Described as the insurance of insurance companies, reinsurance provides reimbursement to the ceding insurer (the insurance company purchasing reinsurance) for losses covered by the reinsurance agreement. The focus of this article is to provide insight into the valuation of reinsurers and the market's current pricing of these businesses.
Reinsurance enhances the fundamental objective of insurance, which is to spread risk so that no single entity finds itself saddled with a financial burden beyond its ability to pay. Essentially, reinsurance is a transaction in which one insurance company indemnifies, for a premium, another insurance company against all or part of the loss that it may sustain under its policy or policies of insurance.Reinsurance Association of America: Fundamentals of Property and Casualty Reinsurance, pp. 1.
A reinsurance contract written on a proportional basis simply prorates all premiums, losses, and expenses between the insurer and the reinsurer on a prearranged basis. Excess of loss contracts, on the other hand, require the primary insurer to keep all losses up to a predetermined level of retention, and the reinsurer to reimburse the company for any losses above that level of retention, up to the limits of the reinsurance contract.
Insurers purchase reinsurance for essentially four reasons1:
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 higher than they could otherwise provide;
Loss stabilization: insurers can reduce fluctuations in loss experience, and stabilize the company's overall operating results;
Catastrophe protection: reinsurance protects against catastrophic financial loss resulting from an insurance event affecting a single large contract, as well as from the aggregation of many smaller claims from many policyholders simultaneously resulting from a single event; and
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
The worldwide reinsurance industry is highly competitive, as well as cyclical by product and market. As a result, financial results tend to fluctuate with periods of constrained availability, high rates, and strong profits, followed by periods of high capacity, low rates, and constrained profitability.2
The cycle is driven by competition, the amount of capital and capacity in the industry, loss events, and investment returns.3
The disturbance in the capital markets resulting from the subprime crisis suggested that the supply of alternative capital to the reinsurance market might be similarly disrupted. However, the uncorrelated risk provided by reinsurance-backed assets has been a key attraction in the growth of these capital market instruments, collectively called insurance linked securities (ILS). In fact, the credit crisis of 2007 highlighted the benefit of ILS as uncorrelated risk instruments, and this has lead to interest from a wider spectrum of investors.4
Following is a group of publicly traded companies (the Industry Group) that are representative of the reinsurer segment of the insurance industry.
Allied World Assurance Company Holdings Ltd. (AWH)
Montpelier Re Holdings Ltd. (MRH)
Arch Capital Group Ltd. (ACGL)
Odyssey Re Holdings Corp. (ORH)
Argo Group International Holdings, Ltd. (AGII)
PartnerRe Ltd. (PRE)
Aspen Insurance Holdings Ltd. (AHL)
Platinum Underwriters Holdings Ltd. (PTP)
Axis Capital Holdings Ltd. (AXS)
Reinsurance Group of America Inc. (RGA)
Endurance Specialty Holdings Ltd. (ENH)
RenaissanceRe Holdings Ltd. (RNR)
Everest Re Group Ltd. (RE)
Transatlantic Holdings Inc. (TRH)
Flagstone Reinsurance Holdings Ltd. (FSR)
Validus Holdings, Ltd. (VR)
IPC Holdings Ltd. (IPCR)
White Mountains Insurance Group Ltd. (WTM)
Max Capital Group Ltd. (MXGL)
Willis Group Holdings Ltd. (WSH)
Data from Capital IQ, a division of Standard and Poor's, for the Industry Group can be used to calculate valuation multiples. A valuation multiple compares a company's equity value or market value of invested capital (MVIC) (i.e., total interest-bearing debt plus the equity value) to an earnings stream such as revenue, earnings before interest, taxes, depreciation, and amortization (EBITDA), or net income (earnings). Valuation multiples can also be calculated based on industry-specific metrics, such as premiums and annuity revenues.
Analysts can calculate a value for a firm by deriving multiples from data on similar publicly traded companies or recent transactions involving similar companies. Depending on the company being valued, adjustments to the multiples may potentially be necessary to account for company-specific factors, such as lack of management depth, customer concentration, etc. The resulting multiple can be applied to the firm being analyzed to arrive at an indication of value.
While there may be exceptions, the value of most reinsurers is driven by growth, profitability, and risk.
Generally, companies with greater prospects for growth are more valuable than companies with less growth potential, holding all else equal. Similar to insurance companies, reinsurers generate growth by underwriting more reinsurance contracts and/or through rising reinsurance premiums. However, growth must be considered within the context of the risk inherent in the company's underwriting policies. A reinsurer may be growing slower than its peers due to more conservative underwriting policies, which would normally result in lower risk.
Growth can also be affected by the amount of retrocession utilized by the reinsurer. Retrocession is essentially a reinsurance of reinsurance. Reinsurers can enhance growth by use of less retrocession, increasing the amount of reinsurance premiums retained. However, such activities expose the company to greater potential claims-related liabilities thus increasing risk. As such, analysts should generally weigh the effects of the subject company's growth prospects with the risk associated with such growth.
Profitability is primarily driven by the occurrence (or lack) of catastrophic events, such as hurricanes, which results in large losses to reinsurers. While these events generally affect most reinsurers, the effects depend on 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.
Besides claims-related expenses, the profitability of reinsurers is affected by expenses such as policy acquisition/underwriting costs and overhead costs. A company that is able to generate premiums with lower overhead costs than its peers will tend to be valued higher.
Reinsurer's profits are also affected by investment income. Typically, reinsurers maintain relatively liquid portfolios of debt and equity securities so that claims can be paid as quickly as necessary. However, the effect of the investment income on the reinsurer's valuation must be analyzed within the context of the risk of the company's investment portfolio. For instance, a company that generates negative underwriting profits, yet produces a positive net income due to the income from its highly risky investment portfolio, would normally be less valuable than a company in a similar situation with a less risky portfolio.
The primary risk factor for the reinsurer is the risk of underwritten policies. This risk factor should be considered in the context of the company's growth in reinsurance premiums written. While higher risk policies will tend to have a negative effect on the value of the reinsurer, they will provide the benefit of higher growth in reinsurance premiums. Thus, the analyst should weigh these two effects in the valuation analysis. A helpful tool in analyzing this risk is the loss ratio, which measures the historical amount of losses relative to premiums earned. During periods of catastrophic events, loss ratios in the industry can rise significantly.
As discussed previously, a factor that can reduce the reinsurer's risk is the utilization of retrocession. Greater use of retrocession generally lowers the risk of a reinsurer; however, the use of retrocession also means that premiums that the company would otherwise receive are shared with another reinsurance company. As such, the costs and benefits of the use of retrocession should be considered in the valuation analysis.
As discussed previously, reinsurers are also exposed to risk associated with their investment portfolios. While higher risk may potentially result in greater investment income in some periods, it could also result in less investment income depending on market performance. Typically, reinsurers will hold relatively liquid portfolios of debt securities allowing the company to access the funds quickly if needed for claims-related expenses. Given that catastrophic events can quickly and significantly change the reinsurer's need for cash, liquidity can be an important factor with respect to the company's risk profile. Holding all else equal, a reinsurer with greater resources and cash flow to cover its potential claims and other liabilities will be more valuable.
Current Valuation Trends
A graph shows the equity-to-earnings (or price-to-earnings) multiples for the latest 12 months for the Industry Group.
The current average valuation for large, publicly traded reinsurers is approximately 7.0 times earnings. However, the range varies from a low of 3.9 times earnings to a high of 12.5 times earnings. These differences can be attributable to a variety of factors including company-specific issues such as growth strategy, product line exposure, and risk.
The last 24 months represent a period of exceptional profitability for the reinsurance industry. Nevertheless, the industry is showing signs of reverting to its historic cyclical pattern.5 According to Reinsurance Association of America, the net premiums written by 20 major reinsurance companies in the United States decreased 12.0 percent from $25.8 billion during 2006 to $22.7 billion in 2007.6 A declining trend in net premiums written would have a negative effect on the valuation of the reinsurers.
Reinsurers' impairment from the subprime crisis appears to be limited.7 However, during the fourth quarter of 2007, the declining trend in security class action filings seen in the United States over the previous 2 years reversed due to the large number of claims resulting from the subprime issue. Although reinsurer investment portfolios appear to be well diversified, substantial downside potential exists associated with this factor.8 Although the firms engaged in financial guarantee reinsurance will likely have substantial losses as a result of exposure to subprime mortgage instruments, conventional reinsurers' exposure to these risks mostly appears to be minimal.9
In January 2007, the state of Florida passed legislation that increased coverage provided by the Florida Hurricane Catastrophe Fund, thus potentially reducing the amount of reinsurance that Florida companies will purchase from the private reinsurance market. In addition, the legislature broadened the mandate of the state sponsored homeowners' insurance company to render it a fully competitive market participant.10 Such a factor would likely have a negative effect on the valuation of reinsurers that derive a substantial portion of their earnings from Florida property insurance market.
Outlook for 2008
There is no definitive consensus among analysts regarding the forecast for 2008. Despite another relatively mild year for major catastrophe losses, the longer term escalation in size and frequency appears to be set to continue given predictions on climate change. Hurricane activity is forecasted to be above average in 2008. A major natural catastrophe in 2008 would radically change the outlook for rates and capacity in the property market. Benfield predicts that, without such an event, the industry is likely to follow a trend of cyclical downturn.11 On the other hand, A.M. Best argues that the sector is poised for a profitable 2008 given that technical rates of most major lines of business are still profitable to this point. Investment income fueled by strong cash flow should also support earnings.12
Some describe 2007 as the year of the flood. Predictions suggest that changes in precipitation are one of the biggest consequences of climate change. Areas of high population density and large wealth concentration, namely, North America, the United Kingdom, and Europe, as well as the tropical East and South East Asia, all face the prospect of increasing flood exposure.13 Any major natural catastrophe in 2008 will likely exhibit a downward pressure on the valuation of reinsurers.
Key factors that influence the value of the reinsurers are growth, profitability, and risks. In conjunction with consideration of these factors, valuation analysts should consider the market's current valuation of similar publicly traded companies, as well as be aware of various forces, such as the cyclicality of the industry and the potential for catastrophic events, that affect the valuation of reinsurance firms.
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