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Valuation of Insurance Organizations

The Value of Insurance Customer Relationships or Policies

Jeff Balcombe | May 1, 2010

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Businesses employ a variety of tangible and intangible assets in their operations that work together to generate cash flows. Intangible assets, such as customer relationships, trademarks, technology, and employees, are generally key value drivers for a business. Frequently, the intangible value of a business is greater than its tangible value. Therefore, it is important to understand whether or not intangible assets exist and their possible contribution to a business's value.

Within the insurance industry, one intangible asset that is often critical to the success of an organization is customer relationships. This article discusses a conceptual framework for valuing customer-related intangible assets, such as insurance customer relationships or individual policies/expirations. By understanding how such value is quantified, we can gain greater insight into the drivers of value for both the intangible asset and, in turn, the business as a whole.

Valuing Customer-Related Intangible Assets

Although the idea of intangible asset value may seem somewhat abstract, there are certain instances where there is a need to quantify a value specifically for a customer-related intangible asset. For example, following an acquisition, a purchase price allocation may be required for financial reporting purposes, which often involves the valuation of customer relationships. Additionally, certain litigation matters require financial experts to quantify aspects of customer relationships to calculate economic damages or lost profits. There are also situations involving the sale of customers, in which both the buyer and the seller would want to know how much the customers are worth.

For the valuation of any intangible asset, there are three general approaches: the cost approach, the market approach, and the income approach. 1

The Cost Approach

The cost approach is based on the premise that "that an investor will pay no more for an investment than the cost to obtain (i.e., either by purchase or by construction) an investment of equal utility." Although least commonly used in practice for valuing customer intangible assets, the cost approach is applicable when it is possible to collect all of the costs associated with the development and maintenance of the subject customer relationships. Unfortunately, this information is typically not available as businesses usually do not track this type of information. 2

The Market Approach

The market approach involves the use of transactions of similar customer intangible assets as a basis for determining the value of the subject asset. However, more often than not, it is very difficult to find sufficient information regarding the price paid and financial statistics of the asset purchased.

The Income Approach

Accordingly, the most commonly used method for valuing customer-related intangible assets is the income approach. This method determines value by measuring the "present value of expected economic income to be earned from ownership of that intangible asset." 3 Because the income approach analyzes the specific economic benefits of the subject intangible asset, this article will examine customer relationships from an income approach perspective.

A form of the income approach often used in valuing customer-related intangible assets is the multi-period excess earnings (MPEE) method. 4 Essentially, the MPEE method estimates revenues and, in turn, cash flows derived from the intangible asset and then deducts portions of the cash flow that can be attributed to supporting assets, such as a brand name or fixed assets, which contributed to the generation of the cash flows. These deductions are sometimes referred to as "supporting asset charges." The resulting cash flow, which is attributable solely to the subject intangible asset, is then discounted at a rate of return commensurate with the risk of the asset to calculate a present value.

This valuation model is summarized in the following table:

Valuation Model

Insurance Customer Relationship Valuation

By applying the methodology described above to insurance customer relationships or policies/expirations, one can gain a greater understanding of the fundamental value drivers for this essential asset. As an aside, this methodology can also be applied to an individual customer relationship or policy rather than a bundle of customer relationships, which is the focus of this article.

The first step in the MPEE valuation framework is estimating cash flow derived from the intangible asset. One element impacting cash flows from customer relationships is the stream of revenue, which can be in the form of either premiums or commissions depending on whether your perspective is from an insurer's or an agency's viewpoint. Premiums (and commissions) can either increase or decrease over time depending on a number of factors. Growth in premiums can be generated by increases in the wealth of the customers (e.g., customers buy more expensive houses that need to be insured) or through referrals from the customers that lead to new customers/policies. Developing strategies to acquire growing customers could yield more value for a company's customer base. Conversely, premiums generally have a tendency to decline over time due to customer turnover.

As such, it is clear that by increasing customer retention rates, managers can increase the value of their customer relationships and, in turn, their overall business. According to one author, "many studies have shown that $1 paid towards customer retention increases profits by more than $5 spent on acquiring a new customer." 5

Retention rates are affected by a wide variety of factors, which is a topic outside the scope of this article. However, there are a few key factors that are worth noting. Customer communication, for example, can have a significant impact on the value of customer relationships, and ultimately the value of the insurer or agency. More human interaction can build stronger relationships and, therefore, reduce customer turnover.

One study conducted by Travelers showed that 65 percent of customers who left never spoke to an agent during the year studied, but 80 percent of the customers that talked to an agent during the year remained with the insurance company. 6 In other words, customer interaction was directly linked to an increase in retention.

Another factor to consider is that different types of customers have differing levels of loyalty. One article discussing the topic of loyalty noted that customers in the Midwest and rural areas as well as married customers and older customers tended to be more loyal. 7 The article goes on to discuss "how the success of many companies was due to their method of attracting the right customers—those who had a high loyalty coefficient. These acquisition methods might be more expensive, but if they resulted in more loyal customers, they would be worth it."

For example, USAA targets a special niche of active duty military officers, which tend to be loyal, reliable, and honest customers. Given this strategy, it is no surprise that less than 2 percent of USAA's auto insurance policy holders leave each year. 8

Yet another factor influencing customer retention is the sale of multiple policies to customers. "When people own two (or more) policies from a company, they are more loyal than if they own just one." 9 So, companies with broad policy offerings may be at an advantage to players with thinner offerings, since they are able to serve as a "one stop shop" for insurance.

These examples are just a few of many strategies/factors that can be considered to improve customer retention. As mentioned previously, it is generally much less costly to invest in retaining customers than to spend money gaining new customers. These investments not only have the benefit of saving costs, but they also have a very real impact on future revenue. A key takeaway for purposes of this article is that customer retention can have a significant impact on cash flows and, in turn, the value of a company's customer relationships.

The Costs of Generating Revenues

Certainly, the amount of future premiums or commissions directly influences value, but one also must take into consideration the costs incurred in generating those revenues. As an example, losses from claims filed have a negative impact on cash flows. However, these losses can be partially mitigated through diversification of the customer base. For instance, a property and casualty insurance company might provide policies to companies in several geographic regions so as to reduce the risk of incurring significant catastrophe-related losses all at once. Other costs of maintaining policies must also be considered. These expenses primarily consist of salaries and commissions for employees and agents necessary to maintain policies and relationships. In valuing customer relationships, expenses associated with the acquisition of new customers should not be considered.

Based on the valuation framework discussed so far, it might seem logical that simply reducing costs, such as salaries and commissions, will increase value. However, compensation directly influences the quality of the workforce and the agents managing the customer relationships. In turn, the quality of the workforce and agents impacts the strength of the customer relationships. By making investments in employees and agents, companies may actually be able to drive revenues higher and yield a net increase in cash flow.

Supporting Asset Charges

The next step in the MPEE methodology involves the application of supporting asset charges. As mentioned previously, businesses employ a variety of tangible and intangible assets in their operations that work together to generate cash flows. To determine the value solely relating to the customer relationships or policies/expirations, portions of the cash flow must be allocated to the other assets that supported the customer relationships.

For example, to value State Farm's customer relationships, we might attribute a portion of the forecasted cash flows to its brand or trade name. The magnitude of the charge for each supporting asset is dependent on the role that each asset plays in the revenue generation process. For instance, the brand or trade name charge would likely be greater for large corporations with extensive marketing campaigns than for smaller, regional players, which are more heavily driven by the customer relationships.

Application of the supporting asset charges yields the cash flow stream expected to be generated as a result of the customer relationships. However, to estimate value, one calculates the present value of these cash flows using a discount rate that is commensurate with the risks associated with the asset. The discount rate accounts for both the time value of money and the riskiness of the future cash flows. In developing the discount rate, it is important to consider various events that could cause cash flows to be different than expected and assess the probability of those events occurring. In the case of insurance customer relationships, differences in growth rates and/or retention rates could significantly impact future revenues. It may be possible to mitigate some of the volatility in growth and retention rates through diversification, which would, in turn, increase value. However, managers should also consider the effect of diversification on expected growth.

Another potential risk factor might relate to the company's employees and agents, and their ability to maintain strong relationships with the customers. Additionally, there may be a risk that key agents will leave, which could lead to higher customer turnover. This risk factor could be mitigated by executed long-term employment agreements or otherwise incentivizing agents to continue with the company. To the extent that managers can mitigate some of the risks associated with the forecasted cash flows, they may be able to create additional value for the company's relationships.


The valuation methodology discussed in this article provides managers with a tool for thinking about business issues from a valuation perspective. For instance, the MPEE model suggests that customer retention is a critical factor in the valuation equation as it can both increase revenue and reduce risk (i.e., lower the discount rate) by providing cash flow stability. As mentioned previously, development of strong customer relationships and diversification of policy offerings may help to improve customer retention. By using this framework, managers can develop strategies aimed at improving any element of the valuation equation to enhance the value of their company's customer-related intangible assets.

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1 Reilly, Robert F., and Robert P. Schweihs. Valuing Intangible Assets (New York: McGraw-Hill, 1999) 96.
2 Ibid, 345.
3 Ibid, 113.
4 Hitchner, James R. Financial Valuation: Applications and Models, Second Edition. (New Jersey: John Wiley & Sons, Inc., 2006) 972–973.
5 Hughes, Arthur M. "Increasing Insurance Customer Retention." Database Marketing Institute.
6 Ibid.
7 Hughes, Arthur M., "The Loyalty Effect: A New Look at Lifetime Value." Database Marketing Institute.
8 Ibid.
9 Hughes, Arthur M., "Increasing Insurance Customer Retention." Database Marketing Institute.