2009 Health and Life Insurance Trends
March 2009
This article provides an update of my
March 28 article on the
valuation of life and health (L&H) insurers, with an emphasis on the
challenges that L&H insurers face in the current economic environment.
by Jeff
Balcombe
The BVA Group LLC
In its simplest form, L&H insurance is a business of shared risk.
Insurers collect premiums from policyholders, invest those premiums, and
share some of that income with policyholders (in the form of a policy
dividend or income from an annuity, or through a policy's cash value).
Eventually, insurers give policyholders some sort of financial
reimbursement, either upon the policyholder's death or when a policy or an
annuity matures.
Current Economic Environment
A myriad of factors, including consumer and corporate overleveraging,
excessive financial risk taking, and increased foreclosures, have led to the
current economic recession, which was officially declared by the National
Bureau of Economic Research as having begun in December 2007.1
Advance figures from the Bureau of Economic Analysis indicate that the gross
domestic product declined 3.8 percent (annualized) in the fourth quarter of
2008.2 Additionally, the unemployment rate increased
from 4.9 percent as of December 2007 to 7.2 percent as of December 2008, an
increase of 2.3 percent, or an equivalent of 3.6 million lost jobs.3
All equity indices have exhibited substantial declines, with the Standard
& Poor's (S&P) 500 Index down 38.0 percent and the Dow Jones Industrial
Average down 34.7 percent year-over-year.4 The L&H
segment alone declined 48.1 percent since January 23, 2008.5
The poor performance of the financial markets has had a significant impact
on L&H insurers in a variety of ways, such as lower portfolio returns, lower
fee income, and increased hedging costs.
Effect on the Life and Health Insurance Industry
The current macroeconomic situation has put increased pressure on
insurers' portfolios due to declining equity prices and increased bond
defaults. Analysts cite L&H insurers' sizable positions in commercial
mortgage-backed securities, commercial loans, and lower grade corporate debt
as a source for concern given increasing bond default rates and current
market illiquidity.6 Speculative-grade bond default
rates reached 4.0 percent in December 2008 and are expected to rise to 15.1
percent by December 2009.7 However, L&H insurers'
extensive stress-testing procedures should help mitigate potential exposure.
Increased market volatility also contributed to declining sales for
variable rate products as consumers shifted their focus to fixed annuities
with stable returns. Variable annuity sales declined 5.7 percent during the
first half of 2008, while sales of fixed annuities rose 40 percent over the
same period as consumers preferred the safety offered by guaranteed
payments. Sales of equity-indexed annuities (EIAs) also performed well,
increasing by 6 percent year-over-year in the second quarter of 2008. EIAs
provide investors with a tax-deferred, guaranteed return on these products,
while also offering potential excess returns based on the performance of the
underlying equity securities. Increasing EIA sales contribute to insurers'
margins, as commissions on these products average 7.8 percent to 9 percent,
compared with 2 percent to 3 percent on mutual funds. However, analysts
expect EIA sales to decline in the future as the risk of regulation
increases.8
Furthermore, the current interest rate environment poses significant
challenges to L&H insurers, as the recent flight to the safety of government
bonds has put downward pressure on government bond yields, which is
generally a significant source of investment income for L&H insurers.
Additionally, historically low short-term interest rates may prevent L&H
insurers from lowering minimum crediting rates on new policies, which would
encourage higher surrender rates on existing policies that are already at
minimum credit rates. While insurers' margins had been suffering from a
relatively flat yield curve in 2007 and early 2008, the steepening yield
curve over the past year has reduced spread compression between deposit-type
funds and contracts. Click here for Figure 1,
which illustrates the Treasury yield curve as of January 29, 2007, 2008, and
2009.9
One of the critical issues L&H insurers face is increasing unemployment.
As of October 2008 (latest data available), 61 percent of Americans relied
on employer-provided health insurance.10 As
unemployment has risen substantially in the past year, insurers are likely
to receive less corporate premium revenue. Furthermore, declining consumer
spending has caused many individuals to cut back on expenses, including L&H
insurance. Consumer cutbacks generally result in rudimentary coverage with
minimal premiums or policy cancellations.11
Valuation Trends
As could have been expected given the challenging
macroeconomic conditions, L&H industry revenue declined 17.9 percent in the
12 months ended January 26, 2009. Additionally, earnings margins from
continuing operations fell from 6.6 percent in 2007 to 5.3 percent as of
January 26, 2009. In absolute terms, earnings from continuing operations
have declined 34.1 percent since 2007.12
As a
result of the overall poor economic conditions, transaction financing has
become difficult to obtain. For this and other reasons, industry merger and
acquisition (M&A) activity has declined significantly from $3.3 billion in
the fourth quarter of 2007 to $200 million in the fourth quarter of 2008,13
as the number of deals declined from 25 to 11.14 A
low level of deal flow results in lower market multiples, as competitive
bidding subsides and upward price pressure decreases. Despite the slowdown
in M&A activity, analysts expect industry consolidation to increase going
forward. In fact, the reduced M&A activity and lower multiples could offer
an opportunity to some industry participants. The capital positions of many
L&H insurers remain strong, leaving substantial capital available for
corporate expansions. With the general decline in valuations, strong
industry participants may be able to acquire other L&H insurers at
historically low multiples.
In analyzing current valuation trends, we
reviewed market statistics for the following 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")
As shown in
Figure 2, price-to-earnings (P/E) multiples and enterprise value (EV)15-to-earnings
before interest, taxes, depreciation, and amortization (EBITDA) multiples
have substantially declined in recent quarters for the Industry Group. The
Industry Group average price-to-earnings and EV-to-EBITDA multiples declined
from 12.1 and 7.7, respectively, as of January 29, 2008 to 8.5 and 5.6, as
of January 28, 2009. The Industry Group median price-to-earnings and
EV-to-EBITDA multiples declined from 10.8 and 6.9, respectively, to 8.1 and
4.2 over the same period.16 In-line with the major
declines in the overall stock market, the largest decreases in market
multiples occurred between July 2008 and October 2008, as illustrated in
Figure 2.
Notably,
valuation multiples continued to decline despite significantly lower
earnings. Because earnings represent the denominator in calculating a market
multiple, significantly reduced earnings place upward pressure on multiples
from a mathematical viewpoint. As such, the significant decline in multiples
seen in the stock market illustrates investors' perceptions of increased
risk in the industry and substantially reduced growth opportunities. These
changes in perceptions, which tend to drive multiples downward, are more
than offsetting the upward effect that lower earnings have placed on
multiples. We note that such changes in perceptions may or may not represent
changes in long-term fundamentals for the industry but rather an
over-exuberant financial market.
Conclusion
The current economic
environment has proven exceedingly difficult for L&H insurers, whose
valuations depend upon growth, profitability, and risk. Growth and
profitability metrics have declined due to macroeconomic difficulties, and
risk has increased as a result of turmoil in the bond and equity markets,
resulting in substantially decreased valuations of L&H insurers. Some
industry participants, who are able to secure financing and who deem the
market's current expectations to be irrational, may find opportunities to
make acquisitions at historically low prices.
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