Expert Commentary

Growth and Uncertainty in P&C Insurer Valuation

This article discusses the impact of recent industry trends on the market's valuation of property and casualty (P&C) insurers. Valuation multiples, such as the price-to-earnings ratio, are generally impacted by the market's assessment of two characteristics of the subject company: growth prospects and risk.


Valuation of Insurance Organizations
February 2010

Generally, all else being equal, the expectation for greater growth in the future increases the amount an investor is willing to pay for each dollar of earnings. Stated alternatively, generally, with greater growth comes a higher valuation multiple. However, market participants also consider the level of risk surrounding the subject company and its ability to generate the expected earnings. If the risk profile of a given company suggests that there is a substantial probability of underperformance, then market participants will likely pay less for each dollar of earnings than they would for an otherwise similar company with less risk. With this framework in mind, we consider the impact of recent industry trends on the growth prospects and risk profiles of firms operating in the P&C industry.

Growth Prospects

Two primary avenues for property and casualty insurers to generate growth are by underwriting more insurance policies with higher premiums and by increasing investment earnings. Historically, the insurance industry experienced cyclical trends based largely on market conditions. In soft market conditions, P&C insurers provide coverage at low premiums while utilizing strict, low risk underwriting practices to generate capital. Firms typically focus on increasing capacity in markets with more profitable underwriting margins, while implementing control risks in markets with lower margins. Conversely, during a hard market, insurers are able to increase profitability through higher premiums as there is greater demand for insurance products.

Currently, the industry is in the midst of a 6-year-old soft market characterized by low demand and lack of premium pricing power. The lack of demand is partly attributable to high unemployment levels as well as reduced construction and manufacturing activity due to the recent economic downturn. One source notes, "Business bankruptcies have soared, and business formations slumped, so that the demand for commercial insurance in 2010 will rise from a smaller base."1

Additionally, regarding unemployment, another industry source states, "When these people finally get new jobs, 40 percent will accept lower pay than from their prior job. This affects consumer buying power in general and the workers compensation exposure base in particular."2

Expectations for a smaller employment base and lower compensation tend to indicate lower overall growth prospects for insurers, and an outlook for lower growth reduces the amount that investors and potential acquirers are willing to pay for a business or business interest. As described in further detail below, this relationship was prevalent in P&C insurer valuations as the economy entered into the recession in December 2007 and as economic conditions began to recover in recent months.

The magnitude of decreases in commercial insurance pricing is gradually diminishing, potentially indicating a trend toward recovery. Additionally, according to the Consumer Price Index data, home insurance prices increased 3.0 percent and auto insurance premiums increased 4.5 percent in the third quarter of 2009 compared to the same period in 2008.3 However, net written premiums declined by 5.0 percent in the same period, marking a continued acceleration in the rate of premium reduction.4 Given the opposite trends in price and volume, there is uncertainty regarding the future net impact on growth prospects for P&C insurers. Such uncertainty is likely to be a risk factor considered by market participants in assessing valuations.

Improvements in the stock and bond markets yielded an increase of $27.8 billion (or 6.0 percent) in policyholder surplus during the third quarter of 2009.5 Previously, investment earnings had been adversely affected by the recession as credit markets stalled causing bond prices to plummet resulting in $29.4 billion in realized capital losses since the beginning of 2008.6 However, it appears the P&C industry has seen the worst of the recession in terms of realized investment losses as the economy began to recover in 2009, as illustrated by the Congressional Budget Office's (CBO's) revision of their real GDP forecast.

The CBO improved its outlook from negative 1.0 percent to negative 0.4 percent,7 as real GDP in the third quarter increased at an annual rate of 2.2 percent.8 With the resulting increases in policyholder surplus, insurers have achieved greater capacity to underwrite premiums in the future when demand for insurance products improves. The potential for increased underwriting of premiums and, in turn, greater cash flows, tends to have a positive influence on firm valuations.

In addition to increasing capacity, some industry analysts expect P&C insurers to seek out the benefits of expanding their overall operations. According to Tony Ursano, Chief Executive Officer of Willis Capital Markets & Advisory, "The size and scale of insurance companies was becoming increasingly important for rating agencies, investors, and clients."9

Increasing firm size is expected to be achieved partly through acquisitions, as the industry experiences consolidation in the coming years, especially as a favorable credit environment returns. With greater size, firms may be able to benefit from economies of scale resulting in greater growth in earnings. The impact on valuation multiples resulting from this expectation is likely to be that market participants will be willing to pay more for greater growth prospects. But market participants also recognize that industry consolidation could result in numerous acquisitions of publicly traded P&C insurers at a premium to their stock prices.

Uncertainty

As stock and bond market conditions deteriorated with the recession beginning in December 2007, the profitability of P&C insurers declined, which increased market participants' perception of risk and therefore reduced valuation multiples. However, improvement of the markets throughout 2009 allowed for a rebound in profitability. Specifically, in the first 9 months of 2009, P&C insurers reported an annualized statutory rate of return on average surplus of 4.5 percent.10

Higher levels of profitability are generally associated with lower risk as there is a lower probability that the company will be unable to meet its ongoing expenses and debt service payments. Accordingly, the market rewards these improvements with higher valuation multiples, which is consistent with the trends exhibited by P&C insurer valuations in recent months, as discussed below.

Portfolio risk decreased substantially as plunging share prices reduced equity exposure from 17.7 percent at year-end 2007 to 14.9 percent as of year-end 2008.11 Additionally, as 2009 progressed, concerns over exposure to toxic assets began to be alleviated to some extent, resulting in overall less perceived risk. Furthermore, companies are generally well capitalized by historical standards,12 providing a safety net for any unexpected downside events. As a result, the decline in overall perceived risk as the general economy recovered has provided justification for higher valuation multiples.

In terms of future risk factors, the prospect of political changes has potentially offset some of the recent recovery in P&C insurer valuation multiples given the possibility that future regulation could have an adverse effect on the ability of P&C insurance firms' to grow. For example, under current law, taxes will be increasing substantially in 2011 with the expiration of various provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA). As a result, the highest income tax bracket will increase from 35.0 percent to 39.6 percent, and the capital gains tax will increase from 15.0 percent to a maximum of 20.0 percent.13

In addition, increased spending under the Obama administration causes some analysts concern over inflation.14 While the CBO believes inflationary risk will be low over the next 2 years, a study by Conning Research & Consulting discusses the potential impact of inflation on the P&C industry in the coming years. A review of the historical impact of inflation shows that in the "longer term we see dramatic value destruction from hyper-competitive pricing and loss reserve development."15 Under such a scenario, profitability will decline, and the valuation of P&C companies will be adversely affected.

Furthermore, President Obama's healthcare reform plan is likely to impact the valuation of insurance companies via changes in the regulation of the industry such as with the attempt to repeal the McCarran-Ferguson Act. This legislation grants the insurance industry limited federal antitrust exemption so insurers can share historical data "in order to more accurately determine the risks they are underwriting and properly set their prices."16 The Act increases competition, providing small insurers with the tools needed to compete with larger insurance companies. Repealing the Act is likely to decrease efficiency, leaving smaller companies more prone to insolvency.17 These political risks significantly affect the uncertainty of the outlook for P&C insurers, which, all else being equal, places downward pressure on valuation multiples.

Improved Valuations

Below is a group of publicly traded companies (the "Industry Group") that are representative of the P&C insurance segment of the insurance industry.

The Chubb Corporation ("CB") RLI Corp. ("RLI")
Cincinnati Financial Corp. ("CINF") Safety Insurance Group Inc. ("SAFT")
Donegal Group Inc. ("DGIC.B") Selective Insurance Group Inc. ("SIGI")
Erie Indemnity Co. ("ERIE") Specialty Underwriters' Alliance Inc. ("SUAI")
First American Corp. ("FAF") The Hanover Insurance Group Inc. ("THG")
Hallmark Financial Services Inc. ("HALL") The Travelers Companies Inc. ("TRV")
Harleysville Group Inc. ("HGIC") Tower Group Inc. ("TWGP")
Mercer Insurance Group Inc. ("MIGP") W.R. Berkley Corporation ("WRB")
Progressive Corp. ("PGR") Alleghany Corp. ("Y")

As the economy and stock market began to turn around in early 2009, valuations for P&C insurers improved, although multiples have not fully recovered to historical levels. Figure 1 illustrates the average forward price/earnings (P/E) multiples from 2005 through 2009.

Figure 1: Average Forward P/E Multiple

Average Forward P/E Multiple

Source: Data provided by Capital IQ.

During the period from January 2005 through November 2007, prior to the beginning of the recession, the average forward P/E multiple for the Industry Group was 12.7 times, as shown in Figure 2. However, as economic conditions worsened, the average multiple declined to 11.0 times for the 13 months from December 2007 through the end of 2008. While increased risk relating to the prevailing economic conditions likely played a role in the decline in multiples, the market also expected lower long-term growth in P&C insurer earnings, as shown in Figure 2, exacerbating the decline in valuations.

Figure 2: Average Forward P/E Multiples and Long-Term Growth Rates

Average Forward P/E Multiples and Long-Term Growth Rates

Source: Data provided by Capital IQ.

Subsequently, in the first half of 2009, despite relatively unchanged expectations for growth, valuations continued to decline, resulting in an average forward P/E multiple of 10.1 times. The persistent downward trend was likely influenced by the significant perceived risks relating to lack of profitability.

Conditions in the P&C industry began to improve in the latter half of 2009 as profitability returned and the stock and bond markets improved. This has resulted in an increase in the average forward P/E multiple to 11.4 times between July and December 2009.

Conclusion

The performance of the P&C insurance industry was greatly impacted by the declining economic conditions as profitability fell substantially throughout the recession. Valuation multiples declined from levels prior to the recession through the first quarter of 2009, after which they began to recover. While profitability returned to the industry with the recovery of the economy in the third quarter of 2009, multiples have not reverted to historical levels. Notably, expected growth remains lower than pre-recession levels, and many areas of uncertainty/risk still exist.

Soft market conditions continue to subdue insurance product demand and the ability of insurance companies to increase premium revenue. Furthermore, political risk is likely to weigh on the industry as future regulation changes are uncertain. It will be interesting to observe P&C insurer valuations in the near future and see how the market weighs these risk factors against the industry's potential growth opportunities and the outlook for increased industry merger and acquisition activity.


1"Insurance Industry Leaders Believe Financial Crisis Easing, But Recovery in Some Areas will be Slower, I.I.I. Survey Finds," January 14, 2010, www.insurancenewsnet.com.

2Ibid.

3Insurance Information Institute, "2009-First None Months Results," December 22, 2009.

4Ibid.

5Ibid.

6Ibid.

7"CBO's Projections Highlight Budget Challenges," January 26, 2010, www.americanprogress.org.

8Bureau of Economic Analysis, News Release: Gross Domestic Product and Corporate Profits, December 22, 2009.

9"Insurance Mergers and Acquisition Activity to Increase in 2010," September 7, 2009, www.newsinsurances.co.uk/.

10Insurance Information Institute, "2009-First None Months Results," December 22, 2009.

11Ibid.

12Ibid.

13Congressional Budget Office, "Policies for Increasing Economic Growth and Employment in 2010 and 2011," January 2010, p.14.

14Associated Press, "Health News." January 23, 2010.

15"Conning Research: Inflation Volatility a Significant Planning Concern for Property-Casualty Insurers," January 22, 2010, www.Insurancenewsnet.com.

16Lexology.com, "Repeal of Antitrust Exemption Gains Traction as House and Senate Democrats Reconcile Healthcare Reform Bills," January 8, 2010.

17Insurance Information Institute, Antitrust Law and Insurance.


Note: See 2012 update of this article, 2012: Commercial Insurer Growth Remains Uncertain.


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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