Expert Commentary

Valuation Insights: TARP and Insurers

The recent economic recession has resulted in substantial uncertainty regarding the future performance of many companies. Specifically, life and health (L&H) insurers that collect premiums from policyholders and then invest those premiums have been affected and face a potentially devastating cash crunch should policyholders decide to redeem their policies. Such an event would force the liquidation of substantial investments.


Valuation of Insurance Organizations
May 2009

Recent valuations of these companies reflect the market's concern regarding the risks surrounding the financial soundness of some of these L&H insurers. Additionally, as indicated by reactions to news relating to the Troubled Asset Relief Plan (TARP), recent valuations also provide evidence of the importance of access to capital to L&H insurers. This article discusses the recent economic environment, the relief efforts that have been implemented, and the impact on the valuation of firms operating in the L&H insurance industry.

Current Economic Environment

A myriad of factors, including consumer and corporate overleveraging, excessive financial risk-taking, and increased foreclosures contributed to the current economic recession. Since December 2007, which the National Bureau of Economic Research marks as the beginning of the recession,1 many firms across the United States, including insurance providers, have felt the impact of the slowing economic activity.

With respect to recent economic performance, advance figures from the Bureau of Economic Analysis indicated that domestic gross domestic product, which provides a general indication of U.S. economic activity, declined 6.1 percent on an annualized basis in the first quarter of 2009.2 Additionally, equity indices have recently experienced continued declines with the Standard & Poor's (S&P) 500 Index falling 11.7 percent in the first quarter of 2009. Additionally, the Dow Jones Industrial Average fell 13.3 percent in the first quarter of 2009.3

Among the many firms affected by these significant declines were the L&H insurers who experienced lower portfolio returns, lower fee income, and increased hedging costs. In addition to lower earnings, stock investments in L&H insurers were also negatively impacted by the market's perception of substantially increased risk which, in many cases, yielded greater declines in stock prices than declines in future expected earnings.

Brief Overview of Relief Efforts

Beginning in the middle of 2007 and into 2008, the Federal Reserve began taking action by cutting the federal funds target rate to combat the lending crisis. Since December 11, 2007, the Fed cut the rate 7 times to a historical low of 0 to 0.25 percent on December 16, 2008.4 By September 2008, the Treasury realized more action was needed to stem eroding financials and a potential lending freeze that could cripple the economy. Accordingly, the Treasury presented Congress with the $700 billion TARP, which was intended to be used to buy mortgages and related toxic assets from financial institutions in an attempt to stabilize their balance sheets.

The plan was to release the TARP funds in several stages to provide stability to the U.S. financial system. The initial three-page proposal turned into the Emergency Economic Stabilization Act of 2008, which was signed into law October 3, 2008.5

The first planned allocation under the TARP, launched on October 14, 2008, was the $250 billion Capital Purchase Program (CPP), which involved capital injections into healthy financial institutions in return for compensation restrictions and corporate governance limitations. Being widely criticized as straying from their initial proposal, the Treasury backed the CPP by noting its ability to restore confidence in the banking system and impede an imminent collapse.

Following the CPP, the Treasury provided an initial allocation of $40 billion in TARP funds to the major global insurer, American International Group (AIG).6 AIG had previously received a bailout from the Federal Reserve, and at that time, the effect of the crisis on insurance companies was not widely known. As the grim situation facing AIG was realized, additional funds amounting to $30 billion have been allocated to AIG since January 20, 20097 as the Treasury believed that AIG's failure could result in a systematic shock to the U.S. economy. The allocations to AIG, coupled with sustained economic declines, resulted in several other firms in the insurance industry desiring relief through the receipt of TARP funds.

TARP Needs Spread to L&H Insurers

For a time, L&H insurers seemed to be immune to the credit crisis, since they generally invest in relatively safe assets in order to match their liabilities. However, due to aggressive decision-making and weak financial markets, several L&H insurers began to feel the impact of the poor economic conditions. The Wall Street Journal noted,

Many of the roughly 2 dozen insurers that dominate the variable-annuity business made aggressive promises on these popular retirement-income products, guaranteeing minimum returns, no matter what happened to the stock market. With the market's decline, the issuers are on the hook for big payouts, though most of the payments won't come due for 10 or more years.

Patterson, et al., "U.S. to Offer Aid to Life Insurers," Wall Street Journal, April 8, 2009.

Combining this with losses on investments in bonds and real estate which backed their insurance policies resulted in a potentially severe situation for L&H insurers. The article went on to note that if massive numbers of customers sought to redeem their policies due to lack of confidence, insurers would require significant amounts of cash, which would potentially force them to sell off holdings in bonds, real estate, and other investments. Given that insurers hold substantial investments in such securities, a sell-off could cause markets to tumble.

As a part of the statute passed in October 2008 by Congress and the George W. Bush Administration, insurers were originally eligible to gain TARP funding. However, the Treasury adopted a more constricted program which prohibited pure-play insurers from receiving TARP funds. Almost immediately after the Stabilization Act was passed, three L&H insurance companies—Hartford Financial Services Group (HIG), Genworth Financial Inc. (GNW), and Lincoln National Corp. (LNC)—applied to the Office of Thrift Supervision (OTS) to buy individual savings and loan companies as a means of bypassing this statute by becoming banks and gaining eligibility under the CPP. As a result, larger insurers, including Prudential Financial (PRU), also approached the OTS in hopes of gaining TARP money.

Although converting into a bank holding company would allow insurers to become eligible under the CPP, there was still uncertainty as to whether or not these insurers would actually receive TARP funds. Nevertheless, the market appeared to place substantial value on the potential opportunity of receiving relief funds as indicated by the trends in the valuation multiples of several major L&H insurers. From the end of March 2009 through April 29, 2009, the average price-to-next year's expected earnings multiple (the "forward P/E multiple") for HIG, GNW, LNC, and PRU increased approximately 52 percent from 1.78x to 2.71x, exhibiting the value of access to capital in a market where funds have become one of the scarcest resources.

Valuation Trends

Over the past year and even during the year-to-date, there have been significant changes in the market's perception of value for L&H insurers, especially those seeking TARP funds. Below is a discussion of recent trends in the valuation of these companies. Specifically, consider the forward P/E multiples for four insurers that sought capital from TARP funds: GNW, HIG, LNC, and PRU (the "L&H Insurers"). In addition to these companies, also consider recent trends in AIG's forward P/E multiples given its significant allocations under the TARP. Figure 1 exhibits the forward P/E multiples for these companies between June 30, 2008 and April 29, 2009.

As shown in Figure 1, the L&H Insurers and AIG experienced substantial declines in their valuations (relative to expected earnings) between early September 2008 and March 2009. Typically, factors that negatively impact valuation multiples include increased risk and/or reduced growth opportunities. Based on the circumstances surrounding the insurance industry during this timeframe, the market appeared to be factoring in significantly heightened market risk as well as increased liquidity concerns specifically relating to insurance companies.

Figure 1: Forward P/E Multiples

Forward P/E Multiples

Recently, the L&H Insurers and, to a greater extent, AIG saw increases in their forward P/E multiples, which can be attributed, at least in part, to the increased perceived probability of receiving TARP funds that would alleviate some of the aforementioned liquidity concerns. The multiples of AIG, which some have considered to be "too big to fail," appear to have benefited from being a likely candidate of receiving further bailout funds should they be required, thus resulting in a substantial increase in its forward P/E multiple.

The L&H Insurers appear to be trading at multiples substantially below their historical valuations, which could potentially present an attractive investment opportunity to those who believe the related risks to be less than the market's current assessment. As economic conditions stabilize, one would generally expect multiples to revert to a normalized level, which appears to be in the range of 6 to 8 times next year's expected earnings, based on data provided by Capital IQ.

Conclusion

The current economic environment has L&H insurers facing greater uncertainty than in recent history, although, with TARP funds potentially becoming available, at least some of the uncertainty may be alleviated. At this point, only few insurers have sought out TARP funding; however, more could follow if market conditions continue to deteriorate. With respect to the valuation of firms in the L&H insurance segment, there is significant uncertainty and perceived risk, which has resulted in substantially depressed valuation multiples. Valuations cannot be expected to recover until the market receives greater certainty with respect to the financial positions of these companies.


1"NBER Makes it Official: Recession Started in December 2007," Wall Street Journal, December 1, 2008.

2Gross Domestic Product: First Quarter 2009 (Advance)," Bureau of Economic Analysis.

3Yahoo! Finance.

4Federal Reserve Bank of New York, Historical Changes of the Target Federal Funds and Discount Rates.

5Morrison and Foerster, "From TARP to ARRP: Is 2009 the Year We Get Out from Under the TARP?", January 16, 2009.

6Ibid.

7Department of the Treasury, Update of Funds, April 20, 2009.


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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