Expert Commentary

2014 Valuation of Reinsurers

The purpose of this article is to provide an update regarding the valuation of companies operating in the reinsurance industry (see "Valuation of Reinsurers: 2013"). Specifically, the article discusses some of the factors that impact the valuation of businesses and how certain trends and expectations for the reinsurance industry may be affecting the market's current valuations of reinsurance companies.


Valuation of Insurance Organizations
November 2014

Reinsurance is the business of insuring insurance policies. Through reinsurance, direct insurers are able to transfer portions of their risk portfolios and mitigate the risk of concentrated claims and catastrophic losses. Reinsurance companies enter into transactions in which they indemnify, for a premium, another insurance company against all or part of the loss that it may sustain under its policy or policies of insurance.

Depending on the contract, reinsurance can enable the insurer to improve its capital position, expand its business, limit losses, and stabilize cash flows. Reinsurers draw experience from a significant number of primary insurers and therefore usually have a larger compilation of data for assessing risks. Reinsurance can take a variety of forms and may represent a layer of risk or a sharing of both losses and profits for a certain type of business.

Reinsurance contracts fall into two broad groups: treaty contracts and facultative contracts. Treaty contracts are written so that the reinsurer assumes risk associated with a group of policies within a certain business class or classes. Facultative contracts are written so that the reinsurer assumes the risk of all or part of an individual policy. Facultative contracts are often used to cover catastrophic and unusual risk exposures or to cover risks specifically excluded in treaty contracts.1

In addition to the two types of contracts, there are two types of coverage: proportional and non-proportional. Proportional contracts provide primary insurers with coverage for a determined percentage of losses incurred. Non-proportional contracts, also known as "excess of loss" contracts, include a predetermined level of retention, or deductible, and losses in excess of the set deductible are covered by the reinsurer up to the limits of the contract.

There are four primary reasons direct insurers seek reinsurance:2

  1. Limiting liability: by providing a mechanism through which insurers limit their loss exposure to levels commensurate with their net assets, reinsurance enables insurance companies to offer coverage limits considerably higher than they could otherwise provide.
  2. Stabilization: through reinsurance, insurers can reduce fluctuations in loss experience and stabilize a company's overall operating results.
  3. Catastrophe protection: reinsurance protects against catastrophic financial loss resulting from a single event, as well as against the aggregation of many smaller claims resulting from a single event that affects many policyholders simultaneously.
  4. Increased capacity: the insurer shares a portion of its underwriting expenses with its reinsurer and reduces the drain on surplus, thus increasing its capacity to underwrite more contracts.

The Reinsurance Market

In assessing the value of any company, it is important to consider the market in which the subject company operates. Industry factors and trends can affect the expectations for a company's future performance and, in turn, the valuation for that business.

The US reinsurance industry is somewhat concentrated. The number of businesses competing within the industry as reported by IBIS World declined to 159 from 234 since our previous update, reflecting consolidation within the industry. The largest two industry participants, Berkshire Hathaway and Reinsurance Group of America, together hold approximately 35 percent of market share.3 PricewaterhouseCoopers expects industry concentration to grow as insurers become more commoditized and pressures mount to build scale and cut costs.4

Similar to traditional insurance, reinsurers generate income from policy premiums and investment returns. Generally, premiums are affected by changes in policy counts and pricing, which fluctuate between hard and soft cycles. During hard pricing cycles, prices rise as insurers try to build reserves and maximize underwriting profits. In contrast, soft cycles occur when prices fall, as reinsurers competitively price policies in an attempt to gain market share. The change between these two cycles depends highly on catastrophic activity and investment returns, as unusual spikes in claims and decreases in investment income curtail reserves and profitability.

The reinsurance industry continues to face a soft cycle, and the record issuances of insurance‑linked securities (ILS) have lessened the likelihood of rate increases in the near term. ILS include a range of financial instruments, most notably catastrophe bonds, which are issued in order to provide insurance or reinsurance protection to insurers, reinsurers, governments, and corporations. ILS issuances allow companies to purchase reinsurance from a diversified capital pool and decrease credit risk relative to purchasing from traditional reinsurance providers.5 Industry experts warn that the reinsurance industry has become commoditized and firms must either create more specialized offerings or achieve economies of scale if they wish to remain competitive. Additionally, despite a trend of increasing interest rates beginning in 2013, rates have remained below pre-recession levels. Depressed interest rates have continued to plague industry participants as they have struggled to achieve satisfactory returns on their investments.

Public Guideline Companies

In analyzing a "subject company," it can be helpful to look at the recent and expected performance of other companies operating in the same industry. Public guideline companies can be used to develop a range of valuation multiples that may be applicable to the subject company.6 Listed below is a group of publicly traded companies (the "Industry Group"), each of which generally represents the reinsurance industry.

Allegheny Corporation (Y) PartnerRe Ltd. (PRE)
Endurance Specialty Holdings, Ltd. (ENH) Platinum Underwriters Holdings Ltd. (PTP)
Enstar Group Limited (ESGR) Reinsurance Group of America Inc. (RGA)
Everest Re Group Ltd. (RE) RenaissanceRe Holdings Ltd. (RNR)
Greenlight Capital Re, Ltd. (GLRE) SCOR SE (SCR)
Hannover Rück SE (HNR) Swiss Re Ltd (SREN)
Maiden Holdings, Ltd. (MHLD) Third Point Reinsurance, Ltd. (TRPE)
Montpelier Re Holdings, Ltd. (MRH) Validus Holdings, Ltd. (VR)

Premise on Market Approach to Valuation

Analysts can calculate a value for a firm by deriving multiples from data on similar publicly traded companies or recent transactions involving similar companies. The resulting multiple can be applied to the firm being analyzed to arrive at an indication of value. Throughout the remainder of this article, concepts relating to factors that impact valuation multiples will be discussed.

Data from Capital IQ (a division of Standard and Poor's), can be used to calculate valuation multiples for the Industry Group. A valuation multiple compares a company's equity value or market value of invested capital (i.e., total interest-bearing debt plus the equity value) to an earnings stream such as revenue; earnings before interest, taxes, depreciation, and amortization; or net income (earnings). Valuation multiples can also be calculated based on industry-specific metrics, such as premiums and annuity revenues. However, in the case of reinsurance companies, which assume residual risk, earnings streams tend to be volatile even after making adjustments that are typically applied in valuing other types of insurers. Consequently, earnings-based metrics frequently used in a valuation context such as the forward price‑to‑earnings ratio tend to lose their significance. The most conservative and reliable valuation metric used for the reinsurance industry is the price-to-tangible book value ratio (P/TBV).

Valuation Drivers

While there may be exceptions, for most reinsurers, value is driven by growth, profitability, and risk.

Growth

Companies with greater growth prospects tend to be more valuable than those with less growth potential. However, growth must be considered within the context of risk. For example, a reinsurer may exhibit slower growth than its peers due to more conservative underwriting policies, which would normally result in lower risk. As a result, in determining an appropriate valuation multiple, the analyst should weigh the value of the reinsurer's more conservative risk profile against the negative impact of its lower growth prospects.

Profitability

In the reinsurance industry, profitability is generally driven by the occurrence (or lack) of catastrophic events, such as hurricanes for property and casualty reinsurers, which result in large losses. The specific impact on a given reinsurer depends on many factors such as the following:

  • each individual reinsurer's exposure to the product line in which the event occurred,
  • the magnitude of the insurance event, and
  • the type of the reinsurance contract (proportional or excess of loss) the reinsurer has underwritten.

In addition to claims-related expenses, profitability is affected by policy acquisition/underwriting costs, overhead costs, and investment income.

Risk

One primary risk factor for reinsurers is the risk of underwritten policies, which, as mentioned previously, should be considered in the context of the company's outlook for growth in premiums. While higher risk policies tend to have a negative impact on value, they can also provide higher premium growth. Thus, policy risk and growth potential need to be considered together in order to assess value.

Current Valuation Trends

Reinsurer capital continued to exhibit strong growth, reaching a record level of $570 billion in the second quarter of 2014. Global catastrophe losses of $45 billion in 2013 were well below the 10-year average of $58 billion and at the lowest level since 2009. As of September 1, 2014, catastrophe losses for 2014 totaled $27 billion and are expected to remain below the 10‑year average. Unfortunately for industry participants, growth in demand for reinsurance has remained relatively stable in the past year despite rate decreases, and much of the growth is being serviced by ILS issuances.7 Lower growth expectations typically yield lower valuations; thus, if the soft market is expected to continue, or if global catastrophe levels experience an increase, valuations could decline from current levels.

As previously mentioned, catastrophe claims were at a 5-year low during 2013 and the first 8 months of 2014. Industry profits were estimated at 25.0 percent of revenue and were expected to remain stable as reinsurance rates fall and participants cut cost through consolidation.8 Investment returns have been slightly more favorable since our previous update, with interest rates finally beginning to show signs of returning to normalized levels in late 2013. However, in October of 2014, a number of factors including the fear of an Ebola epidemic in the United States, economic struggles in Europe and emerging markets, a sudden and steep decline in oil prices, and the prospective end of the Federal Reserve's Quantitative Easing program at the end of the month sent bond and equities markets into a sell-off.9 Accordingly, the future impact on investment returns for the industry remains largely uncertain.

Looking forward, reinsurers that are unable to achieve economies of scale will look to exit the commoditized segments of the market and offer more specialized products. Cyber and onshore energy risk products present attractive opportunities for reinsurers as companies seek ways to mitigate rising losses from online security breaches and as hydrocarbon production through more complex hydraulic fracturing operations becomes more common in the United States. However, as reinsurers begin to address these needs and expand premiums, it is important to consider implications of entering a space that does not have a long record of historical incidence data through which risk can be assessed.10

Mergers and acquisitions activity in the industry was robust in the first 7 months of 2014 with deal value 30 percent higher than the same period in the previous year. As discussed previously, consolidation among reinsurers is expected to increase as participants seek to diversify to include international exposure. The continuing soft cycle is also likely to drive small and midsize reinsurers to merge in order to benefit from economies of scale.11

As shown in the graph below, current market valuations (measured using P/TBV) for the Industry Group ranged from a low of 0.85 times to a high of 1.38 times, with an average of 1.03 times. Differences in each company's multiples can be attributed to varying levels of exposure to catastrophe risk along with company-specific factors such as growth strategy and product-line exposure.

Figure 1: Price-to-Tangible Book Value

Price-to-Tangible Book Value

Insights can also be drawn from observing historical ratios and trends for the Industry Group. We looked at monthly data from January 2008 to October 2014. The summary of our analysis is presented in Figure 2 below.

Figure 2: Average Price-to-Tangible Book Value and Average Price-to-Tangible Book Value Trend Line

Average Price-to-Tangible Book Value and Average Price-to-Tangible Book Value Trend Line

Since January 2008, the Industry Group has traded at an average 0.94 times their net tangible book value, which is represented by the horizontal line in the graph shown above. Theoretically, net tangible book value should serve as a lower bound on the valuation company, as an investor could expect to receive a comparable payout in the case of liquidation. Furthermore, one would expect that the average P/TBV of the Industry Group would trend toward 1.0 times, as this would imply that the underlying companies were worth the amount of capital they carried on their books. The trend line on the graph demonstrates that the Industry Group's average annual P/TBV began to increase from depressed levels in 2012 and converged at 1.00 and 1.01 times book value in 2013 and 2014, respectively. The lack of catastrophic events and a more optimistic market after the end of the recession have likely been the drivers of multiple expansion since 2012.

Outlook for 2014

Low catastrophe losses in 2013 and the beginning of 2014 spurred multiples higher. However, a number of factors including abundance of overwriting capacity, uncertain economic conditions, commoditization of services, and pricing pressures from ILS offerings caused P/TBV multiples to revert toward the 1.0 times benchmark during the second half of 2014. Both stagnant demand and market volatility in October are expected to adversely affect the reinsurance industry. Consolidation within the industry combined with more specialized offerings and disciplined underwriting are expected to partially offset the effects of the recent market downturn. However, the outlook for the industry largely depends on whether volatility dissipates and normal market conditions return in the fourth quarter.12


1"Fundamentals of Property and Casualty Reinsurance," Reinsurance Association of America.

2Ibid.

3"IBIS World Industry Report: Reinsurance Carriers in the United States" (June 2014).

4Bryan Joseph, Arthur Wightman, Jorge Camarate, and Utz Helmuth, Reinsurance 2020: Taking control of your destiny, Tech, PricewaterhouseCoopers (Oct. 20, 2014).

5"What are Insurance Linked Securities (ILS) and Why Should they be Considered?" Swiss Re, Presentation to the CANE Fall Meeting, Casualty Actuarial Society (Sept. 2012).

6Shannon P. Pratt, Valuing a Business: The Analysis and Appraisal of Closely Held Companies.

7"Reinsurance Market Outlook-Growth Capital from Growing Reinsurer Capital," Aon Benfield (Sept. 2014).

8"IBIS World Industry Report: Reinsurance Carriers in the United States" (June 2014).

9John Kimelman, "The Lessons of This Stock Market Selloff"? Barron's (Oct. 15, 2014).

10Bryan Joseph, Arthur Wightman, Jorge Camarate, and Utz Helmuth, Reinsurance 2020: Taking control of your destiny, Tech, PricewaterhouseCoopers (Oct. 20, 2014).

11Aon Benfield (Sept. 2014).

12Ibid.


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