Expert Commentary

2009 Health and Life Insurance Trends

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.


Valuation of Insurance Organizations
March 2009

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

Figure 1: Treasury Yield Curve

Treasury Yield Curve

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.

Figure 2: P/E Multiples and EV/EBITDA Multiples for Life & Health Insurance Companies

P/E Multiples and EV/EBITDA Multiples for Life and Health Insurance 	Companies

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.


1"NBER Makes it Official: Recession Started in December 2007," Wall Street Journal, December 1, 2008.

2"Gross Domestic Product: Fourth Quarter 2008 (Advance)," Bureau of Economic Analysis.

3"The Employment Situation: December 2008," Bureau of Labor Statistics.

4Yahoo! Finance. January 29, 2009.

5"Life and Health Insurance: GICS Sub-Industry Profile," Standard & Poor's Market Insight.

6Standard & Poor's Industry Surveys, Insurance: Life & Health, October 30, 2008.

7John Glover, "Global Default Rate Will Jump to 15.1% by Year-End (Update 2)," January 14, 2009, available at http://www.bloomberg.com/.

8Standard & Poor's Industry Surveys, Insurance: Life & Health, October 30, 2008.

9Data provided by the United States Treasury Department.

10Kaiser Commission, "Health Coverage in a Period of Rising Unemployment," December 2008.

11"Consumer Woes Wallop Insurers," Wall Street Journal, January 30, 2009.

12Life and Health Insurance—Key Stats & Ratios, Capital IQ, January 28, 2009.

13KPMG, "Insurance M&A Monthly," December 2008. Based on deals with value disclosed.

14Ibid.

15Enterprise value is calculated as the sum of common equity, preferred equity, debt, and minority interest less cash and cash equivalents.

16Calculated from data provided by Capital IQ, a division of Standard & Poor's.


Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.

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