinsurance businesscould disappoint investors.

Reasons to Purchase Reinsurance

Reinsurance allows an insurance company to offer coverage limits on insurancecontracts that are higher than what the company is willing to retain. A primarycompany will consider its available capital and surplus to determine the amount ofloss that it is willing to absorb financially. This analysis will determine thedesired retention limit, and the primary company will look to reinsure the lossexposure that is above this retention limit. Another reason an insurance companypurchases reinsurance is to reduce fluctuations in loss experience in order tostabilize the company’s operating results. Primary companies also use reinsurancewhen entering or discontinuing a line of business. Finally, when an insurancecompany initially sells an insurance policy, the underwriting expenses associatedwith issuing the policy are charged against income, which essentially decreasesthe company’s capital surplus. As more expenses are paid from the surplusaccount, the company’s ability to write additional business is limited. Aninsurance company can reduce the strain on their surplus by reinsuring a portion ofthe business it writes. For example, a company that experiences rapid expansioncan share a portion of its underwriting expenses with reinsurance partners.



Three Types of Reinsurance

There are three primary structures of life reinsurance: yearly renewable term,coinsurance, and modified coinsurance.

� Yearly Renewable Term (YRT)

Yearly renewable term (YRT) policies are the simplest type of reinsurancecontract. Each year of the contract, the ceding company pays a premium to thereinsurer and the reinsurer in return pays a predetermined portion of the claims onthe policies reinsured. The premium charged by the reinsurer is determinedindependent of the premiums received by the direct company for the originalpolicy. The amount reinsured is based on the net amount at risk, which is thedifference between the face amount and the accumulated cash value of thepolicies. This type of reinsurance covers only the mortality risk of a policy, anddoes not address lapse, investment or expense risks. The ceding company retainsresponsibility for maintenance of reserves and receives no expense reimbursementfrom the reinsurance company.

� Coinsurance

Under a coinsurance contract, the reinsurer is liable for its proportionate share ofall risks in the policies reinsured, which includes mortality, lapse and investmentrisks. For example, if 50% of a block of business is reinsured under a coinsuranceagreement, the reinsurer receives 50% of the premiums, pays 50% of the claimsand is responsible for 50% of the reserves. The reinsurer also pays an expenseallowance to the ceding company to cover selling expenses, and shares in thesurplus strain created by new business. Coinsurance contracts are more complexthan YRT contracts.

� Modified Coinsurance (Modco)

The primary difference between coinsurance and modified coinsurance is thatunder the latter form, the ceding company retains the reserves (and therefore, theassets) on the ceded portion of the policy. This structure gives the primarycompany control over the invested assets. The reinsurer is responsible for addingto reserves, which occurs through a transfer that is net of investment income(mod-co reserve adjustment).

� Publicly Traded Life Companies Utilize all Types

Based on 10-K disclosures, it appears that the life companies in our universe haveutilized one or more of these three types of reinsurance covers. For example,Protective Life frequently cedes and assumes risk using all three types ofreinsurance agreements (YRT, coinsurance and modified coinsurance). Inaddition to the normal use of reinsurance to manage mortality risk in 2001, thecompany also utilized reinsurance in the sale of its Dental division and reinsuredfixed annuities related to the acquisition of two small insurers.

Three Types of Risks Transferred by Life Insurers

There are three main types of risks that can be transferred (ceded) or accepted(assumed) through a life reinsurance contract: mortality risk, surrender risk andinvestment risk.

� Mortality Risk

A typical reason for a primary insurance company to purchase life reinsurance isto cover excessive mortality risk. If an insurance company issues a policy with aface amount in excess of the company’s retention limit, it can limit the risk oflarge claims by transferring a portion of the risk to a reinsurer. Reinsuranceallows the insurance industry to spread its losses among a large number of

Risk can be transferred (ceded)or accepted (assumed)



companies, lessening the impact of elevated claims on any one company. Thishelps ensure that a few large claims will not effect the solvency of a singleinsurance company. The risk of catastrophic claims can further be spread throughretrocession coverage (“reinsurance for reinsurers”) since life reinsurers also haveretention limits.

� Surrender Risk

Another type of risk that can be transferred to a reinsurer is surrender risk. Forexample, an insurance company that issues policies where premiums increasesharply from one year to another might utilize reinsurance to limit the exposure tounexpected lapses. The rate of lapses on these types of policies can be higher (andpotentially unpredictable) in the earlier years.

� Investment Risk

The increasing demand for interest sensitive products has created a need forinsurance companies to manage exposure to this risk. An insurance company thatsells annuities, for example, can transfer the investment risk inherent in thesepolicies through reinsurance. We believe that this is a small market relative totraditional life reinsurance.

Nature of Reinsurance Contracts

� Exposure

Entering into a reinsurance agreement limits the maximum potential losses andprovides additional capacity for future growth. However, the typical reinsurancecontract does not relieve primary companies from their obligations to policyholders.The primary companies remain liable for the portion of ceded reinsurance if thereinsurer fails to meet its obligations under the reinsurance agreement. Mostinsurance companies carefully review the financial condition of their reinsurers andmonitor the concentration of credit risks to minimize this exposure.

Under what is known as an indemnity reinsurance contract, the policyholder maynever have knowledge that reinsurance exists. All premium payments go to theoriginal writer of the contract and the primary insurer passes on the reinsurancepremium to the reinsurer. Likewise, policyholders look to the primary insurer forclaims payments, and the reinsurer remits its portion of claims expense to theprimary insurer. The primary insurer is responsible if the reinsurer fails to payclaims, and in most cases the primary insurer can recapture all or a portion of itsliabilities under certain circumstances.

With an assumption reinsurance contract, on the other hand, the risk is permanentlytransferred to the reinsurer. Policyholders receive notification and from that pointforward, remit premiums and claims to the assuming carrier (the reinsurer). Theoriginal company terminates its future obligations to policyholders. This is a muchless common form of reinsurance than indemnity coverage.

� The Importance of Ratings

Primary companies generally want to deal with highly rated reinsurers because theprimary writer will remain liable for the portion of ceded reinsurance if thereinsurer fails to meet its obligations. The credit ratings assigned to a reinsurerare particularly important in order to evaluate financial strength. In Table 89, wehave listed the ratings assigned by A.M. Best for some of the largest lifereinsurers. It is not a coincidence that the largest reinsurance companies also havebetter-than-average financial strength ratings.

Primary company remainsliable for the portion of ceded

reinsurance if the reinsurerfails to meet its obligations



Table 89: Financial Strength Ratings of Top Life Reinsurers

A.M. BestSwiss Re A++Transamerica Occidental Life Insurance Co. A+Reinsurance Group of America (RGA) A+Employers Reassurance Corp. A+Munich Re A++ING Re A+

Source: A.M. Best

� Pricing Issues

Reinsurers theoretically have the ability to make pricing decisions that, based onthe vast amount of mortality and lapse information collected, are superior to thedecisions of an individual primary company. An actuary evaluates eachreinsurance plan to develop a pricing scheme, and prices will vary depending on thecategory of reinsurance - YRT, coinsurance and modified coinsurance. Mortalityand persistency assumptions are a critical when pricing reinsurance, and are notnecessarily independent variables. For example, poor persistency may lead to poormortality if the worst risks stay in force, which could prevent reinsurers fromrecovering their initial investment. Traditionally, term insurance mortalityexperience has been worse due to factors at issuance and renewal. An actuary mustalso consider any automatic increases/decreases in benefits paid and the point atwhich they occur in order to price effectively. A chargeback feature can providesome protection for a reinsurer in the case where lapses exceed premiums received.In this case, the excess of the reinsurance allowance paid over the ceded premiumis returned to the reinsurer in the event that an early lapse in the policy occurs.

A number of factors currently in place may bring more pricing discipline to thereinsurance market. Following the terrorist attacks on 9-11, the demand forreinsurance has risen and a shortage of reinsurance capacity has developed.Although the effects of 9-11 were primarily felt on the property-casualty side ofthe business, some of the largest property-casualty reinsurers are also meaningfulplayers in the life reinsurance market. It is possible that reinsurers in general arenow re-examining their pricing approaches and implementing tighter riskmanagement controls in order to stabilize their profit margins. Industry pricinghas been competitive for several years, so these types of actions are probablyappropriate.

� Timing and Integrity of Data

Inherent in the structure of the reinsurance business is a lag between the time aclaim is filed with the primary insurer and the time that the reinsurer is notified ofits liability. Compounding the risk related to the time lag is the potential forcommunication of inaccurate information.

� Reinsurance arrangements for the ML Life Insurance Composite

We have analyzed the reinsurance arrangements for the companies within ourcoverage universe. We have focused on premiums ceded (transfer of risk) ratherthan premiums assumed since we are less interested in acquisitions that werestructured as reinsurance transactions. As shown in Figure 107, Protective Life isthe leader among the Merrill Lynch Life Insurance Composite in reinsurancepremiums ceded as a percentage of gross premiums. According to management,the company’s reinsurers have reduced the net cost of reinsurance in the past fewyears allowing the company to increase the amount of reinsurance it cedes on newlife insurance and credit insurance sales and still generate acceptable profitability.

Mortality and persistencyassumptions important when

pricing for reinsurance

Protective Life is the leader inreinsurance premiums ceded as

a % of gross profits



Figure 107: Reinsurance Premiums Ceded as a % of Gross Premiums, 12/31/01

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AFLTM

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Note: Data for Hartford is life only. Premiums for Torchmark exclude policy charges. Premiums for Phoenix are prior todiscontinued items.Source: Company reports.

� Industry Statistics

The level of ordinary individual life insurance sales has grown at a compoundannual rate of 4.4% over the past ten years (Figure 108). Although thisperformance is consistent with the mature nature of the life insurance business, itmay surprise some that the life reinsurance market has generated rapid growthover the same period. To understand the divergent growth trends, it is helpful tocompare the primary market data with the level of ordinary life reinsuranceassumed on a recurring basis (i.e., insurance policies issued and reinsured in thesame year). Based on this analysis, the level of reinsurance assumed over the pastten years has grown at a compound annual rate of 19.7%. The percentage ofindividual life insurance sales reinsured has increased from 14.9% in 1991 to58.4% in 2001. It is this rapid growth that has led us to question the assumptionsbehind reinsurance pricing. As we have discussed earlier, rapid growth is often aprecursor to bottom-line difficulties in the insurance industry.

Figure 108: U.S. Ordinary Individual Life Insurance Sales vs. Recurring Life ReinsuranceAssumed, 1991 – 2001 (based on face-amount, $ in Billions)

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1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Retained Reinsured

Reinsurance 14.9% 13.7% 15.0% 19.5% 23.9% 31.3% 44.4% 54.2% 57.9% 61.8% 58.4% Penetration (recurring basis)

10 Yr. CAGR:Retained -2.8%Reinsured 19.7%

Note: Does not include assumption reinsurance.Source: Munich American Survey.

Level of reinsurance assumedhas grown at a CAGR of 19.7%

during the past ten years



� Non-U.S. Companies Increase Share through Acquisitions

Foreign-owned companies have increased their share of the U.S. life reinsurancemarket, largely as a result of acquisitions. Nine of the top eighteen life reinsurerswere acquired over the past six years, and the most notable transactions wereforeign companies buying U.S. operations. Significant transactions include SwissRe’s acquisition of Life Re in 1998, AEGON’s acquisition of Transamerica in1999, Munich Re’s acquisition of CNA Re in 2000 and Swiss Re’s acquisition ofLincoln Re in 2001. Six years ago, the top four U.S. life reinsurers were U.S.owned companies. Today, the two largest life reinsurance companies in the U.S.are foreign-owned and only four U.S. reinsurance companies are among the toptwelve life reinsurers (Table 90). Also, the number of participants in the lifereinsurance market has declined over the past several years. There are only twelvelife reinsurers remaining that have market shares of more than 2% versus eighteencompanies in 1995. The top five life reinsurers currently account for 70% of thetotal U.S. market.

Table 90: Top Life Reinsurers

Name Market ShareSwiss Re 30%Transamerica Re 11%Reinsurance Group of America 11%Employers Re 10%Munich Re 8%ING Re 8%American United Life 5%Allianz 5%BMA 3%Cologne Re 3%Gerling Global 3%Annuity and Life Re 2%Others 1%Total 100%

Source: Society of Actuaries, 2001 and Munich American Survey.

Foreign-owned companiesincreased their share of the

U.S. life reinsurance market



21. Accounting for Life Insurance AcquisitionsConsistent with the consolidation in other financial services industries, lifeinsurance merger and acquisition activity began as a theme in the mid-1990s andcontinued through 2001. As shown in Figure 109, M&A activity acceleratedrapidly during the latter part of the decade, but has slowed significantly in 2002.We believe that life company management teams are motivated to pursueacquisitions for two reasons: (1) a modest revenue growth outlook for theindustry; and (2) competition from other financial services industries. The firstreason is probably the biggest driver of consolidation. Management teams strivingfor double-digit earnings growth (to satisfy shareholders) understand that expenseeconomies are necessary because revenue growth is in the mid single digits. Theneed for lower cost structures has become more apparent in recent years due to asubstantial mix shift to lower-margin products (e.g., investment-oriented and termlife insurance, and variable annuities).

Figure 109: Life Insurance Merger and Acquisition Activity, 1988-2002 ($ in Bils.)

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1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Note: Disclosed transactions over $25 million, based on announcement date.Source: Securities Data Company.

For the most part, acquisition accounting is the same in the life insurance industryas it is for any other industry. One unique aspect of purchase accounting for lifecompanies is the creation of a new asset account called either Present Value ofFuture Profits (PVFP or PVP), Cost of Insurance Purchased (CIP) or Value ofBusiness Acquired (VOBA).

PVFP Similar to DAC – Both Are Capitalized“Acquisition” Costs

DAC and PVFP are similar in that they both represent the cost of new business –either written by the insurer itself (DAC) or obtained through the acquisition ofanother company (PVFP). In either case, the insurer will assess the cost of newbusiness based on its internal rate of return requirements. Like DAC, the PVFPasset is amortized over time. PVFP can be thought of as the premium paid toacquire the rights to a future stream of cash flows, which clearly is different fromthe acquisition of hard assets. Similar to the assignment of market values to assetsand liabilities for purchase accounting, the acquired cash flows also must bevalued. There is an important distinction between PVFP and goodwill. PVFPrepresents the value of the acquired insurer’s business written in the past, whilethe goodwill residual represents the portion of the purchase price that relates tobusiness to be written in the future. An insurer’s allocation of value to eitherPVFP or goodwill has implications for future amortization and the timing ofGAAP profits. However, the allocation is not important from a tax perspectivebecause both PVFP and goodwill are treated the same under Section 197 of theInternal Revenue Code.

Life insurance consolidation isa function of slow-growth and

increasing competition

PVFP is calculated beforegoodwill, lowering the

overall value of goodwill



PVFP, calculated by actuaries, equates to the present value of expected future cashflows from the in-force insurance policies, and the amortization method for thePVFP depends on the type of contract used. For example, a FAS 60 product usespremiums as a measurement base and a FAS 97 product uses gross profit. Theunamortized balance will accrue interest, just like DAC, and will amortize basedon premiums for FAS 60 products and on gross profits for FAS 97 products. Inthe footnotes to the financial statements in the Form 10-K, life insurancecompanies are required to disclose the PVFP amortization schedule for the nextfive years. Other required disclosures include a description of the accountingpolicy used and an analysis of the PVFP account for the same periods as arepresented on the income statement.

� But Some Key Differences

A key difference between DAC and PVFP is that the initial capitalized amount iseasily determined for DAC but generally involves very complex calculations forPVFP. Life insurers vary significantly in their methods for assignment of a valueto the PVFP intangible asset, and there is considerable room for “gaming” thecalculation to allow an insurer to claim that the acquisition will be accretive toearnings per share. Another important difference between DAC and PVFPcalculations involves the interest rates used. While DAC amortization is based onthe same assumptions used when calculating reserves, PVFP uses two separateinterest rates. PVFP accretes interest to the unamortized balance at the policycontract rate (the same as DAC), but the discount rate for the present valuecalculation is a different story. The discount rate essentially is the unlevered costof capital, and we believe that most companies currently are using rates of 15% to18% pretax.

According to Conseco’s 1997 10-K, the following considerations determine thediscount rate:

• Recent discount rates used in acquisitions;

• The cost of capital to fund the acquisition;

• The synergy of the acquired company, which may increase future cash flows;

• The chance that cash flows are affected by changes in insurance regulation;

• The magnitude of risks associated with the assumptions used to value theblock of business; and

• The complexity of the business acquired.

� Potential for Abuse Reduced

The adoption of FAS 142 has lessened the risk for abuse of PVFP, in our view.When goodwill was amortized, an easy way to increase the accretion from a lifecompany acquisition was to assign more of the purchase price to goodwill and lessto the present value of future profits. (This would not be the most efficientapproach from a tax standpoint, however.) GAAP earnings were higher under thistype of approach because the PVFP asset was written off at a more rapid pace thangoodwill. Therefore, the annual “hit” to earnings from the amortization ofintangibles declined as the portion of the purchase price assigned to goodwillincreased. Now that goodwill amortization has been eliminated, the potential forthis kind of abuse no longer exists.

Examples of Old and New Methods

Before the issuance of the FASB’s EITF (Emerging Issues Task Force) statement92-9, life insurers calculated PVFP amortization as shown in Table 91. Theexample clearly relates to FAS 97 products, since the primary driver is grossprofit. The calculation for FAS 60 products would use premium instead. First, theinsurer calculates the present value of the expected stream of gross profit using the

PVFP is a difficultnumber to get to

Unreasonable valuation ofPVFP can lead to questionable

earnings quality



discount (or risk) rate. Each period’s gross amortization is equal to the grossprofit generated that year. (We assume that actual profit is equivalent to expectedprofit.) Each year’s present value amount accretes interest at the discount rate.For each period, net amortization is the gross amortization less the interestaccretion, and earnings equal the interest accretion. Therefore, when actual profitproves to be the same as estimated profit, the only income statement effect will bethe accretion of the discount or the priced-for internal rate of return.

Table 91: Previous Method for Amortization of PVFP

Estimated Beg. PVFP Gross Accretion of NetYear Gross Profit Balance @ 15% Amortization Interest Amortization Earnings1 100.0 332.6 (100.0) 49.9 (50.1) 49.92 85.0 282.5 (85.0) 42.4 (42.6) 42.43 72.3 239.8 (72.3) 36.0 (36.3) 36.04 61.4 203.5 (61.4) 30.5 (30.9) 30.55 52.2 172.6 (52.2) 25.9 (26.3) 25.96 44.4 146.3 (44.4) 22.0 (22.4) 22.07 37.7 123.9 (37.7) 18.6 (19.1) 18.68 32.1 104.8 (32.1) 15.7 (16.4) 15.79 27.2 88.4 (27.2) 13.3 (13.9) 13.310 23.2 74.4 (23.2) 11.2 (12.0) 11.211 19.7 62.4 (19.7) 9.4 (10.3) 9.412 16.7 52.1 (16.7) 7.8 (8.9) 7.813 14.2 43.2 (14.2) 6.5 (7.7) 6.514 12.1 35.5 (12.1) 5.3 (6.8) 5.315 10.3 28.7 (10.3) 4.3 (6.0) 4.316 8.7 22.7 (8.7) 3.4 (5.3) 3.417 7.4 17.4 (7.4) 2.6 (4.8) 2.618 6.3 12.6 (6.3) 1.9 (4.4) 1.919 5.4 8.2 (5.4) 1.2 (4.2) 1.220 4.6 4.0 (4.6) 0.6 (4.0) 0.6


In Table 92, we demonstrate the current method for calculating the PVFP assetand the related amortization. The PVFP beginning asset balance in year one is thepresent value of estimated gross profits using the discount rate discussed above.In years 2 through 20, the asset value is the beginning balance less the grossamortization plus the interest accretion. (As was the case in the previous example,we assume that actual profits are the same as estimated profits.) The grossamortization is the current year’s gross profits divided by the present value of theremaining gross profits (including the current year) discounted at the contract ratemultiplied by the PVFP asset. Interest is accreted on the profit balance at thecontract rate and is then subtracted from the gross amortization to arrive at the netamortization. The earnings from the acquired block of business equal the grossprofit less the net amortization. This method generates an earnings stream that isequivalent to the earnings for produced business assuming that the up-front cost isthe same in both cases.

We have explained the old and the current methods above because life insurerscontinue to use both. The old method was “grandfathered” when the EITF 92-9became effective, and some companies still are amortizing PVFP related tobusiness that was acquired before the change in accounting. Yet, the change inaccounting for PVFP has only a modest effect on reported GAAP earnings. InFigure 110, we illustrate the earnings streams related to both methods for the sameblock of FAS 97 policies. Cumulative GAAP profits are the same under bothmethods, but – in this example – the current method produces slightly lowerearnings in early years and slightly higher earnings in later years. The type ofpolicies will determine the difference in profit emergence by method, but in mostcases the impact is not substantial.



Table 92: New Method for Amortization of PVFP

Estimated Beg. PVFP Balance PV of Profits Gross Accretion of NetYear Gross Profits @ 15% @ 6% Amortization of Interest Amortization Earnings1 100.0 332.6 470.5 (70.7) 20.0 (50.7) 49.32 85.0 281.8 398.7 (60.1) 16.9 (43.2) 41.83 72.3 238.7 337.6 (51.1) 14.3 (36.8) 35.54 61.4 201.9 285.6 (43.4) 12.1 (31.3) 30.15 52.2 170.6 241.3 (36.9) 10.2 (26.7) 25.56 44.4 143.9 203.6 (31.4) 8.6 (22.7) 21.77 37.7 121.2 171.4 (26.6) 7.3 (19.4) 18.38 32.1 101.8 144.0 (22.7) 6.1 (16.6) 15.59 27.2 85.2 120.6 (19.2) 5.1 (14.1) 13.110 23.2 71.1 100.6 (16.4) 4.3 (12.1) 11.111 19.7 59.0 83.4 (13.9) 3.5 (10.4) 9.312 16.7 48.6 68.7 (11.8) 2.9 (8.9) 7.813 14.2 39.7 56.2 (10.0) 2.4 (7.7) 6.514 12.1 32.0 45.3 (8.6) 1.9 (6.6) 5.515 10.3 25.4 35.9 (7.3) 1.5 (5.8) 4.516 8.7 19.6 27.8 (6.1) 1.2 (5.0) 3.717 7.4 14.7 20.8 (5.2) 0.9 (4.4) 3.018 6.3 10.3 14.6 (4.5) 0.6 (3.8) 2.519 5.4 6.5 9.2 (3.8) 0.4 (3.4) 2.020 4.6 3.1 4.3 (3.3) 0.2 (3.1) 1.5


Figure 110: GAAP Earnings Stream, Old versus New Acquisition Accounting

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FAS 141 & 142

FAS 141, “ Business Combinations”, was adopted in 2001 and FAS 142,“Goodwill and Other Intangible Assets”, was adopted in 1Q02. These accountingstandards address the way business combinations, goodwill and intangible assetsare reported under U.S. generally accepted accounting principles. FAS141eliminated pooling-of –interests accounting for all business combinationsinitiated after June 30, 2001. All mergers and acquisitions are now accounted forunder the purchase method of accounting. In FAS 142, the amortization ofgoodwill was eliminated after December 31, 2001, replaced by at least an annualtest of this asset for impairment. For non-goodwill intangible assets, if the usefullife can be estimated, amortization of the asset will continue with no limit onaverage life. For non-goodwill intangible assets with an infinite life, noamortization is required in lieu of annual impairment tests.

Pooling of interests accountingand amortization of

goodwill have been eliminated



The elimination of goodwill amortization had a one-time positive impact onearnings for the companies in our coverage universe in 2002. Given that thisaccounting change had no economic impact, we do not believe that this one-timestep up in earnings translated to higher valuations. Greater scrutiny of therecoverability of the goodwill asset, however, may lead to more timelyinformation on the true economic value of acquired properties.

It is useful to think conceptually about what the elimination of goodwillamortization now implies. In our view, there are two arguments for excludinggoodwill amortization from earnings: 1) if the goodwill asset is considered to be“evergreen” or appreciating in value; or 2) if the goodwill asset is perceived toreflect overpayment for an acquisition. Under the first argument, goodwill shouldbe considered a real asset, and therefore included in equity. The second instance,however, implies that the goodwill asset is worthless, and therefore should bededucted from equity. In both of these instances, earnings will be identical, butthe balance sheet implications are substantially different. We believe theincreased focus on asset recoverability through benchmark assessments andimpairment tests has helped clarify and quantify these risks.



22. Modeling Blocks of PoliciesAlthough accounting conventions for FAS 60 and FAS 97 products clearly aredifferent, we believe that it is inappropriate to assume that one broad product classis either more or less profitable than the other. For example, according to a surveyof life insurance companies that was performed by Ernst & Young shortly after theadoption of FAS 97, only 8% of the respondents stated that they had repriced orredesigned products as a result of FAS 97. We note that, prior to the 1988adoption of FAS 97, life insurers used FAS 60 for all products.

With the dramatic mix shift in insurance offerings in the 1980s, it became clearthat the premium-based accounting of FAS 60 did not work well for products thatnow are classified as FAS 97. We have prepared two examples of modelingGAAP income statements that relate to a hypothetical block of FAS 60 products inone case and a hypothetical block of FAS 97 products in the other. We emphasizethat the examples are based on numerous assumptions that are not specificallypatterned to correspond with an actual real world block of policies. As a result,evaluating the income statement results of the examples on a stand-alone basisprobably is more instructive than an attempt to compare these models to the actualfinancial statements of a life insurer. In our FAS 60 example, profit declines overtime as the risk associated with the “closed block” of policies runs off (Figure112). In our FAS 97 example, profit increases gradually each year after a first-year loss (related to expenses that are not deferred) because account values areincreasing (Figure 113). We note that our two examples involve different productclasses and many assumptions. Because no variables are held constant, acomparison of the earnings patterns for our FAS 60 and FAS 97 examples is notuseful. For a meaningful comparison of earnings patterns, Figure 111 illustratesthe profit emergence for the same book of business under FAS 60 and FAS 97.

Figure 111: FAS 60 and FAS 97 Earnings Streams

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FAS 60 FAS 97

Source: FASB Financial Accounting Series, November 1996.

FAS 60 (Term Policy) – Assumptions

In creating this example, we used several simplifications. We have selectedvalues for premium and benefits paid. Although not patterned after an actualblock of policies, we believe that our assumptions are reasonable. Second, thepresent value calculations on the “Assumptions” page already have been increasedby the investment rate. Third, the investment, borrowing and discount rate are allset to the same number, 7%. Fourth, the model assumes that all premiums arecollected on the first day of the year and that all benefits are paid on the last day ofthe year. Fifth, there are no surrenders.



Commissions represent 4% of collected premium each year. The excesscommission, which represents the extra commission a salesperson receives fromthe initial sale of a policy, is 46% of first-year premium. This is the deferrablecomponent of total first-year commissions. Maintenance expenses are set at 1% ofcollected premium and acquisition expenses (other than commissions) are 65% offirst-year premium.

PV CalculationsUsing premiums as an example, in the first year, the present value calculationsrepresent premiums collected in years one through ten. In the second year, thepresent value represents years two through ten, and so forth. The calculation ofpresent values for all years is only necessary for premiums and benefits. Forexpenses, the present value calculation is important for the first year only.

ReservesThe relevant formula is ReservesT+1 = PVFBT+1 – PVFNPT+1. Also, remember thatPVFBT = PVFNPT when T = 0 (the beginning of a policy). For example, thebenefit reserve at the end of year 1 (the beginning of year two) is 14,397 –(70.37%) x (19,985) = 333.

Deferred Acquisition CostsThe calculation is conceptually the same as the reserve calculation above. At theend of year one (the beginning of year two) the DAC asset is 0 – (15.36%) x(19,985) = –3,070.

Structurally, reserves and DAC are calculated almost exactly the same way. ThePV of future deferrals is substituted for PVFB, and PVFNP becomes the DACamortization percentage * PVFGP. So the basic reserve formula, ReservesT+1 =PVFBT+1 – PVFNPT+1 , when manipulated algebraically for DAC, becomesDACT+1 = PV of Future DeferralsT+1 – (PVFGP * DAC amortization)T+1.

Investment IncomeFor ease of calculation, investment income excludes interest from any equityassociated with risk based capital requirements. Also, the model assumes allprofits or loss are distributed to the shareholders at the end of the year. Therefore,investment income is calculated as cash flow (premiums minus hard costs, whichare benefits, commissions, and acquisition and maintenance expenses) minus thenet liability (DAC plus reserves).

� Profit Emergence

If actuarial predictions are perfect, the profit will be a constant percentage ofpremium collected, giving the profit emergence chart a downward slope (Figure112). The profit pattern is a straight line because we have assumed that premiumsdecline at a constant amount. The reality is that provisions for adverse deviation(PADs) will lead to a more back-loaded profit stream as they are released intoincome. We excluded PADs from the example for the sake of simplicity.



Figure 112: Profit Emergence of a FAS 60 Product

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Term Policy Example- Assumptions

ASSUMPTIONS Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10

Commission rates 50.00% 4.00% 4.00% 4.00% 4.00% 4.00% 4.00% 4.00% 4.00% 4.00%Excess Commission Rate 46.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%Excess Commissions 1,380 0 0 0 0 0 0 0 0 0Ultimate Commission 120 119 118 116 115 114 113 112 111 110

Discount/ Investment Rate 7%

PV Premiums 21,678 19,985 18,206 16,335 14,363 12,285 10,093 7,777 5,329 2,741PV Death Benefits 15,255 14,397 13,421 12,317 11,075 9,682 8,127 6,396 4,475 2,349PV Excess Commissions 1,380 0 0 0 0 0 0 0 0 0PV Acquisition Expenses 1,950 0 0 0 0 0 0 0 0 0PV Deferrals 3,330 0 0 0 0 0 0 0 0 0PV Maintenance Exp 217 200 182 163 144 123 101 78 53 27PV Ultimate Commission 867 799 728 653 575 491 404 311 213 110PV Maintenance Exp + Ultimate Comm 1,084 999 910 817 718 614 505 389 266 137

Deferrals / Premiums 15.36%Death Benefits / Premiums 70.37%Other Expenses / Premiums 5.00%Subtotal 90.73%PV of Pretax Income 9.27%

Benefit Reserve Beg. Of Year 0 333 609 822 967 1,037 1,025 923 725 420 0Change in Reserve 333 276 213 145 70 (12) (101) (199) (305) (420)DAC Beg. Of Year 0 (3,070) (2,797) (2,509) (2,206) (1,887) (1,550) (1,195) (819) (421) 0Change in DAC (3,070) 273 288 303 319 337 356 376 398 421

Investment IncomeNet GAAP Liability Beg Of Year 0 (2,737) (2,188) (1,687) (1,240) (851) (526) (271) (94) (1) 0Cash Flow (2,280) 968 884 798 712 624 534 443 350 255Investment Income (160) (124) (91) (62) (37) (16) 1 12 18 18


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191

Term Policy Example- GAAP Income Statement

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10RevenuePremium Income 3,000 2,970 2,940 2,911 2,882 2,853 2,824 2,796 2,768 2,741Investment Income (160) (124) (91) (62) (37) (16) 1 12 18 18Total Revenue 2,840 2,846 2,849 2,849 2,845 2,837 2,825 2,808 2,786 2,758

BenefitsDeath Benefits 1,800 1,854 1,910 1,967 2,026 2,087 2,149 2,214 2,280 2,349Surrenders 0 0 0 0 0 0 0 0 0 0Benefit Reserve Increase 333 276 213 145 70 (12) (101) (199) (305) (420)Total Benefits 2,133 2,130 2,123 2,112 2,096 2,075 2,048 2,015 1,976 1,929

ExpensesCommissions - First Year 1,500 0 0 0 0 0 0 0 0 0Commissions - Renewal 0 119 118 116 115 114 113 112 111 110Acquisition Expenses 1,950 0 0 0 0 0 0 0 0 0Maintenance Expenses 30 30 29 29 29 29 28 28 28 27DAC Increase (3,070) 273 288 303 319 337 356 376 398 421Total Expenses 410 422 435 448 463 479 497 516 536 558

Pretax Income 297 295 292 289 286 283 280 277 275 272Profit / Premium 9.92% 9.92% 9.92% 9.92% 9.92% 9.92% 9.92% 9.92% 9.92% 9.92%Taxes 104 103 102 101 100 99 98 97 96 95Net Income 193 191 190 188 186 184 182 180 178 177

Proof of IncomePremium Revenue 3,000 2,970 2,940 2,911 2,882 2,853 2,824 2,796 2,768 2,741Time PV of Net Income (9.27%) 278 275 272 270 267 264 262 259 257 254Plus Interest (7%) 19 19 19 19 19 19 18 18 18 18Pretax Income 297 295 292 289 286 283 280 277 275 272Profit / Premium 9.92% 9.92% 9.92% 9.92% 9.92% 9.92% 9.92% 9.92% 9.92% 9.92%




FAS 97 (Universal Life) Example – Assumptions

As in the FAS 60 example, we made several simplifications in our universal lifeexample. First, no surrenders were assumed until the end of year 10, wheneveryone is assumed to lapse (obviously unrealistic). Second, premiums and feesare collected at the beginning of the year, and benefits are paid at the end of theyear.

Premiums, Administrative Charges & Renewal ExpensesThese charges are a function of the polices in force.

Life Insurance in ForceLife insurance in force is the aggregate amount of coverage on which premiumsare still being paid. It is calculated as the death benefit times the percentage ofpolicies in force.

Cost of InsuranceThe cost of insurance, which is the value of the net protection in any year, is basedon the net amount at risk (life insurance in force less the benefit reserve). Theformula is:

[life insurance in force – (beginning-of-year account value + premium –administrative charge)] * COI charge of 0.9%.

Account Value Released at DeathThe amount of the policyholder account balance available to pay death benefits isequal to the account balances of the people who die.

End-of-Year Account ValuesGenerally, account values increase by premiums and interest credited less any feesassessed by the insurer. Specifically, this is calculated as the beginning-of-yearaccount value + premiums – administrative charges – the cost of insurance +interest credited – the account value released at death.

Gross MarginThe gross margin is the sum of the charges, benefits and interest items. Wepresent value these items for the calculation. Gross margin is calculated as:

(administrative charges – renewal expenses) + (cost of insurance + account valuereleased at death – death benefits paid) + (interest earned – interest credited).

Policy FeesPolicy fees are calculated as the administrative charges plus the cost of insurance.

Investment Income/Interest CreditedWe determine these items by multiplying the earned and crediting rate by theaccount balance. The account balance used here is the beginning-of-year accountvalue + premium – administrative charge – the cost of insurance.

Policyholder BenefitsPolicyholder benefits expense for FAS 97 products are only shown in excess ofthe associated account value. Therefore, the calculation is death benefits paidminus the account value released at death.

Deferred Acquisition CostsWe calculate the DAC asset the same way described earlier for the FAS 60example. First-year expenses are 105% of first-year premium. The amountdeferred is 95% of the first-year expenses, an assumption in the model. The DACamortization percentage is 86.44%. The earnings charge equals net DACamortization less the acquisition costs capitalized during the period.



ExpensesThe combination of first-year expenses and renewal expenses. Renewal expensesare calculated as the renewal expense percentage (8%) times the premium.

� Profit Emergence

Unlike in our FAS 60 example, our FAS 97 profit stream is not smooth, at leastnot initially. The first-year loss (as shown in Figure 113) relates to the portion ofthe up-front costs that cannot be deferred under GAAP. However, the loss isexaggerated in our example.

Figure 113: Profit Emergence of a FAS 97 Product

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portant disclosures at the end of this report.

Universal Life Policy Example- Assumptions

ASSUMPTIONSMortality 0.70% PV of Gross Margins $21.98Annual Premium $20.00First Year Exp as % of Ann Prem 105% PV of DAC Exp $19.00Renewal Expense 8%Face Amount of Policy $1,000 DAC Amortization 86.44%Cost of Insurance 0.90%Administrative Expense per Policy $1.50Earned Rate 7.25%Credited Rate 5.00%% of First Year Exp Deferred 95%Tax Rate 35%

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10

% of Policies in Force 1.00 0.99 0.99 0.98 0.97 0.97 0.96 0.95 0.95 0.94 0.93Account Value- Beg of Year 0.00 0.00 10.08 20.62 31.64 43.16 55.23 67.85 81.08 94.92 109.43Premiums 0.00 19.86 19.72 19.58 19.45 19.31 19.17 19.04 18.91 18.77 18.64Administrative Charge 0.00 1.49 1.48 1.47 1.46 1.45 1.44 1.43 1.42 1.41 1.40Life Insurance in Force 0.00 993.00 986.05 979.15 972.29 965.49 958.73 952.02 945.35 938.74 932.16Cost of Insurance 0.00 8.77 8.62 8.46 8.30 8.14 7.97 7.80 7.62 7.44 7.25Interest Credited on Acct Bal. 0.00 0.48 0.99 1.51 2.07 2.64 3.25 3.88 4.55 5.24 5.97Acct. Val. Released on Death 0.00 0.00 0.07 0.14 0.22 0.30 0.39 0.47 0.57 0.66 0.77Account Value- End of Year 0.00 10.08 20.62 31.64 43.16 55.23 67.85 81.08 94.92 109.43 124.63Death Benefits Paid 0.00 6.95 6.90 6.85 6.81 6.76 6.71 6.66 6.62 6.57 6.53Renewal Expense 0.00 1.59 1.58 1.57 1.56 1.54 1.53 1.52 1.51 1.50 1.49Interest Earned on Acct Bal. 0.00 0.70 1.43 2.19 3.00 3.83 4.71 5.63 6.59 7.60 8.66Gross Margins 0.00 1.94 2.13 2.34 2.55 2.78 3.01 3.26 3.52 3.80 4.08Acquisition Expenses 0.00 21.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00Acquisition Expenses Deferred 0.00 19.95 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00DAC- Beg of Year 0.00 0.00 18.28 17.35 16.19 14.80 13.14 11.19 8.93 6.33 3.36Interest on DAC 0.00 0.00 0.91 0.87 0.81 0.74 0.66 0.56 0.45 0.32 0.17DAC Amortization 0.00 1.67 1.84 2.02 2.21 2.40 2.61 2.82 3.05 3.28 3.53DAC- End of Year 0.00 18.28 17.35 16.19 14.80 13.14 11.19 8.93 6.33 3.36 0.00

Source: Merril Lynch

Primer V

– 6 February 2003


195

Universal Life Policy Example- GAAP Income Statement

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10RevenueU.L. Policy Fee Income 10.26 10.10 9.93 9.76 9.59 9.41 9.23 9.04 8.85 8.65Premiums 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00Net Investment Income 0.70 1.43 2.19 3.00 3.83 4.71 5.63 6.59 7.60 8.66Total Revenue 10.96 11.53 12.13 12.76 13.42 14.12 14.86 15.63 16.45 17.31

Benefits & ExpensesInterest Credited 0.48 0.99 1.51 2.07 2.64 3.25 3.88 4.55 5.24 5.97Policyholder Benefits 6.95 6.83 6.71 6.58 6.46 6.32 6.19 6.05 5.91 5.76DAC (18.28) 1.84 2.02 2.21 2.40 2.61 2.82 3.05 3.28 3.53Expenses 22.59 1.58 1.57 1.56 1.54 1.53 1.52 1.51 1.50 1.49Total Benefits & Expenses 11.74 11.24 11.81 12.41 13.05 13.71 14.42 15.15 15.93 16.75

Pre-Tax Earnings (0.79) 0.29 0.32 0.35 0.38 0.41 0.44 0.48 0.51 0.55Taxes (0.28) 0.10 0.11 0.12 0.13 0.14 0.15 0.17 0.18 0.19Net Earnings (0.51) 0.19 0.21 0.22 0.24 0.27 0.29 0.31 0.33 0.36

Account Val- Beg of Year 0.00 10.08 20.62 31.64 43.16 55.23 67.85 81.08 94.92 109.43Account Val- End of Year 10.08 20.62 31.64 43.16 55.23 67.85 81.08 94.92 109.43 124.63Average Account Value 5.04 15.35 26.13 37.40 49.19 61.54 74.46 88.00 102.18 117.03

After Tax Return on Assets -10.16% 1.22% 0.79% 0.60% 0.50% 0.43% 0.39% 0.35% 0.33% 0.31%




23. Appendix A: Life Insurer AccountingSurveyPlease answer the questions as they relate to your company and its products. Insome cases, you will find that the question is not applicable:

For each of the following product groups (SPDA, FPDA, SPIA, whole life,universal life, term, variable life, variable annuities, group disability, individualdisability, Medicare supplement, long-term care, dread disease, and other accidentand health), what is your company’s:

(a) Statutory and GAAP interest rate assumptions for insurance liabilities;

(b) Commission level – first year and renewal;

(c) Estimate of liability duration;

(d) View regarding the appropriate asset mix;

(e) Statutory strain and the required number of years to recover the strain;

(f) The percentage of profits that is a function of assets vs. a function of premiums;

(g) Use of reinsurance;

(h) Use of derivatives for risk management;

(i) View on the biggest risks to achieving priced-for results (persistency, expenses,mortality, morbidity, etc.);

(j) Margin target (be specific whether it’s pretax, aftertax, and percentage ofpremiums, assets or revenues); and

(k) Statutory and GAAP capital requirements.

What portion of DAC remains after the surrender charge period is over?

What is the DAC shock lapse assumption for asset accumulation products in thefirst year after the end of the surrender charge period? What level of shock lapsesdo you assume for each distribution system – independent agents, career agents,banks, regional broker-dealers, and wirehouses?

What are your company’s policies on DAC unlocking? How often doesmanagement review the carrying value of DAC? How much deviation onpersistency or spread is required for DAC unlocking?

What is the ratio of initial DAC to present value of gross profits for FAS 97 products(universal life, variable universal life, fixed annuities and variable annuities)?



24. Appendix B: Life Insurance Products

Policy “Adjectives”

Many life insurance contracts can be varied to fit the needs of the policyholder.The most common variations are:

� Fixed Policies

The terms of the policy are fixed. The face amount of the policy will not change,but the premium paid may not be level over time.

� Flexible Policies

The policyholder has the unilateral right to vary the terms of the policy, withinlimits. This includes both the premium paid and the face amount of the policy.The premiums can only be lowered if the policy’s built-up cash value is sufficientto cover the cost of insurance.

� Group Policies

Group policies cover numerous insured persons under a single master contract.The parties to the contract are the insurer and the group policyholder (generally anemployer). The insured persons typically are the policyholder’s employees.Virtually all group life policy contracts are constructed as one-year renewableterm insurance.

� Non-Participating Policies

Policies that do not include the insurer’s payment of a dividend to thepolicyholder.

� Participating Policies

Policies that include the insurer’s payment of a dividend to the policyholder,provided that the insurer experiences favorable mortality, expense or investmentresults.

Fixed-Premium Life Insurance

� Endowment Life

Similar to term insurance, endowment life provides the face amount of the policyif the insured dies during the coverage period. However, unlike term insurance,the insurer also will pay the face amount at the end of the term to the insuredindividual if the insured is still alive. Term is bought for the benefit of thebeneficiary, but endowment is purchased for the insured.

� Term Life

Term life insurance provides protection only for a specified period of time, asdesignated by the contract. The death benefit is paid only if death occurs withinthe stated time frame. The insurer pays no death benefit if the policyholdersurvives beyond the coverage period. These policies tend to have lower premiumsthan other types of life insurance, generally are renewable at the option of thepolicyholder, and often are convertible into whole life policies.

� Whole Life

Whole life insurance provides protection for the entirety of the policyholder’s life.The death benefit is paid regardless of the timing of the death. The whole lifeinsurance product class includes many different variations, such as:



Indeterminate-Premium Whole Life: A non-participating policy that hassmaller annual payments at first (than would normally be found in a non-participating policy) and then larger ones in later periods.

Interest Sensitive Whole Life: A whole life policy that uses current interest ratesin the cash value calculation and has an indeterminate premium structure.

Joint Life: A policy that insures two or more people, with the benefit paid afterthe first person dies. The policy is cancelled after that.

Limited Payment Whole Life: A policy that requires premium payments onlyfor a specified period, at which time the policy is considered “paid up”.

Ordinary Life: The oldest and most basic form of whole life insurance. It coversthe insured for the entirety of life, and the insurance company determines thepremiums. Premiums are paid until the insured dies.

Single-Premium Whole Life: An extreme example of a limited payment policy.The policyholder only makes one payment at the beginning of coverage.

Split Dollar Life: A policy in which the premiums and ownership rights are splitbetween two entities. Typically it involves an employer and employee or parentand child.

Survivorship Life: A joint policy that insures two or more lives and pays thedeath benefit only after all the insured persons die.

Variable Life: A whole life policy whose death benefit or surrender valuereflects the investment experience of a separate pool of assets. To a great extent,policyholders direct the investment decisions and bear the investment risk. Theseparate account assets typically are more diverse, and riskier, than generalaccount assets. Variable life policies typically involve fixed premiums and aminimal death benefit.

Flexible-Premium Life Insurance

� Adjustable Life

Whole life insurance for which the policyholder can unilaterally adjust thepremium and face value. However, between adjustments, premium paymentsremain level. It can either be a whole life or a term policy.

� Universal Life

Universal life has the same features as an adjustable policy, except that it is evenmore flexible. Policyholders determine both the timing and the amount ofpremium payments. Another feature is that these policies are transparent, meaningthat the expenses and charges are disclosed to the policyholder.

� Variable Universal Life

Combines features of both variable and universal products. It has the flexiblepremium aspect of universal policies along with the investment aspects of variablelife. The assets backing the reserves are held in separate accounts.

Annuities

An annuity is a contract involving the payment to the contract holder (annuitant) aspecified amount of money periodically for a specified period of time.

� Fixed Annuity

An annuity involving a fixed payout during the benefit period, regardless of theinvestment experience of the underlying assets. Fixed annuity assets are part ofthe insurer’s general account.



� Flexible-Premium Deferred Annuity

A deferred annuity contract under which the policyholder can unilaterally vary thepremium payments, within limits.

� Non-Qualified Annuity

Annuities involving contributions made with after-tax dollars.

� Qualified Annuity

Annuities for which contributions made with pretax dollars. These products areespecially important to certain professions, such as teachers, employees of non-profit organizations and employees of municipalities. Qualified products tend tobe the most persistent and profitable annuities for insurance companies.

� Single-Premium Deferred Annuity

Similar to a single-premium immediate annuity, however, the deferred annuity’spayments commence after a specified period of time.

� Single-Premium Immediate Annuity

An annuity in which the benefits begin a short time after the first and onlypremium is received. The payments may be guaranteed for a specified period oftime, despite the death of the annuitant.

� Variable Annuity

An annuity in which the benefits vary with the investment experience, but theinsurer absorbs the mortality and expense experience. Variable annuity assets arepart of the insurer’s separate account.

Health Insurance

Generally, health insurance provides benefits for losses as a result of illness orinjury.

� Dental

Covers dental procedures with an emphasis on preventive care. These plans arenormally available through group plans and have substantial co-payments.

� Disability

Replenishes income lost due to an illness, accident or pregnancy. These policiescan provide benefits for the short term (two years or less) or long term (five yearsor more, up to the entirety of one’s life).

� Hospital Indemnity

A limited coverage policy that pays for a portion of a hospital stay at a specifiedrate per day.

� Long-Term Care

Provides health coverage for disabled, chronically ill or mentally impairedpersons. These services can be inpatient, outpatient or in the home.

� Major Medical

Major medical insurance covers large, unexpected medical expenses. Its coveragecan be extensive, both in terms of expenses covered and maximum benefits.These policies usually are subject to deductibles or coinsurance payments.



� Medicaid

A state and federal program that provides medical insurance to those who alreadyreceive cash payments from the government, such as Aid for Families ofDependent Children (AFDC) and Supplemental Security Income (SSI). The statesgenerally determine eligibility requirements and are responsible for the program’sadministration.

� Medicare

A government sponsored program that furnishes medical and hospital insurance topersons 65 and over, to Social Security recipients who are under 65, and to thosewith chronic kidney disease.

� Medicare Supplement

Insurance intended to provide additional medical, surgical or hospital insurance toMedicare recipients.

� Specified Disease

A limited coverage policy that provides benefits for specific diseases like canceror strokes.

Reinsurance

� Aggregate limit

The maximum amount of recoveries payable under a reinsurance agreement thatprovides for an overall maximum loss limitation.

� Assumption Reinsurance

Under this contract, risk is permanently transferred to the reinsurer. Policyholdersreceive notification of the transfer and from that point forward, remit premiumsand claims to the assuming carrier (the reinsurer). The original companyterminates its future obligations to policyholders.

� Automatic Treaty

Business that is ceded on an automatic basis that does not require specificreinsurer underwriting, assuming it falls within the provisions of the treaty.

� Capacity

The amount of risk an insurer (or reinsurer) can assume base on its capital surplus.

� Captive Reinsurer

The reinsurer is an affiliate of the ceding company.

� Ceding Commission

The amount a reinsurer pays to cover the acquisition costs, overhead expenses,taxes, licenses and fees incurred by the ceding company.

� Coinsurance

A form of life reinsurance under which the risks and plan reserves are transferredto the reinsurer.

� Excess

Excess reinsurance provides coverage above specified retention limits.



� Facultative Treaty

Under most facultative arrangements, the reinsurer has the ability to underwriteany and all specific risks before assuming any level of risk.

� Indemnity Reinsurance

Under this contract, the policyholder may never have knowledge that reinsuranceexists. All premium payments go to the original writer of the contract and theprimary insurer passes on the reinsurance premium to the reinsurer. The primaryinsurer is responsible if the reinsurer fails to pay claims, and in most cases theprimary insurer can recapture all or a portion of its liabilities under certaincircumstances.

� Layering

A method of allocating reinsurance among several reinsurers. Using this method,reinsurance is ceded in layers. One reinsurer will receive all reinsurance up to thelimit of the first layer. A second reinsurer will receive all reinsurance in excess ofthe first layer up to the limit of the second layer, and this cycle continues,depending on the number of layers.

� Modified Coinsurance (Modco)

A form of life reinsurance under which the risks are transferred to the reinsurer,however, the ceding company retains the reserves on the ceded portion of thepolicy.

� Nonproportional

Under a nonproportional contract, the amount of liability that the reinsurerassumes is not fixed in advance. These types of contracts are most commonlyused for property-casualty stop loss or catastrophic coverage, and the reinsureronly makes claims payments if claims exceed the predetermined attachment point.

� Proportional

Under a proportional contract, the amount of liability that the reinsurer assumes isfixed and defined at the beginning of the contract. For example, if a companychoses to reinsure exposure above its $100,000 per life retention limit, it wouldretain 20% of the risk on a $500,000 yearly renewable term policy and cede theremaining 80%. Life and annuity reinsurance is largely proportional.

� Quota Share

A quota share treaty covers a fixed percentage of all claims, and is typically notsubject to an attachment point (i.e., a 50% quota share treaty would cover $0.50 ofthe first $1.00 of claims).

� Spread loss

A form of reinsurance in which the ceding company pays premiums to thereinsurer and, if the ceding company experiences total losses in a given year thatare greater than a certain limit, the reinsurer remits the amount of the excess lossto the ceding company. The ceding company pays back the losses to the reinsurerover a period of time, usually through increased reinsurance premiums.

� Stop loss

A form of reinsurance under which the reinsurer pays some or all of a cedingcompany’s aggregate retained losses in excess of a predetermined amount.

� Retention limit

The maximum amount of risk a company will insure on a policy. Any amount inexcess of the retention limit can be reinsured.



� Retrocession

A transaction in which a reinsurer transfers all or part of the risk it has assumedfrom a primary company (the ceding company) to another reinsurer (theretrocessionare).

� Yearly Renewable Term (YRT)

A form of life reinsurance under which the risks are transferred to he reinsurer butnot the plan reserves.



25. BibliographyStatement of Financial Accounting Standards No. 60, Accounting and Reportingby Insurance Enterprises. Financial Accounting Standards Board, June 1982.

Statement of Financial Accounting Standards No. 97, Accounting and Reportingby Insurance Enterprises for Certain Long-Duration Contracts and for RealizedGains and Losses from the Sale of Investments. Financial Accounting StandardsBoard, December 1987.

Statement of Financial Accounting Standards No. 115, Accounting for CertainInvestments in Debt and Equity Securities. Financial Accounting StandardsBoard, May 1993.

Statement of Financial Accounting Standards No. 120, Accounting and Reportingby Mutual Life Insurance Enterprises and by Insurance Enterprises for CertainLong-Duration Participating Contracts. Financial Accounting Standards Board,January 1995.

Statement of Financial Accounting Standards No. 133, Accounting for DerivativeInstruments and Hedging Activities. Financial Accounting Standards Board, June1998.

Statement of Financial Accounting Standards No. 138, Accounting for DerivativeInstruments and Hedging Activities – An Amendment of FASB Statement No. 133.Financial Accounting Standards Board, June 2000.

Statement of Financial Accounting Standards No. 141, Business Combinations.Financial Accounting Standards Board, June 2001.

Statement of Financial Accounting Standards No. 142, Goodwill and OtherIntangible Assets. Financial Accounting Standards Board, June 2001.

EITF 99-20, Recognition of Interest Income and Impairment on Purchased andRetained Beneficial Interests in Securitized Financial Assets, FinancialAccounting Standards Board, April 2001.

A Survey of Life Insurance Accounting Practices. Ernst &Young, February 1991.

Accounting for Life Insurance and Annuity Products – Understanding andImplementing FASB Statement No. 97. Ernst & Whinney, June 1988.

Mulligan, Elizabeth & Stone, Gene. Accounting and Financial Reporting in Lifeand Health Insurance Companies. Life Office Management Association, 1997.

A Primer on Accounting Models for Long-Duration Life Insurance Contractsunder U.S. GAAP. Financial Accounting Standards Board, November 1996.

The Booke Seminar in Accounting and Financial Reporting for Life Companies.Goodwins Booke & Dickenson, April 1995.

Rubin, Harvey W. Dictionary of Insurance Terms. Barron’s Educational Series,1991.

Life Insurance Fact Book. American Council of Life Insurance, 1998, 1999, 2000,2001, 2002

A.M. Best’s Aggregates & Averages, Life & Health, 2000, 2001, 2002

Black, Kenneth & Skipper, Harold. Life Insurance. Prentice-Hall, 1987.

Huggins, Kenneth & Land, Robert D. Operations of Life and Health InsuranceCompanies. Life Office Management Association, 1997.

Webb, Bernard L. & Lilly, Claude C. Raising the Safety Net: Risk Based Capitalfor Life Insurance Companies. National Association of Insurance Commissioners,1994.



Accounting Practices and Procedures Manual for Life, Accident and HealthInsurance Companies. National Association of Insurance Commissioners, 1990.

J.A. Elliott and J.D. Hanna. Repeated Accounting Write-Offs and the InformationContent of Earnings. Journal of Accounting Research, 1996.

Tiller, John E. and Denise Fagerberg. Life, Health & Annuity Reinsurance, 2ndedition. ACTEX Publications, Inc., 1990, 1995.

Companies Mentioned in This Report

Company Ticker Price OpinionAFLAC AFL $30.97 B-2-7American International Group AIG $48.20 A-1-7Hartford Financial Group HIG $38.78 B-1-7Jefferson-Pilot JP $37.51 A-3-7John Hancock JHF $25.52 B-2-7Lincoln National LNC $29.05 B-1-7MetLife MET $25.56 B-1-7Nationwide Financial NFS $26.01 B-1-7Phoenix Companies PNX $8.12 C-2-7Principal Financial Group PFG $26.81 B-2-7Protective Life PL $25.75 B-1-7Prudential Financial PRU $30.65 B-2-7StanCorp Financial SFG $49.18 B-2-7Torchmark TMK $34.69 B-1-7UnumProvident UNM $14.45 B-2-7



Investment Rating Distribution: Financial Services Group (as of 31 December 2002)Coverage Universe Count Percent Inv. Banking Relationships* Count PercentBuy 84 46.15% Buy 41 48.81%Neutral 82 45.05% Neutral 35 42.68%Sell 16 8.79% Sell 6 37.50%

Investment Rating Distribution: Global Group (as of 31 December 2002)Coverage Universe Count Percent Inv. Banking Relationships* Count PercentBuy 1110 43.46% Buy 391 35.23%Neutral 1236 48.39% Neutral 319 25.81%Sell 208 8.14% Sell 43 20.67%

* Companies in respect of which MLPF&S or an affiliate has received compensation for investment banking services within the past 12 months.

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[PL, TMK] One or more analysts responsible for covering the securities in this report owns such securities.[AFL, HIG, JP, JHF, LNC, MET, NFS, PNX, PFG, PL, PRU, SFG, TMK, UNM] MLPF&S or one or more of its affiliates acts as a market maker for the

recommended securities to the extent that MLPF&S or such affiliate is willing to buy and sell such securities for its own account on a regular and continuousbasis.

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