Last week, I wrote about current aggressive accounting practices. This week, I’m going to write about future aggressive accounting that will be practiced.

How can I so confidently predict the future? I’ve been doing this a long time. Some things are easy to forecast.

What’s the accounting treatment I will eviscerate in the future? M&A accounting for reserves.

The Casualty Reserve Stink

This is something I will try to write about later in the year, but a cursory review of year end reserves show casualty reserves are still a steaming mess.

The large reserve charges taken last year were far from adequate to put the issue in the past. My guess is we’re in something like the third inning.

And that’s only if the problems are confined to last decade. If they have spread into the 20s accident years, we’re in the top of the second inning.

Now, if you’ve lived through a casualty reserve cycle, you know there’s a few ways ultimate loss ratios will ultimately get raised to where they need to be.

Big Bath

The first path is companies could take the “big bath” charge and try to put the issue behind them. This is unlikely. No CEO wants to endure that confession.

The most likely cause of a big bath is a management change. The new CEO wants to come in and “clear the decks” with a large charge to signal the past is in the rear view mirror. I don’t think any CEO is currently at heightened risk where the odds of a big bath anywhere are high.

Slow Bleed

The second option is the “slow bleed“. Insurance executives love this tactic! A slow bleed is when you set your current year pick higher than reality to allow you to add less to prior reserves upfront.

In other words, rather than add 12 points to your soft market block today and report a 91 accident year, you print a 93 AY and add 2 points to the deficient reserves.

You’ve effectively added four points of reserve strengthening, split evenly between the new and old blocks. If you do this for three straight years, you will get to your 12 points.

Then, for the following three years, you continue to add 2 points a year to the old block while releasing 2 points from the new block. Eventually, you have your full 12 points in the necessary years and your recent years settle out where they belong.

The downside of this is you have to show lower earnings for several years. But this is less embarrassing then taking a big charge and admitting you did dumb stuff.

The upside is you are less likely to get your rating put on watch (or downgraded), you don’t have to worry about the capital hit because it gets spread over time, and, once you get to the end, investors will be excited that your accident year returns to 91 and you are now releasing reserves from recent years!

The Old Razzle Dazzle

Then, there is door number three. This is a higher degree of difficulty, but, if you can pull it off, it’s a get out of jail free card. What is it?

The “Old Razzle Dazzle“. Jumble up the financials so nobody can figure out what the heck is going on with your reserves.

How do you pull off a razzle dazzle? Through buying an unsuspecting insurer to be your patsy.

The M&A “Solution”

Imagine I’m a large insurer with $30B of equity and $75B of reserves. I could easily have a $2B hole in my reserves. (Note, I’m not describing anyone in particular, but tried to do an average of the larger insurers.)

Now, let’s assume there’s a competitor with $8B in equity and $20B of reserves that are roughly adequately picked.

Let’s say my market value is $50B and theirs is $15B. I pay a premium and buy them for $20B.

How does this help me? You may be surprised!

Erasing History

This is the smaller benefit, but it’s worth mentioning. When an insurer buys another insurer, public reserve reporting becomes all but useless.

The 10-K disclosures, which are already barely of value, lose all historic context as the acquired entity is only added on a post-deal basis. You don’t get to see its historic triangles.

So, you lose all ability to compare historic results to the new accident years going forward.

For the more useful Schedule P, the answer is it depends. If the acquirer keeps the acquired stat entities operational, you can continue to look at each historic company independently and continue to have steady triangles.

However, if the buyer doesn’t want you to have this info anymore, it’s very easy to muddy the waters.

The most obvious way is to kill off the target’s stat entities and merge them into your own. Game over.

It will be years before you can figure out what’s going on with reserve patterns. But, even if they don’t do that, they can commingle things in a way that accomplishes much of the same.

For example, they could decide all the small account comp will switch over to the buyer’s paper while all the large account comp will go to the seller’s paper. All historical patterns have been destroyed on a forward basis. Mission accomplished.

Magical Accounting

But all of that is child’s play. After all, it only makes it harder for the outsider to tell what’s going on. It doesn’t change the reported earnings or future development of the troubled years.

But you can do all that with our next trick. PGAAP accounting.

What is PGAAP? It’s the accounting for mergers. It stands for “purchase GAAP” but it may as well be “poof goes all adverse prior-period”

PGAAP requires you to fair value all the assets and liabilities of the acquired entity. This allows a CFO to play a lot of games, but the two main places are with investment income and reserves. I’ll ignore the former for today’s discussion to focus on reserves.

Recall, in our hypothetical acquisition, there are $20B of reserves being bought and our buyer has a $2B reserve hole.

Do you know what will magically happen during the PGAAP process of fair valuing those reserves? They will be booked at $22B!

Why? Because it creates a $2B redundancy which can be released into future reserves to offset the $2B hole as it develops. Magic!

Now, some might object won’t investors see through this and penalize the $2B of adverse as it bleeds through?

Nope. That’s why the section above about erasing history matters. It will be too hard to tell how much of the reserve impact came from each company and investors will only get reported the net number.

This is a far better outcome than the slow bleed approach. The slow bleed reduced your earnings for years as you smoothed the reserve pain.

By contrast, PGAAP has no earnings penalty. You heard me right. It’s truly magic!

The Catch

So there’s no free lunch, right? Surely, there must be a catch. There is, but it’s of much less consequence.

So what happens when we throw an extra $2B into reserves? Remember we paid $20B for a company with $8B of equity. The $12B premium goes into goodwill (and other intangibles).

But that $12B changes with the PGAAP adjustments. If the totality of the fair value adjustments increased the target’s book, the goodwill would be less. If it lowered book, the goodwill would be higher.

By adding $2B to reserves, we’ve lowered the target’s book by $2B pre-tax ($1.6B a/t). So instead of $12B of goodwill and $8B of net assets, the accounting entry would add $13.6B of goodwill and $6.4B of net assets.

While this $1.6B BV hit isn’t nothing, it’s on a combined equity base of over $36B (probably more if the deal was mostly equity financed). It gets lost in the weeds.

The Invisible Big Bath

The practical effect is similar to the big bath, but without any of the pain. No large stock drop, no egg on your face at RIMs, no rating agency downgrade, no hit to executive comp.

The only downside is BV is a little lower. But hey, if your earnings are untouched, this means your ROE is higher, so your stock ends up in the same place (higher multiple on lower book)!

The Happy Mark

Normally, there is a victim when the illusionist pulls a fast one. The poor mark who lost his watch or wallet.

But in this case, the “victim” is thrilled they got taken advantage of. Their company got bought at a big premium! No harm, no foul.

Buyer Beware

Of course, there is one potential risk to this ploy. You may have to overpay to acquire your host. After all, if too many CFOs figure this solution out, the price for deals will go way up.

One can easily overpay by $2B or more, thus spending good money to paper over a non-cash issue. This, of course, is foolish.

But we have seen many companies, in insurance and beyond, do dumb things when it comes to M&A.

Overpaying for a target to hide a reserve issue would be far from the worst logic I’ve seen for a deal. It doesn’t mean its good logic, but I’ve definitely seen far more offensive things.

So make a mental note on this one. When a year or two from now, you hear companies say they’re thinking about acquisitions, it should send off an alarm for you to go check on their reserves and see if that’s what is motivating them to buy something.

Remember, the first step to fixing a reserve problem isn’t to admit you have one. It’s to buy something so you never have to admit you have one!