ACCOUNTING CONSIDERATIONS FOR INSURANCE ACQUISITIONS Paul Medini, CPA, Partner, PricewaterhouseCoopers LLP

1. ACCOUNTING CONSIDERATIONS FOR INSURANCE ACQUISITIONS Paul Medini, CPA, Partner, PricewaterhouseCoopers LLP William Lowry, CPA, CLU, FLMI, Capital Decision Services LLC April 2000

2. Discussions Topics • Business Combinations -- Purchase vs. Poolings • Purchase Accounting • Overview • Purchase accounting adjustments • Financial statement impact of purchase accounting • FASB’s view of useful life and Goodwill • Reserve covers • Reserve adjustments • Pooling of Interest Accounting • Overview • Pooling transactions in the Insurance Industry • Future of pooling • Restructuring Charges

3. Purchase vs Pooling Accounting Purchase Pooling Theory Acquisition Merger Accounting Fair Value Book Value EPS Impact Bad Good Structuring Flexibility Yes Limited * * Limited flexibility refers to restrictions on certain transactions such as asset dispositions, the issuance of options, and treasury stock repurchases.

4. Purchase Accounting Overview • Determine the acquirer • General rule: • Payer of cash and monetary securities is the acquirer • Exceptions: • Stock for stock transactions, consider: • Shareholder group ownership • Composition of top management and board of directors • Relative values • Imposed restricting conditions • The determination of the “acquirer” can potentially be different depending on legal or accounting definitions

5. Purchase Accounting Overview, cont. • Determine the purchase price Cash and monetary securities + Non-monetary consideration paid + Direct acquisition costs + Contingent consideration = Purchase price

6. Purchase Accounting Overview, cont. • Allocation of the purchase price • Purpose: • To create a new balance sheet stated at fair value. Consider it as if acquirer purchased or assumed a group of individual assets or liabilities • Assets and liabilities are valued using various techniques depending on their nature: • Net realizable value • Present value • Fair value

7. Balance Sheet Impact of Purchase Accounting  Other assets/liabilities Revaluation of office buildings or reflection of favorable/unfavorable leases Deferred Taxes Restated for tax effect of difference between purchase accounting basis and tax basis Goodwill  Differences between purchase price and allocated value to tangible net assets Equity Restated to reflect purchase price

8. P&L and Equity Impact of Purchase Accounting P&L Investment Income Effect of amortization/depreciation of purchase accounting adjustments to invested assets Interest expense Effect of acquisition debt, if any Other expenses  Amortization of Goodwill Taxes  Current Deduction of Goodwill amortization, if any, and adjustments to taxable investment income  Deferred Reflects change in differences between purchase accounting and tax bases Equity Unrealized gain/loss onReflects difference between historical investments and purchase accounting basis

9. FASB’s Emerging View of Useful Life • The FASB is moving toward a view that it will no longer accept a useful life of Goodwill over 20 years • FASB has made it clear that it prefers 10 years or less • Entities will have to carefully evaluate the expected useful life

10. Potential Disclosures The FASB has proposed that Goodwill be shown separately on the financial statements, as exemplified below: Income before Goodwill charges and taxes $xxxx Income tax expense xxxx Income before Goodwill charges xxxx Goodwill charges (net of $__tax benefit) xxxx Net income xxxx EPS before Goodwill charges xx Goodwill charges per share xx EPS (basic) xx Issues and Implications • The impact on M&A activity, shareholder value, and deal pricing is uncertain. Preliminary reaction ranges from “little impact” to “severe adverse impact.” Impact may be lessened due to the separate disclosure of goodwill amortization on the face of the financial statements. However, amortization of other intangibles will not be segregated. • Additional disclosures bring FASB closer to cash flow EPS as a performance measure. However, it only partially addresses on difference between net income and cash flow. • This proposal would not change the existing life of goodwill. • New reporting style favors consolidated investment over minority interests since the embedded Goodwill associated with minority investments will not be included in the Goodwill line item.

11. Reserve Adjustments • Insurance Industry has similar rules to Banking • Reserves should not be adjusted in Purchase Accounting • Large adjustments should be reflected as an error in prior years financial statements, not as adjustments to Goodwill

12. Reserve Covers • Insurance Companies are allowed to guarantee the loss reserves of an acquired entity • Applying normal insurance rules would yield a result that would not benefit acquiror -- retroactive accounting • GAAP provides for a solution

13. Reserve Covers, cont. -- GAAP Solution • Provided the seller guarantees the reserves, the Buyer can off-set adverse development with recoveries from guarantee • Recovery must be shown gross in the balance sheet along with increase in losses

14. Taxes in a Business Combination -- Purchase • Stock deals -- Goodwill is not tax deductible • Asset deals -- Goodwill generally is deductible • There are provisions in the tax code that allow stock deals to have deductible Goodwill (e.g., 338 (h)10 )

15. Pooling Accounting • Accounts for a business combination as the uniting of ownership interests • Reported as if the merger occurred in the beginning of the year • Restate historical financial statements • Pooling is typically the preferable acquisition strategy from an earnings perspective • No step-up in target’s assets and liabilities • No Goodwill • Restate historical financial statements • The SEC staff for years has been increasingly scrutinizing pooling of interests accounting • SEC staff views are provided on a “piece-meal” basis • FASB business combinations project

16. Why So Few Poolings in the Insurance Industry? • Greater Flexibility • Purchase accounting allows the seller to guarantee the loss reserves • No benefit of pooling under SAP

17. FASB Legislative Action • FASB is contemplating a new standard that would eliminate pooling of interest accounting as early as 2001 • Why? • Many pooling deals are economically not mergers • Pooling creates an uneven playing field • Eliminate comparative advantage

18. Potential Impact of Eliminating Pooling • EPS will be substantially diluted • Deals may be rejected because of EPS decreases driven by Goodwill • Valuation: No difference from a cash flow or EBITDA multiple perspective

19. Restructuring Charges • Accounting regulators do not want to allow one time charges that relate to expense for future periods • Expenses must be recognized in the period accrued • Entities should not expense items that have future benefits to the enterprise

20. Restructuring Charges • Restructuring charges are expenses commonly reported in connection with business combinations and existing activity • Some examples include: • Termination and severance benefits • Loss recognition for leases and other commitments • Write-off of related intangibles • Capitalized software costs