Insurance Industry Valuation Insights: Recent Trends 2008
August 2008
The general focus of this article is to analyze
the direct and indirect impacts of recent economic trends on the valuation of
companies operating in the insurance industry. Key trends recently impacting
insurance companies are the subprime mortgage crisis, soft market conditions,
and significant catastrophe losses, each of which affects the valuation of insurance
entities. Notably, these recent trends have negatively impacted the valuation
of companies operating in the insurance industry, as discussed in greater detail
below.
by Jeff
Balcombe
The BVA Group LLC
The discussion in this article is presented in the context of impacts on
valuation drivers of the business. Generally, the value of a firm in the insurance
industry is driven by three broad drivers: expected growth, profitability, and
risk. Below are a few examples outlining the relationship between the insurance
business and these three broad valuation drivers.
Property and casualty (P&C) insurers generate growth either by increasing
underwriting volume or by increasing premiums. Health and life (H&L) insurers,
however, generate growth through increases in investment income from the company's
invested premiums.
The profitability of P&C insurers and reinsurers is primarily driven by the
occurrence of catastrophic events, while H&L insurers' bottom lines are generally
affected more by underwriting income and investment income, which is offset
by policyholder benefits (i.e., death benefits; accident, health, and disability
benefits; and annuity benefits) either partially or completely, depending on
the company's profitability.
Risk of an insurance company is driven by numerous factors including liquidity
and leverage. Liquidity allows a business to shield itself from unexpected downturns,
which can put severe strain on a company's needs for cash. With greater liquidity,
there is less risk that the company will not be able to meet its obligations.
Leverage allows a company's equity holders to benefit from another source of
financing; however, it can also put the company in a riskier position with respect
to not being able to service debt payments. In addition, insurance companies
are subject to additional risks relating to underwritten premiums and the insurer's
investment portfolio.
Economic Trends and the Effect on Valuation Drivers
Three key factors have driven financial performance during 2008: (1) the
impact of the housing and credit crisis on mortgage and financial guarantee
insurers and the resulting effect on the overall P&C insurance industry sector's
financial results; (2) the continuation of soft market conditions through the
industry; and (3) a surge in catastrophe losses.1
Each of the factors and its impact on valuation is discussed below.
Subprime Mortgage Crisis
The effects of the subprime mortgage crisis have reached far beyond the residential
real estate industry. In fact, insurance companies have recently felt an impact
rippling from the crisis. Standard & Poor's (S&P) indicated that it was concerned
that the slowdown in the economy and a broad-based deterioration in the corporate
credit market would limit earnings growth of insurance companies. For example,
S&P noted that higher bond defaults may potentially result in a decline in the
quality of the insurance industry's bond portfolios. Furthermore, the low interest
rate environment and the relatively flat yield curve may make it more difficult
for the life insurance industry to continue to post strong earnings growth.2
With concerns of decreasing investment income, insurance companies are at risk
of generating less cash flow, which, holding all else equal, would generally
warrant a reduced value.
Another related factor recently affecting the insurance industry is litigation
losses stemming from the U.S. subprime mortgage crisis. The P&C segment's primary
loss exposure is expected to be from financial institutions' claims to recover
losses under their directors and officers, and errors and omissions coverages.
Insurers may also face claims under other potentially applicable coverage such
as fiduciary liability and comprehensive general liability.3
The long-term impact of the credit crisis on the U.S. life insurance industry
could arise via lawsuits over whether insurance companies have a fiduciary responsibility
to their customers with respect to any financial losses customers may incur
on the investment options within their insurance policies.4
While P&C insurers are by no means immune to the effects of the current economic
downturn, the impact in terms of growth and profitability will be somewhat limited.
With respect to revenue, P&C insurers are distinct from more economically vulnerable
sectors such as homebuilders or carmakers. This is because approximately 98
to 99 percent of insurer growth is tied to renewal business. Insurance is, in
effect, an economic necessity, not a discretionary purchase. Homes, cars, businesses
and workers all need to be insured irrespective of the state of the economy.5
These factors suggest that the negative impact of the subprime mortgage crisis
on the valuation of P&C insurance companies would be relatively limited.
Soft Market Conditions
The P&C segment reported an annualized statutory rate of return on average
surplus of 6.4 percent in the first quarter of 2008, a decline of more than
50 percent from the 13.2 percent in the first quarter of 2007. The sharp decline
in profitability reflects the substantial deterioration in underwriting performance
in the mortgage and financial guaranty segments of the industry. Net written
premium growth, which in 2007 turned negative for the first time since 1943,
continued its downward trend during the first quarter of 2008.6
The industry has moved into a cyclical downturn in terms of profitability.7
A decline in profitability and growth of insurance companies will tend to have
a negative impact on the valuation.
Due to volatility in the securities markets, the industry's total investment
gain declined by 18.8 percent to $12 billion during the first quarter of 2008
from $15 billion during the first quarter of 2007.8
The first quarter was very volatile for capital markets, which were affected
by waves of bad news related to the credit markets, skyrocketing oil prices
and economic weakness. The S&P 500 Index lost 9.7 percent during the first quarter
of 2008 (and 14.7 percent through July 28, 2008). Approximately 17 percent of
P&C insurer-invested assets are equities while two-thirds are bonds.9
This trend would have a negative effect on the valuation of insurers that derive
a substantial portion of their income from investment activities.
Catastrophe Losses
Catastrophe losses in the first quarter of 2008, at $3.4 billion, reached
the highest level for any first quarter since 1994 and continued through the
second quarter. As of June 20, 2008, total catastrophe losses for the year were
at $8.3 billion, $1.6 billion more than for 12 months of 2007.10
Catastrophe losses during the first half of 2008 were caused by record-breaking
tornado activity, severe hail and wind damage. Additionally, during the second
quarter of 2008, the Midwest suffered its most severe floods since 1993, which
cost private insurers $600 million.11 The surge
in the level of catastrophe losses will have greater negative effect on the
valuation of insurers, because insurers' ability to cope with such losses has
substantially declined due to the current soft market conditions.
Impact on Valuation of Insurance Companies
Exhibit 1 illustrates a declining trend in the average price-to-earnings
multiples for various segments of the insurance industry from April 2007 through
July 2008. The average multiples were calculated using data provided by
Capital IQ.
The pace of merger and acquisition (M&A) activity in the U.S. life insurance
sector slowed in 2006 and 2007 compared with 2005.12
Despite the softening market, P&C M&A deal volume in the first quarter of 2008
remained relatively constant compared to the first quarter of 2007, although
M&A valuations decreased.13 Equity analysts covering
the insurance industry are predicting an increase in M&A activity in 2008, with
nearly 90 percent of U.S. analysts expecting a rise in deal volume, according
to a survey.14 One factor that may contribute to
growth in M&A volume is declining valuations of insurers.
Conclusion
The weak economy, soft market conditions, and deterioration in the credit
markets appears to be limiting the growth of insurance companies. Additionally,
the recent volatility in the securities markets (not unrelated to the state
of the economy and the credit markets) contributed to a decline in the industry's
total investment gain. The combination of these factors has negatively affected
growth and profitability for insurance companies, and, in some ways, such as
the potential for litigation, recent trends have subjected the insurance industry
to a greater risk. The current environment suggests decreased valuations relative
to historical levels, which is consistent with the stock market's recent assessment
of insurance companies.
Note: See the August 2009 update,
Recent
Trends in Valuation of P&C Insurers: 2009.
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