Credit Crisis and Insurance Companies
November 2008
The general focus of this article is to discuss
the impact of the recent economic turmoil on the valuation of companies operating
in the insurance industry.
by Jeff
Balcombe
Business Valuation
Advisors LLC
Declining lending standards, consumer over-borrowing, and rising interest
rates, among other factors, have generated a rising wave of foreclosures, which
has resulted in declining consumer spending and a plummeting stock market.1
While the root causes of these events took place over a period of several years,
their effects have only recently become apparent. U.S. foreclosure filings increased
71 percent in the third quarter of 2008, as compared to the same period in 2007.2
Additionally, the Dow Jones Industrial Average posted a 34.5 percent year-to-date
decline, and the Standard & Poor's (S&P) 500 declined 38.2 percent.3
Many companies have been affected by the recent economic turmoil. Notably,
the severe downturn has had a marked effect on AIG, the world's largest insurer,
which nearly went bankrupt as a result of credit default swaps it wrote for
asset-backed securities and collateralized debt obligations. These products,
while derivative in form, were essentially insurance contracts in substance
and served to protect third-parties from debt defaults on pools of loans that
included subprime mortgages and other risky investments. As the nation suffered
from skyrocketing foreclosure rates, the value of the assets underlying the
credit default swaps plummeted, and AIG was forced to write down its positions.4
While loss rates on other types of insurance, such as life and property, may
be reasonably consistent and estimable, AIG failed to account for systemic risk
factors, such as a broadly declining market, to which financial guaranties are
exposed.
The results of AIG's decline have been far reaching. During its near collapse,
the credit markets virtually froze, as lenders had to retain cash for fear of
their own potential obligations and were unable to determine which companies
were creditworthy. As companies were unable to obtain financing, they found
it difficult to continue their operations, which caused their share prices to
fall dramatically. The decline in the financial markets is expected to exhibit
significant pressure on insurers' investment portfolios, resulting in market
value losses and impairments, while placing strain on insurers' credit ratings.5
Effect on P&C Insurers
There has been a significant drop in residential premium growth due to declining
new construction and banks' unwillingness to continue lending at their prior
lax lending standards. It is estimated that the housing market crash has already
cost home insurers $1 billion per year in lost premium growth, based on a 50
percent decline in new home construction.6 This
trend is expected to result in declining underwriting revenue growth and, thus,
negatively impact the valuation of insurance companies.
Industry data from the first half of 2008 (latest available) indicated that
net written premiums declined 0.6 percent.7 Additionally,
77 percent of insurance executives expect the subprime crisis to have a significant
negative impact on insurance companies' financial results and performance in
2009.8
Despite the downward trend in home prices across the nation, homeowners insurance
premiums have not declined on an individual basis. Home insurance is based on
replacement cost, not market cost, and replacement cost has continued climbing
due to higher labor and material prices.9 However,
this factor is expected to only partially offset the negative effects of slowing
premium growth.
Effect on D&O and E&O Insurers
The recent subprime crisis has greatly impacted providers of directors and
officers (D&O) and errors and omissions (E&O) liability insurance, which are
generally written by property and casualty (P&C) insurers. D&O policies indemnify
a corporation and its officers from litigation caused by wrongful acts that
result in the financial harm of third-parties. E&O policies indemnify a policyholder
for wrongful acts conducted in the provision of professional services. Claims
on these policies are expected to rise due to increased litigation against mortgage
lenders, investment banks, real estate investment trusts, and other firms believed
to have contributed to the current crisis.10
Advisen, Ltd., an insurance consultancy, expects D&O losses of $3.6 billion
related to the subprime mortgage crisis.11 In 2007,
278 civil litigation cases were filed related to the subprime issues, and directors
and officers were named as defendants in 97 percent of the class action cases.
Underwriting firms were also targeted due to alleged material misrepresentations.
Some analysts expect that the majority of defendants will be making claims against
their D&O and E&O policies once the litigation has been resolved.12
Despite the potential for significant claims, the responsibility of insurers
in these cases is in question, as exclusions may apply. The majority of D&O
and E&O policies contain exclusions for fraud and profiteering conduct, breach
of contract, and violations of securities laws. Although it is too early to
determine the results of the litigation, the American Bar Association expects
that insurance companies will closely scrutinize the facts surrounding policyholder
claims.13 As litigation exposure becomes more defined,
volatility in the valuation of insurers should be tempered, but in the short
term, firms' potential exposure is a risk factor contributing to lower valuations.
Weak Securities Market
Insurers have historically derived approximately 15 to 20 percent of their
revenue from investment income. However, the subprime crisis and the resulting
market downturn are expected to put a significant dampening effect on this revenue
stream, and many insurers have already realized investment losses.14
Life insurers have faced the greatest losses, as they own the greatest amount
of mortgage-related investments and investments in financial institution stocks.
Some firms have already begun raising new capital for stabilization.15
These companies' exposure to an exceptionally volatile and risky market negatively
impacts their valuations, as investors are unable to determine true loss exposure.
Investment losses could ultimately trigger downgrades from credit rating
agencies. Fitch recently revised its outlook for the domestic non-life insurance
sector to negative from stable, and affirmed its negative ratings on the domestic
health, life, and title insurance sectors, citing the global market declines
and the effect such declines have had on companies' balance sheets.16
Such credit worries could result in lost business as solvency concerns increase.
Additionally, downgrades could result in increased collateral requirements,
particularly for reinsurers, whose policies often contain provisions requiring
the reinsurer to post additional capital if its credit rating falls below a
specified level. This would limit insurers' ability to deploy its capital surplus
and, therefore, restrict its earnings growth. Ultimately, these trends could
have a negative impact on the future valuation of insurers.
Current Valuation Trends
The following charts illustrate a declining trend in the average price-to-earnings
multiples for the property and casualty (P&C) and life and health (L&H) insurance
segments of the insurance industry from April 2007 through October 2008. The
average multiples were calculated using data provided by
Capital IQ, as of October 23, 2008.
Click for
price-to-earnings multiples for P&C insurers.
Click for
price-to-earnings multiples for H&L insurers.
Notably, multiples declined despite significantly lower earnings. Generally,
if low earnings are perceived to be nonrecurring, the dollar valuation of the
subject company will not change substantially, resulting in a temporarily inflated
price-to-earnings multiple. Earnings from continuing operations and revenue
for the insurance industry as a whole declined 37.3 percent and 6.7 percent,
respectively, during the latest 12 months. However, the industry also exhibited
a 61.0 percent year-to-date drop in market value as of October 23, 2008.17
As the decline in the valuation of insurance companies was greater than the
decline in earnings, the price-to-earnings multiples contracted. The recent
decline in multiples reflects the market's perception of greatly reduced future
growth opportunities in addition to heightened risk.
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not necessarily held by the author’s employer or IRMI. This article does not purport
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