There have been several negative events within the insurance industry over the past few years. In 2017, there were 18
restatements among registrants in the insurance industry, versus 10 in both 2016 and 2015. This uptick has continued into
2018, with 16 restatements filed in the first eight months. There has also been an increase in control weaknesses, having
13 already in 2018 in comparison to 10 in both in 2017 and 2016. And despite the overall downward trend of SEC comment letters for all registrants, the industry had 169 back-and-forth letters in 2017, a large jump from the 80 in 2016.
It is unclear why there has been an increase in negative events, as no one specific reason ties these events together. Yet the insurance industry is very complex and that, itself, could be an issue.
Let’s look at some recent examples.
MetLife, Inc. [MET] is one insurer that has recently encountered accounting troubles. In March 2018, the company restated its financial statements to increase reserves to reflect the finding of missing annuity policy holders.
MetLife stated, in a January press release, the previous data regarding the group annuity reserves “resulted from a material weakness in internal control over financial reporting. MetLife expects to increase reserves in total between $525 million and $575 million pre-tax, to adjust for reserves previously released, as well as accrued interest and other related liabilities… The total amount expected to impact fourth quarter 2017 net income is between $135 million and $165 million pre-tax, the majority of which represents a current period strengthening of reserves and will be reflected in Adjusted Earnings (formerly known as Operating Earnings). We expect the full year 2017 net income impact to be between $165 million and $195 million pre-tax.”
Although MetLife claimed the previously reported amounts were immaterially restated following the adjustments, this news forced the company to reschedule its fourth quarter earnings call which caused a sharp decline in stock price.
In the restated 10-K filing, MetLife addressed the annuities:
“The company increased reserves by $510 million, before income tax, to reinstate reserves previously released, and to reflect accrued interest and other related liabilities. Of this increase, $372 million was considered an error and, recording this amount in the fourth quarter of 2017 financial statements would have had a material effect on the results of operations for 2017.”
The final reserve adjustment of $510 million was in line with the January estimate.
Yet, MetLife also needed to reduce reserves regarding variable annuity guarantees after erroneously increasing them subsequent to assuming a former operating joint venture in Japan, a new issue not disclosed in January.
Of the joint venture variable annuity guarantee reserves, MetLife stated:
“The company reduced these reserves by $896 million, before income tax. Of this decrease, $682 million was considered an error and, recording this amount in the fourth quarter of 2017 financial statements would have had a material effect on the results of operations for 2017.”
Combined, these two errors increased previously reported net income, primarily because of the $896 million benefit associated with the Japanese joint venture reserves.
The company also noted that the SEC and other regulators are investigating the matter:
“…we have informed the New York State Department of Financial Services (the “NYDFS”) about our practices in connection with the payment of pension benefits to annuitants and related matters, and the NYDFS is examining the issue. The U.S. Securities and Exchange Commission (“SEC”) staff is also investigating this matter, and several additional regulators have made inquiries into these practices, including as to related disclosures. Similarly, the SEC staff is investigating the matter relating to our calculation of certain reserves associated with variable annuity guarantees assumed from a former operating joint venture in Japan. We have also informed other regulators of this matter.”
Unrelated to the investigation disclosed in the 10-K filing, the SEC had other questions for MetLife. In May, the agency sent MetLife a comment letter requesting additional details about the restatement, suggesting that the reason for the restatements and adjustments, and the way the errors were corrected, were not clear. Among the comments, the SEC queried whether the restatement was material and if previously filed financial statements were reliable.
In its five page response to the agency, MetLife said the net impact effect did not exceed 5% on any of the years. Specifically, MetLife said:
“Based on the quantitative analysis using the rollover method, the impact of correcting the variable annuity guarantee reserves item, the group annuity reserves item and all other immaterial items in the originally identified period was a decrease to net income of $216 million or 5.3% for 2017, and an increase to net income of 4.5% and 0.3% for 2016 and 2015, respectively.”
In July, the SEC sent another comment letter to MetLife asking why part of the reserve adjustment was not considered an error correction, whether the errors materially affected interim periods, and whether the company considered qualitative factors in addition to quantitative factors in assessing the materiality.
MetLife explained the difference was an estimate change and not an error because the change was applied timely.
“The $214 million assumed variable annuity guarantee revision in 2017 corrected immaterial errors of $14 million, $47 million and $67 million for the first quarter, second quarter and third quarter of 2017, respectively. The fourth quarter 2017 amount was $86 million and did not correct an error because it was timely applied when the quarter was first reported. Similarly, the $214 million adjustment did not correct an error for the 12-month period ended December 31, 2017 because it was timely applied when that 12- month period was first reported.”
This example highlights the overall complexity within the insurance industry and how adjustments may cause large fluctuations between the reserves estimates and changes in income. Changes in estimates are a big issue for the insurance industry and it’s not always easy to differentiate a change in an estimate and an accounting error; the difference between the two is sometimes thin and blurry.
This is the third Corp Fin review of MetLife in just two years. In December 2017, the SEC issued comments to MetLife surrounding the use of non-GAAP titles that are confusingly similar to those used for GAAP metrics.
1. “Operating revenues”, “operating expenses” and “operating earnings” that you identify as non-GAAP
measures appear to be titles that are the same as, or confusingly similar to, those used for GAAP financial measures and precluded by Item 10(e)(ii)(E) of Regulation S-K. As such, please confirm to us that you will revise the titles of these measures in future filings to provide an appropriate description of each measure that complies with Item 10(e).
We confirm that, to the extent we include such non-GAAP measures in our filings beginning with 2017 fourth quarter and full-year disclosures, we will revise the titles of those measures to provide an appropriate description of each measure that complies with Item 10(e).
MetLife agreed to revise the disclosure in future filings. In 2018, the labeling of the metrics was changed from “operational” to “adjusted” to avoid confusion.
MetLife was subject to another non-GAAP review. In October 2016, the SEC issued seven comments to MetLife questioning undue prominence in non-GAAP presentation and lack of comparable GAAP metrics that are required to be presented to avoid confusion.
It is not very common for the SEC to issue comments on three distinct occasions in less than three years. The SEC is required to review registrants at least once every three years, comments are only issued if disclosures are not clear. Only 58 additional companies had three reviews since 2016, less than 3% of all companies receiving comments. This shows that SEC monitors insurance industry and, in particular, loss reserves and non-GAAP presentations.
Aflac Inc. [AFL], another insurance company that has an open SEC investigation, is facing allegations claiming the company may have misled investors when it reported its financial results. In May 2018, Bloomberg News reported a whistle-blower complaint was filed by two employees, stating Aflac exaggerated its sales metric, suggesting the insurer changed the timing of when it booked revenue to improve its earnings reports. Aflac, which had already internally investigated the employees’ allegation, said an external counsel found the allegations meritless and immaterial. The SEC did not comment on the news reports. Separately, Aflac settled with five states regarding allegations the firm didn’t notify the beneficiaries of policy holders who had died.
Aflac has had two SEC Corp Fin reviews since 2016. The first review began in April 2016 and concluded two months later in June. The second review started a year later, in April 2017, and concluded in May of 2017. Both reviews focused on the lines of business in Japan and the corresponding disclosure of revenue recognition practices and loss reserves. Assumptions behind the actuarial models used to estimate loss reserves can be complex and difficult to get right, which is why these calculations appear to be a frequent area of concern for the SEC. In 2018, more than 40% of the comment letters to insurance companies included loss reserves comments, in comparison to about 50% in 2017 and 9% in 2016.
SEC investigations can take several years to complete. Looking at another example, in August 2018, Citizens, Inc. [CIA] settled an SEC investigation that began in 2015:
“As disclosed in prior periods, the legal and regulatory actions facing the Company include those relating to compliance with U.S. federal securities laws. Specifically, the Company has been the subject of an investigation by the Securities and Exchange Commission (“SEC”), which appears to be focused on the Company’s internal control over financial reporting and disclosure controls and procedures in light of the Company’s determination in 2015 that a portion of the life insurance and annuity policies issued by its subsidiary insurance companies failed to qualify for the favorable U.S. federal income tax treatment afforded by Sections 7702 and 72(s) of the Internal Revenue Code of 1986. There have been no allegations of fraud presented by the SEC. We have cooperated fully with the investigation and expect that the matter will be resolved soon, although we cannot predict the timing of a resolution or the ultimate outcome of the investigation.”
In the disclosure above dated March 2018, the company noted that the matter will be resolved soon. On August 22, 2018 the Company issued a notice that investigation was completed, and that SEC did not recommend any enforcement action.
“On August 22, 2018, the Company received a notice from the SEC (the “Notice”) stating that the SEC has concluded the Investigation and, based on the information that the SEC has as of the date of the Notice, the SEC has decided to not recommend an enforcement action against the Company relating to the Investigation. The Notice was provided under the guidelines set forth in the final paragraph of Securities Act Release No. 5310.”
Although the three examples above involve life insurance companies, complexity is an issue for insurance companies, in general. Often times, financial surprises are unveiled when these complexities are questioned and magnified, which can cause investors to punish a company’s share price. Take, for example, General Electric Company [GE], whose stock price fell to a new low in January 2018 following the company’s announcement it finished a comprehensive review of its legacy insurance portfolio and took an after-tax charge of $6.2 billion, twice the amount the market expected. The charge was related to its long-term care insurance, part of the industry that, for many years, had seen growing claims trends, compounded by low interest rates that reduce returns on investments. From an accounting standpoint, changes in claim reserves are often disclosed prospectively as changes in accounting estimates.
While GE is not an insurance company and exited the insurance business in 2004 with the Genworth Financial Inc [GNW] spin-off, this example emphasizes how difficult it can be to clearly understand a company’s liabilities when balance sheets have the potential to shift so much. This complexity is a major reason why the SEC may file comment letters requesting further explanation of any restatements and adjustments. Comment letters themselves are fine, and for the sake of investors, may be necessary for further clarification of these complex issues.
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This post was co-authored by Olga Usvyatsky, Derryck Coleman, and Nicole Hallas.