The focus of this article is to give greater insight into the valuation of property and casualty (P&C) insurers and the market's current pricing of these businesses. P&C insurers provide insurance coverage for lines such as automobiles, homeowners multi-peril, workers compensation, and commercial multi-peril.
The P&C industry follows cycles "characterized by periods of soft market conditions, in which premium rates are stable or falling and insurance is readily available, and by periods of hard market conditions, where rates rise, coverage may be more difficult to find and insurers' profits increase."1
According to the Insurance Information Institute, the cyclical nature of the P&C industry can be largely attributed to competition. As premiums rise (along with profitability) in a hard market, insurers devote more capital to underwriting and begin to offer more coverage. Accordingly, the supply of insurance increases giving rise to declines in premiums, which, in turn, causes less insurance to be offered given the declining associated profitability.
Below is a group of publicly traded companies (the "Industry Group") that were representative of the P&C insurer segment of the insurance industry.
The Travelers Companies, Inc. ("TRV")
Allstate Corp. ("ALL")
The Chubb Corporation ("CB")
Progressive Corp. ("PGR")
CNA Financial Corporation ("CNA")
Cincinnati Financial Corp. ("CINF")
First American Corp. ("FAF")
Alleghany Corp. ("Y")
Philadelphia Consolidated Holding Corp. ("PHLY")
The Hanover Insurance Group Inc. ("THG")
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). 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 can be made to account for company-specific factors. 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 P&C insurers is driven substantially by growth, profitability, and risk. These drivers are discussed in detail below.
Generally, companies with greater prospects for growth are more valuable than companies with less growth potential, holding all else equal. P&C insurers generate growth by underwriting more insurance policies and/or through rising premiums. Given that most insurers in the industry will be affected by the industry's cyclicality, growth resulting from changes in premiums will normally not affect the relative growth prospects of a certain insurer. However, a company's underwriting activities generally can have an effect on the valuation of the company. Standard and Poor's Insurance: Property-Casualty Industry Survey states:
Pay careful attention to the circumstances surrounding the rate of premium growth. For example, if a company expands its written premium base at 10% a year while the overall industry is growing at 6% a year, that company would appear to be outperforming its peer group. Presumably, the stock market would award that firm a higher valuation than some of its slower-growing counterparts would enjoy. However, if the insurer is achieving premium growth by following risky underwriting standards—such as underpricing policies to gain market share or writing a great deal of business in a high-risk coverage line avoided by other insurers—the insurer's valuation would have to be adjusted downward.2
Additionally, an insurer may be growing slower than its peers due to more conservative underwriting policies, which would normally result in lower risk. Accordingly, the risk associated with an insurer's growth in underwritten premiums should normally be considered when assessing the value of a P&C insurer.
Growth can also be affected by amount of reinsurance utilized by the insurer. Reinsurance is a product that allows insurance providers to share the risk of its policies with reinsurance providers. P&C insurers can enhance growth by electing to use less reinsurance, increasing the amount of premiums that the insurer keeps for itself. However, such activities expose the company to greater potential claims-related liabilities thus enhancing risk. As such, an analysis of the value of a P&C insurer should generally weigh the effects of the company's growth prospects with the risk associated with such growth.
Profitability is primarily driven by the occurrence of catastrophic events, such as hurricanes, which result in large losses to P&C insurers. While these events generally affect most P&C insurers, the effects depend on each individual insurers' exposure to the product line in which the event occurred. In general, changes in profitability relating to claims-related payments are not controllable by the company.
Aside from claims-related expenses, the profitability of insurers is affected by expenses such as commissions paid to brokers/agents (discussed in the August 2007 article) and overhead costs. A company that is able to generate premiums with lower overhead costs than its peers will tend to be valued higher.
Investment income also contributes to the insurer's profits. Typically, insurers will maintain relatively liquid portfolios so that claims can be paid as quickly as necessary. Some insurers have become completely reliant on investment income to generate positive earnings. These companies may be less valuable than other insurers depending on 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.
Several risks have been mentioned throughout this article that are typically important when analyzing a company in the P&C industry, including the risk of underwritten premiums, the effects of reinsurance of the company's exposure to claims-related expenses, and the risks associated with the insurer's investment portfolio. In addition, an analysis of the company's liquidity and leverage positions can give insight into the overall risk of the company.
The risk of underwritten policies should generally be considered in the context of the company's growth in premiums written. As discussed previously, higher risk policies will tend to have a negative effect on the value of the insurer. However, the benefit of higher growth associated with underwriting riskier policies will generally have a positive effect on value, thus an analyst would often weigh these two effects in the valuation analysis. A helpful tool in analyzing this risk is the loss ratio. The loss ratio measures the historical amount of losses relative to premiums earned and is typically between 60 percent and 80 percent.3 During periods of catastrophic events, loss ratios in the industry can rise significantly.
As discussed previously, a factor that can reduce the risk of an insurer is the utilization of reinsurance. Greater use of reinsurance generally lowers the risk of an insurer and will have a positive effect on value. However, a higher level of reinsurance means that premiums that the company would otherwise receive are shared with a reinsurance company.
Insurers are also exposed to risk associated with their investment portfolios. While higher risk may result in greater investment income, it could also result in less investment income depending on market performance. Typically, insurers will hold relatively liquid investments allowing the company to access the funds quickly if needed for claims-related expenses. Given that catastrophic events can quickly and significantly change the insurer's need for cash, liquidity can be an important factor with respect to the company's risk profile. An insurer with greater resources and cash flow to cover its potential claims and other liabilities will likely be more valuable.
Current Valuation Trends
The graph presented in Exhibit 1 shows the MVIC-to-EBITDA multiples for the latest twelve (12) months ("LTM") for the Industry Group.
As illustrated, the current average valuation for large publicly traded property and casualty insurers is approximately 6.6 times EBITDA. However, the range varies from a low of 4.6 times EBITDA to a high of 8.7 times EBITDA. These differences can be attributable to a variety of factors including company-specific issues such as growth strategy and risk.
Many factors—including growth, profitability, and risks—can influence the value of the P&C insurer. Additionally, the market's current valuation of similar publicly traded companies should typically be considered in the valuation of an insurer. However, it is important to be aware of various forces, such as the cyclicality of the industry, that are affecting the market's current valuation of similar companies. Future articles will address other industry segments such as health and life insurers, and reinsurers.
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.
1 "Property/Casualty Insurance Cycle." Insurance Information Institute. 22 Oct. 2007.
2 Standard and Poor's Industry Surveys. "Insurance: Property-Casualty." July 26, 2007. p. 29.
3 Standard and Poor's Industry Surveys. "Insurance: Property-Casualty." July 26, 2007. p. 27.