Property/Casualty Insurer Valuation Insights
November 2007
The focus of this article is to give greater
insight into the valuation of property and casualty (P&C) insurers and the market's
current pricing of these businesses. P&C insurers provide insurance coverage
for lines such as automobiles, homeowners multi-peril, workers compensation,
and commercial multi-peril.
by Jeff
Balcombe
Business Valuation
Advisors LLC
The P&C industry follows cycles "characterized by periods of soft market
conditions, in which premium rates are stable or falling and insurance is readily
available, and by periods of hard market conditions, where rates rise, coverage
may be more difficult to find and insurers’ profits increase."1
According to the Insurance Information Institute, the cyclical nature of
the P&C industry can be largely attributed to competition. As premiums rise
(along with profitability) in a hard market, insurers devote more capital to
underwriting and begin to offer more coverage. Accordingly, the supply of insurance
increases giving rise to declines in premiums, which, in turn, causes less insurance
to be offered given the declining associated profitability.
Below is a group of publicly traded companies (the "Industry Group") that
were representative of the P&C insurer segment of the insurance industry.
- The Travelers Companies, Inc. ("TRV")
- Allstate Corp. ("ALL")
- The Chubb Corporation ("CB")
- Progressive Corp. ("PGR")
- CNA Financial Corporation ("CNA")
- Cincinnati Financial Corp. ("CINF")
- First American Corp. ("FAF")
- Alleghany Corp. ("Y")
- Philadelphia Consolidated Holding Corp. ("PHLY")
- The Hanover Insurance Group Inc. ("THG")
Data from Capital IQ, a division of Standard
and Poor's, for the Industry Group can be used to calculate valuation multiples.
A valuation multiple compares a company's equity value or market value of invested
capital (MVIC) (i.e., total interest-bearing debt plus the equity value) to
an earnings stream such as revenue, earnings before interest, taxes, depreciation,
and amortization (EBITDA), or net income (earnings). Analysts can calculate
a value for a firm by deriving multiples from data on similar publicly traded
companies or recent transactions involving similar companies. Depending on the
company being valued, adjustments can be made to account for company-specific
factors. The resulting multiple can be applied to the firm being analyzed to
arrive at an indication of value. Throughout the article, concepts relating
to valuation multiples will be discussed.
Valuation Drivers
While there may be exceptions, the value of most P&C insurers is driven substantially
by growth, profitability, and risk. These drivers are discussed in detail below.
Growth
Generally, companies with greater prospects for growth are more valuable
than companies with less growth potential, holding all else equal. P&C insurers
generate growth by underwriting more insurance policies and/or through rising
premiums. Given that most insurers in the industry will be affected by the industry's
cyclicality, growth resulting from changes in premiums will normally not affect
the relative growth prospects of a certain insurer. However, a company's underwriting
activities generally can have an effect on the valuation of the company. Standard
and Poor's Insurance: Property-Casualty Industry
Survey states:
Pay careful attention to the circumstances surrounding
the rate of premium growth. For example, if a company expands its
written premium base at 10% a year while the overall industry is growing
at 6% a year, that company would appear to be outperforming its peer
group. Presumably, the stock market would award that firm a higher
valuation than some of its slower-growing counterparts would enjoy.
However, if the insurer is achieving premium growth by following risky
underwriting standards—such as underpricing policies to gain market
share or writing a great deal of business in a high-risk coverage line
avoided by other insurers—the insurer’s valuation would have to be
adjusted downward.
2Additionally, an insurer may be growing slower than its peers due to more
conservative underwriting policies, which would normally result in lower risk.
Accordingly, the risk associated with an insurer's growth in underwritten premiums
should normally be considered when assessing the value of a P&C insurer.
Growth can also be affected by amount of reinsurance utilized by the insurer.
Reinsurance is a product that allows insurance providers to share the risk of
its policies with reinsurance providers. P&C insurers can enhance growth by
electing to use less reinsurance, increasing the amount of premiums that the
insurer keeps for itself. However, such activities expose the company to greater
potential claims-related liabilities thus enhancing risk. As such, an analysis
of the value of a P&C insurer should generally weigh the effects of the company's
growth prospects with the risk associated with such growth.
Profitability
Profitability is primarily driven by the occurrence of catastrophic events,
such as hurricanes, which result in large losses to P&C insurers. While these
events generally affect most P&C insurers, the effects depend on each individual
insurers' exposure to the product line in which the event occurred. In general,
changes in profitability relating to claims-related payments are not controllable
by the company.
Aside from claims-related expenses, the profitability of insurers is affected
by expenses such as commissions paid to brokers/agents (discussed in the August
2007 article) and overhead costs. A company that is able to generate premiums
with lower overhead costs than its peers will tend to be valued higher.
Investment income also contributes to the insurer's profits. Typically, insurers
will maintain relatively liquid portfolios so that claims can be paid as quickly
as necessary. Some insurers have become completely reliant on investment income
to generate positive earnings. These companies may be less valuable than other
insurers depending on the risk of the company's investment portfolio. For instance,
a company that generates negative underwriting profits, yet produces a positive
net income due to the income from its highly risky investment portfolio would
normally be less valuable than a company in a similar situation with a less
risky portfolio.
Risk
Several risks have been mentioned throughout this article that are typically
important when analyzing a company in the P&C industry, including the risk of
underwritten premiums, the effects of reinsurance of the company's exposure
to claims-related expenses, and the risks associated with the insurer's investment
portfolio. In addition, an analysis of the company's liquidity and leverage
positions can give insight into the overall risk of the company.
The risk of underwritten policies should generally be considered in the context
of the company's growth in premiums written. As discussed previously, higher
risk policies will tend to have a negative effect on the value of the insurer.
However, the benefit of higher growth associated with underwriting riskier policies
will generally have a positive effect on value, thus an analyst would often
weigh these two effects in the valuation analysis. A helpful tool in analyzing
this risk is the loss ratio. The loss ratio measures the historical amount of
losses relative to premiums earned and is typically between 60 percent and 80
percent.3 During periods of catastrophic events,
loss ratios in the industry can rise significantly.
As discussed previously, a factor that can reduce the risk of an insurer
is the utilization of reinsurance. Greater use of reinsurance generally lowers
the risk of an insurer and will have a positive effect on value. However, a
higher level of reinsurance means that premiums that the company would otherwise
receive are shared with a reinsurance company.
Insurers are also exposed to risk associated with their investment portfolios.
While higher risk may result in greater investment income, it could also result
in less investment income depending on market performance. Typically, insurers
will hold relatively liquid investments allowing the company to access the funds
quickly if needed for claims-related expenses. Given that catastrophic events
can quickly and significantly change the insurer's need for cash, liquidity
can be an important factor with respect to the company's risk profile. An insurer
with greater resources and cash flow to cover its potential claims and other
liabilities will likely be more valuable.
Current Valuation Trends
The graph presented in Exhibit 1 shows the MVIC-to-EBITDA multiples for the
latest twelve (12) months ("LTM") for the Industry Group.
EXHIBIT
1
As illustrated, the current average valuation for large publicly traded property
and casualty insurers is approximately 6.6 times EBITDA. However, the range
varies from a low of 4.6 times EBITDA to a high of 8.7 times EBITDA. These differences
can be attributable to a variety of factors including company-specific issues
such as growth strategy and risk.
Conclusion
Many factors—including growth, profitability, and risks—can influence the
value of the P&C insurer. Additionally, the market's current valuation of similar
publicly traded companies should typically be considered in the valuation of
an insurer. However, it is important to be aware of various forces, such as
the cyclicality of the industry, that are affecting the market's current valuation
of similar companies. Future articles will address other industry segments such
as health and life insurers, and reinsurers.
Opinions expressed in Expert Commentary articles are those of the author and are
not necessarily held by the author’s employer or IRMI. This article does not purport
to provide legal, accounting, or other professional advice or opinion. If such advice
is needed, consult with your attorney, accountant, or other qualified adviser.