Paul Medini examines the issues of special importance to consider in Latin American mergers and acquisitions, with particular reference to Argentina and Brazil.
Due to a convergence of new developments in the Latin American economy, in recent years the region has become an attractive market for foreign investors. For a number of reasons, this new market provides excellent investment opportunities for insurers, especially in the growing areas of life, health, reinsurance, workers' compensation and pensions. In Brazil, which represents approximately 45% of the regional market, for example, investors can benefit from high growth potential and significant premium volume, as well as the opportunity to participate in joint ventures between banking and insurance interests, while expanding brand-name recognition. And in Argentina some unusual investment opportunities exist as a result of the fact that at least part of the medical insurance industry there - prepaid medical insurers - is unregulated.
While the outlook up to now has generally been a favorable one, investors who look before they leap are more likely to come out ahead in the long run. The recent downturn in the Latin American economies should not cause an investor to end the search for new opportunities because of the time horizon needed to identify and effectively pursue good opportunities. Regulations, statutory requirements and local accounting principles vary from country to country, creating unique opportunities but also unique pitfalls in each specific market. However, investors who enter the market well-informed about local and regional issues can find much to gain in this new economic climate.
Surveying the field
Any merger or acquisition presents a broad set of challenges and opportunities for each party. In addition to the general issues that must always be addressed - integrating acquisition activities with overall strategic objectives, screening acquisition candidates, integrating strategies, operations, and systems, and addressing cultural change management issues - there are also issues of special importance to consider in Latin American markets.
A number of special challenges are presented particularly during the due diligence phase. For example, insurance companies in Brazil are monitored by the Superintendencia de Seguros Privados (SUSEP), and in Argentina by a parallel agency, Superintendencia de Seguros de la Nacion (SSN). These agencies maintain solvency, account, and reserving regulations and require that audited statutory financial statements be published for every insurance company, twice a year in Brazil and on a quarterly basis in Argentina. However, as foreign investors evaluate the published financial results, several differences between Latin American statutory treatment and US GAAP become evident. These differences are most directly related to matters of insurance reserving, asset valuation, solvency margins, and contingencies.
Generally speaking, reserving requirements are less conservative than those of US GAAP. Health claims are accounted for on a cash basis, and other claims are accrued on a reported basis; claims which have been incurred-but-not-yet-reported (IBNR) are not required to be accrued. This makes for one of the most significant risk areas during a due diligence review, since it is difficult to acquire all the information needed to perform an accurate estimation. And while some companies have obtained government approval to accrue IBNR in their statutory financial statements, the majority do not report such liabilities in their published financial statements, making it hard to draw valid comparisons between companies.
In addition, due to the nature of reserving requirements, there is often minimal actuarial guidance provided to or evaluated by insurance companies. Consequently, it is important to include actuarial assessments when evaluating the true reserve position of a local insurance company.
Evaluation of assets is also complicated by differences between Latin American and US accounting principles. In Brazil, the reported assets held by insurance companies are often understated. On the other hand, as a result of the accounting for variances in market values during the volatile economic years prior to the implementation of the Real Plan in 1994, real estate properties in Brazil are generally considered overvalued compared to actual market value. (Under current SUSEP regulations, all Brazilian insurance companies are being required to revalue their real estate properties to current market values, recording any necessary losses by 30 September 1998.)
In Argentina, current investments are always stated at market value, giving accounting recognition to the profit or loss in the income statement. The most important aspect to consider in this regard is that specific admitted investments must be computed in accordance with technical regulations required by the SSN. According to Mirta Maletta, insurance partner at PricewaterhouseCoopers in Argentina: "Overvaluation of real estate assets is also an issue in Argentina, especially taking into account the solvency problems of many companies in the local market. In some cases the value of real estate may include technical appraisal and/or adjustment for inflation." (Inflation adjustment of financial statements was mandatory until August 1995.)
Brazilian regulations require insurance companies to maintain established solvency margins. One of the ratios to pay attention to is the "leverage ratio," whereby the total of unearned premium reserves, loss reserves, and 50% of capital must be "covered" by assets which qualify under Brazilian regulations. Assets admissible for reserve coverage include cash and other invested assets, including real estate. However, the amount of such assets which may be used to "cover" reserves is limited by regulation, and all equity investments in related parties are excluded.
According to Susan Stephenson, insurance manager at PricewaterhouseCoopers in Brazil, "In addition, certain costs generally assumed to represent claim settlement costs, such as direct loss adjustment expenses, may be accounted for as administrative costs under Brazilian accounting methodologies. Therefore, it is often preferable to evaluate a fully-loaded cost-to-earned premiums ratio rather than relying on the actual loss ratio itself."
In Argentina, deferred income tax accounting (FASB 109) is not required. Nevertheless, the most important issue to be considered in evaluating tax and social security issues are those connected with contingencies. Finally, because there are continual changes in tax requirements, maintaining compliance from year to year can be problematic, and litigation between insurance companies and the government is common. Exposure to such contingencies should be evaluated when assessing the value of insurance companies. Merger and acquisition agreements in both Brazil and Argentina often include tax indemnifications.
In Argentina risk areas related to reserving practices, especially those involving the adequacy of case reserve amounts for unadjusted losses, lack of or under-accruals for loss adjustment expenses (LAE), and cut-off for reporting claims (hidden losses), are also factors. In addition, up until 1992 it was mandatory for companies to reinsure their risks with the National Reinsurance Institute (INdeR). But in 1992, INdeR entered into liquidation and has not been in compliance with payments to the insurance market. Currently, a cut-off program has been implemented and is being adhered to by most companies, which foresee the payment of the liabilities recognized by INdeR with bonds. Therefore, one of the important aspects to be considered in a due diligence review in Argentina is the recoverable value of the receivables against INdeR.
While successful investing in Latin America requires some specialized knowledge, for those who take the time to do the research, the region offers promising possibilities, especially for those companies who are looking to become involved in the region over the long run.
Paul Medini is an insurance partner at PricewaterhouseCoopers, New York.