To make an informed decision on whether to buy an insurance company, a bank needs to understand the economics of these organizations.

Insurance companies are strange creatures.

For example, the accounting is arcane. Statutory accounting, which is based on cash flow, is required by the primary regulators, while generally accepted accounting principles remain the convention for public reporting.

Since insurance products have high up-front expenses - such as primary distribution costs - that statutory accounting does not allow to be amortized, each sale creates an immediate loss and commensurate drain on capital.

On a statutory basis, it could be anywhere from two to eight years before a bank turned a profit on insurance products, depending on their structure and features.

A typical term-life product, for example, with a relatively short break- even period of about two years might require $1.635 million in capital for every $1 million in premiums. Furthermore, the capital payback period is five years - and even longer when measured against an investor's hurdle rate, the minimum needed to make the transaction worthwhile.

For a company increasing new business at 10% a year, the result would be statutory losses for the first five years of the program, with the insurance business being a net user - as opposed to a net provider - of capital for the first 10 years of the program.

Statutory accounting thus creates the anomaly that reported losses are associated with fast-growing companies while slower-growing companies will temporarily report increased statutory profits.

GAAP corrects for this by permitting the cost to be spread over the life of policy.

When analyzing a company, however, GAAP accounting falls short of showing the true economics of the business. Because of this unique complexity, a whole body of science has developed around analyzing the true economics of insurance companies.

Since insurance companies' idiosyncrasies go well beyond traditional financial analysis and accounting conventions, actuarial science techniques are critical to helping banks understand the economics of the business.

The economics of a typical life insurance or annuity policy are derived from four sources:

Investment spread. The difference between what an insurer earns on premiums paid and what is credited to policyholder values.

Banks understand investment spread well, though insurance products offer new challenges here.

On most products, guaranteed minimum interest rates are required by regulators. The length of the guarantee is ... forever!

To compound problems, policyholders must be allowed access to policy values at book values, not market values.

The combination of these features presents dangers in both rising and falling interest rate environments. The current low interest rate environment, for example, hurts some insurers while benefiting others. The effect depends on the composition of the insurer's asset portfolio and, more important, the structure of its policyholders' liabilities.

Mortality spread. The difference between what an insurer charges for providing death benefits and the actual cost of those benefits.

This is often a major source of revenue. Not only do mortality charges cover the real cost of death benefits, they are often used to cover expenses not directly covered by other fees.

In recent years, reinsurers have become very aggressive in taking the insurance risks off the books of the direct writers. A market has been created where companies can, in effect, purchase mortality coverage at wholesale prices and sell it at retail. Therefore, banks that are beginning to underwrite insurance and are not fully comfortable with assessing and pricing mortality risk can look to reinsurers for help.

And death rates, which have been improving for many years, can still fluctuate significantly in any given year. Reinsurance can also be used to manage earnings volatility that could result from these fluctuations.

Expense spread. The difference between charges - such as surrender charges, premium loads, and policy fees - and the actual expenses of distributing and maintaining policies.

Expenses continue to be the main challenge facing insurance companies. With almost 3,000 life insurance companies-500 to 800 being significant players - competing in the United States, achieving critical mass is a constant challenge.

Banks, however, will have an advantage in two areas:

Significantly lower incremental distribution and other costs as they leverage their existing sales infrastructure and relationships.

The option to use lower-cost third-party administrators, which are not burdened with legacy systems processing perhaps tens of thousands of types of policies - all with unique administrative requirements.

Cost of capital. The costs insurance companies incur to retain "idle" regulatory capital to support the risks on their books.

Insurers also must be cognizant of the views of rating agencies - Moody's Investors Service, Standard & Poor's, and A.M. Best Co. - which confer the all-important "claims-paying ability" ratings that help support new business development.

Other costs associated with insurers' traditional distribution process and operating systems are also high compared with other industries.

Understanding the economics is a challenging but critical first step for a banking company, whether it enters the insurance industry through ownership or through partnership with established companies, sharing tasks, risks, and rewards. Mr. Overholt is a consultant at Milliman & Robertson, a Chicago-based insurance and investment products consulting firm.

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