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.
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.
Price-to-Earnings Multiples for P&C Insurers
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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1 Kathleen M. Bianco, J.D., "The Subprime Lending Crisis: Causes and Effects of the Mortgage Meltdown."
2 Alan Zibel, Associated Press, "US Foreclosure Filings Up 71 Percent," October 23, 2008.