Valuation Insights: Health and Life Insurers
March 2008
The focus of this article is to give greater
insight into the valuation of life and health (L&H) insurers and the market's
current pricing of these businesses. When compared to other insurance industry
segments, such as property and casualty, the L&H segment of the insurance industry
is relatively noncyclical, as there is sufficient data and a large base of similar
risks (i.e., people) to accurately predict claims and therefore minimize the
risk that the cycle poses to the business.
by Jeff
Balcombe
The BVA Group LLC
Insurers collect premiums from policyholders, and then invest the premiums.
Some of the income generated from the premiums is shared with policyholders,
either through a dividend or income from an annuity. Eventually, policyholders
will receive a repayment on their policies upon the policyholder's death or
when a policy or an annuity matures.1
Below is a group of publicly traded companies (the "Industry Group") that
are representative of the L&H insurance segment.
- AFLAC Inc. ("AFL")
- Assurant Inc. ("AIZ")
- Conseco Inc. ("CNO")
- Delphi Financial Group Inc. ("DFG")
- Genworth Financial Inc. ("GNW")
- Lincoln National Corp. ("LNC")
- MetLife, Inc. ("MET")
- Principal Financial Group Inc. ("PFG")
- Prudential Financial Inc. ("PRU")
- StanCorp Financial Group Inc. ("SFG")
- Torchmark Corp. ("TMK")
- Unum Group ("UNM")
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 L&H insurers is driven substantially by growth, profitability,
and risk. These drivers are discussed in detail below.
Growth—Two important macroeconomic indicators
that affect L&H insurance sales are interest rates and demographics. In a period
of declining interest rates, growth in net investment income (an important revenue
source for an L&H insurer) will slow as yields on insurers' bond portfolios
slide. However, falling interest rates also increase the value of the underlying
assets (usually fixed-income securities) that produce the investment income.2
With regard to demographics, the Census Bureau predicts that growth will
be low in the 20 to 44 age bracket between 2000 and 2010, with only a modest
3 percent growth for those under the age of 20. The low growth for these age
groups will likely weaken demand for more traditional death-benefit products,
where policy benefits are often intended to protect families from the loss of
a working spouse or parent.3 However, the "baby
boomer" cohort represents a source of growth for health and life insurers. "Baby
boomers" generally have a lower level of faith in the Social Security system.
Additionally, life expectancies are projected to increase and healthcare costs
are on the rise. As such, many individuals have begun turning to life insurers
to provide not only traditional death-benefit types of life insurance, but also
savings-oriented life insurance products and annuities.
Profitability—L&H insurers' profits consist
of two components: underwriting income and investment income.4
Factors contributing to the overall profitability of L&H insurers are discussed
below.
If a company increases its premium base at a rate greater than the overall
industry, that company would appear to be outperforming its peer group. The
stock market would generally award that firm with a higher valuation than would
be given to some of its lower-growth peers. However, the level of risk should
also be considered: if the insurer is achieving premium growth by adopting risky
underwriting practices or offering unusually high rates of return on certain
investment-oriented life insurance products, "such insurer's valuation would
be adjusted downward accordingly."5
Fee income (from fee-based products like annuities) growth is another important
factor contributing to the company's profitability. It is important to analyze
the sources of profits separately, because growth in fee income may be masked
by declining or flat premium growth.6
The level of reinsurance is another factor affecting profitability. Because
using less reinsurance allows an insurer to keep more of each premium dollar,
a reduced level of reinsurance may enhance year-to-year premium growth comparisons.
However, using less reinsurance removes protection and leaves an insurer exposed
to greater claims-related risk.7
The largest expense facing most L&H insurers is policyholder benefits. These
include death benefits to life insurance policyholders; accident, health, and
disability benefits to health insurance policyholders; and annuity benefits.
Aside from assorted policyholder benefits, costs to acquire new business, including
agent commissions and other related selling expenses, also take a big bite out
of insurers' budgets.8
Investment income is an important revenue source for L&H insurers. In some
cases, it provides almost half of an insurer's total revenues. While some insurers
may exhibit significant levels of investment income, analysts should typically
consider the riskiness of the insurer's portfolio by analyzing the asset allocation.
Such an analysis will assist in determining whether or not the risk and liquidity
of the insurer's portfolio is warranted given the insurer's potential claims-related
liability.9
Loss reserves can also have a significant impact on an insurer's financial
results. An insurer's prosperity depends largely on its ability to quantify
the ultimate cost of claims from the risks that it assumes.10
Generally, L&H insurers are able to quantify the potential for loss with more
accuracy than other types of insurers, such as those in the property and casualty
segment.
Risk—Liquidity is an important performance
benchmark to consider when analyzing an insurer given that insurers must be
able to pay policyholder claims promptly. An insurer's sources of liquidity
include underwriting cash flow, investment cash flow, and asset liquidation
cash flow.11
For L&H insurers, leverage usually measures the extent to which a firm uses
its policyholders' surplus or shareholders' equity to produce business. The
ratio of premiums to surplus can provide a measure of an insurer's leverage.12
Generally, the higher the premiums relative to policyholders' surplus,
the greater the insurer's leverage is said to be.
Insurance companies tend to hold the bulk of their investment portfolios
in corporate bonds, so an acceleration of corporate bond default rates could
erode the value of their investment portfolios significantly.
Current Valuation Trends—Historically,
L&H insurers were essentially the sole source of health and life insurance products.
However, today, other financial services firms, such as banks and brokerages,
offer insurance products. L&H insurance has become a commodity, and, as such,
it is marketed primarily on price, resulting in an adverse effect on the valuation
of L&H insurers.
The overall aging of the population is turning insurers' attention gradually
away from income-protection financial products toward retirement-oriented financial
products. Longer life expectancies and concerns about the financial safety net
of Social Security have given baby boomers a heightened awareness of the need
to save for retirement. Moreover, a shift in pension trends from defined benefit
plans to defined contribution plans has given many Americans a greater sense
of financial empowerment. Such trends present a growth opportunity for L&H insurers
who can provide quality retirement-oriented financial products to the aging
population.
The U.S. Longshore and Harbor Workers Compensation Act insurance industry
has been in a period of consolidation since the 1990s. The significant number
of smaller L&H insurance companies provides numerous merger and acquisition
(M&A) candidates for the larger insurance companies.13
Industry consolidation could lead to increased acquisition valuation multiples
for smaller L&H insurers.
A
graph shows the MVIC-to-EBITDA multiples for the latest 12 months ("LTM")
for the Industry Group.
The current average valuation for large publicly traded L&H insurers is approximately
7.5 times EBITDA. However, the range varies from a low of 5.4 times EBITDA to
a high of 11.7 times EBITDA. These differences can be attributable to a variety
of factors including company-specific issues such as growth strategy and risk.
Recent developments in the equity markets have had an impact on the L&H insurance
industry. Credit losses in the companies' investment portfolios, lower investment
income due to low interest rates, and equity market effects on variable annuities
tend to place pressure on earnings and weaken some companies' financial flexibility
resulting in a negative impact on the valuation of L&H insurers.
Conclusion
L&H companies continue to experience modest growth in most lines of business.
This is evident by the fact that operating gains for the industry are projected
to rise from $33.1 billion in 2007 to $33.5 billion in 2008, based on statistics
released by Conning Research & Consulting, Inc.14
However, opportunities are driving demand for companies to develop cost-effective
products to reach baby boomers and the underserved middle-market.
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