Valuation Insights: TARP and Insurers
May 2009
The recent economic recession has resulted
in substantial uncertainty regarding the future performance of many companies.
Specifically, life and health (L&H) insurers that collect premiums from policyholders
and then invest those premiums have been affected and face a potentially devastating
cash crunch should policyholders decide to redeem their policies. Such an event
would force the liquidation of substantial investments.
by Jeff
Balcombe
The BVA Group LLC
Recent valuations of these companies reflect the market's concern
regarding the risks surrounding the financial soundness of some of these L&H
insurers. Additionally, as indicated by reactions to news relating to the
Troubled Asset Relief Plan (TARP), recent valuations also provide evidence
of the importance of access to capital to L&H insurers. This article
discusses the recent economic environment, the relief efforts that have been
implemented, and the impact on the valuation of firms operating in the L&H
insurance industry.
Current Economic Environment
A myriad of factors, including consumer and corporate overleveraging,
excessive financial risk-taking, and increased foreclosures contributed to
the current economic recession. Since December 2007, which the National
Bureau of Economic Research marks as the beginning of the recession,1
many firms across the United States, including insurance providers, have
felt the impact of the slowing economic activity.
With respect to recent economic performance, advance figures from the
Bureau of Economic Analysis indicated that domestic gross domestic product,
which provides a general indication of U.S. economic activity, declined 6.1
percent on an annualized basis in the first quarter of 2009.2
Additionally, equity indices have recently experienced continued declines
with the Standard & Poor's (S&P) 500 Index falling 11.7 percent in the first
quarter of 2009. Additionally, the Dow Jones Industrial Average fell 13.3
percent in the first quarter of 2009.3
Among the many firms affected by these significant declines were the L&H
insurers who experienced lower portfolio returns, lower fee income, and
increased hedging costs. In addition to lower earnings, stock investments in
L&H insurers were also negatively impacted by the market's perception of
substantially increased risk which, in many cases, yielded greater declines
in stock prices than declines in future expected earnings.
Brief Overview of Relief Efforts
Beginning in the middle of 2007 and into 2008, the Federal Reserve began
taking action by cutting the federal funds target rate to combat the lending
crisis. Since December 11, 2007, the Fed cut the rate 7 times to a
historical low of 0 to 0.25 percent on December 16, 2008.4
By September 2008, the Treasury realized more action was needed to stem
eroding financials and a potential lending freeze that could cripple the
economy. Accordingly, the Treasury presented Congress with the $700 billion
TARP, which was intended to be used to buy mortgages and related toxic
assets from financial institutions in an attempt to stabilize their balance
sheets.
The plan was to release the TARP funds in several stages to provide
stability to the U.S. financial system. The initial three-page proposal
turned into the Emergency Economic Stabilization Act of 2008, which was
signed into law October 3, 2008.5
The first planned allocation under the TARP, launched on October 14,
2008, was the $250 billion Capital Purchase Program (CPP), which involved
capital injections into healthy financial institutions in return for
compensation restrictions and corporate governance limitations. Being widely
criticized as straying from their initial proposal, the Treasury backed the
CPP by noting its ability to restore confidence in the banking system and
impede an imminent collapse.
Following the CPP, the Treasury provided an initial allocation of $40
billion in TARP funds to the major global insurer, American International
Group (AIG).6 AIG had previously received a
bailout from the Federal Reserve, and at that time, the effect of the crisis
on insurance companies was not widely known. As the grim situation facing
AIG was realized, additional funds amounting to $30 billion have been
allocated to AIG since January 20, 20097 as the
Treasury believed that AIG's failure could result in a systematic shock to
the U.S. economy. The allocations to AIG, coupled with sustained economic
declines, resulted in several other firms in the insurance industry desiring
relief through the receipt of TARP funds.
TARP Needs Spread to L&H Insurers
For a time, L&H insurers seemed to be immune to the credit crisis, since
they generally invest in relatively safe assets in order to match their
liabilities. However, due to aggressive decision-making and weak financial
markets, several L&H insurers began to feel the impact of the poor economic
conditions. The Wall Street Journal
noted,
Many of the roughly 2 dozen insurers that dominate the
variable-annuity business made aggressive promises on these popular
retirement-income products, guaranteeing minimum returns, no matter what
happened to the stock market. With the market's decline, the issuers are on
the hook for big payouts, though most of the payments won't come due for 10
or more years.
Patterson, et al., "U.S. to Offer Aid to Life Insurers,"
Wall Street Journal, April 8, 2009.
Combining this with losses on investments in bonds and real estate which
backed their insurance policies resulted in a potentially severe situation
for L&H insurers. The article went on to note that if massive numbers of
customers sought to redeem their policies due to lack of confidence,
insurers would require significant amounts of cash, which would potentially
force them to sell off holdings in bonds, real estate, and other
investments. Given that insurers hold substantial investments in such
securities, a sell-off could cause markets to tumble.
As a part of the statute passed in October 2008 by Congress and the
George W. Bush Administration, insurers were originally eligible to gain
TARP funding. However, the Treasury adopted a more constricted program which
prohibited pure-play insurers from receiving TARP funds. Almost immediately
after the Stabilization Act was passed, three L&H insurance
companies—Hartford Financial Services Group (HIG), Genworth Financial Inc.
(GNW), and Lincoln National Corp. (LNC)—applied to the Office of Thrift
Supervision (OTS) to buy individual savings and loan companies as a means of
bypassing this statute by becoming banks and gaining eligibility under the
CPP. As a result, larger insurers, including Prudential Financial (PRU),
also approached the OTS in hopes of gaining TARP money.
Although converting into a bank holding company would allow insurers to
become eligible under the CPP, there was still uncertainty as to whether or
not these insurers would actually receive TARP funds. Nevertheless, the
market appeared to place substantial value on the potential opportunity of
receiving relief funds as indicated by the trends in the valuation multiples
of several major L&H insurers. From the end of March 2009 through April 29,
2009, the average price-to-next year's expected earnings multiple (the
"forward P/E multiple") for HIG, GNW, LNC, and PRU increased approximately
52 percent from 1.78x to 2.71x, exhibiting the value of access to capital in
a market where funds have become one of the scarcest resources.
Valuation Trends
Over the past year and even during the year-to-date, there have been
significant changes in the market's perception of value for L&H insurers,
especially those seeking TARP funds. Below is a discussion of recent trends
in the valuation of these companies. Specifically, consider the forward P/E
multiples for four insurers that sought capital from TARP funds: GNW, HIG,
LNC, and PRU (the "L&H Insurers"). In addition to these companies, also
consider recent trends in AIG's forward P/E multiples given its significant
allocations under the TARP. Figure 1 exhibits the
forward P/E multiples for these companies between June 30, 2008 and April
29, 2009.
As shown in Figure 1, the L&H Insurers and
AIG experienced substantial declines in their valuations (relative to
expected earnings) between early September 2008 and March 2009. Typically,
factors that negatively impact valuation multiples include increased risk
and/or reduced growth opportunities. Based on the circumstances surrounding
the insurance industry during this timeframe, the market appeared to be
factoring in significantly heightened market risk as well as increased
liquidity concerns specifically relating to insurance companies.
Recently, the L&H Insurers and, to a greater extent, AIG saw increases in
their forward P/E multiples, which can be attributed, at least in part, to
the increased perceived probability of receiving TARP funds that would
alleviate some of the aforementioned liquidity concerns. The multiples of
AIG, which some have considered to be "too big to fail," appear to have
benefited from being a likely candidate of receiving further bailout funds
should they be required, thus resulting in a substantial increase in its
forward P/E multiple.
The L&H Insurers appear to be trading at multiples substantially below
their historical valuations, which could potentially present an attractive
investment opportunity to those who believe the related risks to be less
than the market's current assessment. As economic conditions stabilize, one
would generally expect multiples to revert to a normalized level, which
appears to be in the range of 6 to 8 times next year's expected earnings,
based on data provided by Capital IQ.
Conclusion
The current economic environment has L&H insurers facing greater
uncertainty than in recent history, although, with TARP funds potentially
becoming available, at least some of the uncertainty may be alleviated. At
this point, only few insurers have sought out TARP funding; however, more
could follow if market conditions continue to deteriorate. With respect to
the valuation of firms in the L&H insurance segment, there is significant
uncertainty and perceived risk, which has resulted in substantially
depressed valuation multiples. Valuations cannot be expected to recover
until the market receives greater certainty with respect to the financial
positions of these companies.
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