Reinsurance is the business of assuming all or part of the risk
associated with existing insurance policies originally underwritten by other
insurance companies as those direct insurers look to effectively manage risk
and limit liabilities. Reinsurance companies enter into transactions in
which they indemnify, for a premium, another insurance company against all
or part of the loss that it may sustain under its policy or policies of
insurance.
Depending on the contract, reinsurance can enable the insurer to improve
its capital position, expand its business, limit losses, and stabilize cash
flows. Reinsurers draw experience from a significant number of primary
insurers and, therefore, usually have a larger collection of information for
assessing risks. Reinsurance can take a variety of forms. It may represent a
layer of risk or a sharing of both losses and profits for a certain type of
business. Reinsurance contracts fall into two broad groups: treaty contracts
and facultative contracts. Treaty contracts cover a group of policies,
whereas facultative contracts are done on a case-by-case basis.
According to the Reinsurance Association of America's
Introduction to Property and Casualty Reinsurance, there are essentially
four reasons that insurers purchase reinsurance:
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 considerably higher than they could otherwise
provide.
Stabilization: Through
reinsurance, insurers can reduce fluctuations in loss
experience and stabilize a company's overall operating
results.
Catastrophe Protection:
Reinsurance protects against catastrophic financial loss
resulting from a single event, as well as against the
aggregation of many smaller claims resulting from a single
event that affects many policyholders simultaneously.
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
In assessing the value of any company, it is
generally important to consider the market in which the subject company
operates. Industry factors and trends can affect the expectations for a
company's future performance and, in turn, the valuation for that business.
With respect to the U.S. reinsurance industry, there is generally a low
level of concentration, as the top four firms account for about 38.5 percent
of industry revenue, according to U.S. Census data and IBISWorld estimates.
Over the next few years, industry experts expect concentration to remain
relatively steady due to the nature of the reinsurance business. It is
easier to spread out risk when there are a greater number of industry
participants, ensuring no U.S. reinsurer can accumulate a significant amount
of market share. If they do, then the company will be overly exposed to U.S.
risks, which can lead to negative financial consequences.1
While lower risk tends to increase the value of a firm, competition and the
resulting reduced growth prospects generally have a negative impact on
value.
Similar to traditional insurance, reinsurers generate income from
policy premiums and investment returns. Generally, premiums are affected by
changes in policy counts and pricing, which fluctuate between hard and soft
cycles. During hard pricing cycles, prices rise as insurers try to build
reserves and increase underwriting profits. In contrast, soft cycles occur
when prices fall, as reinsurers competitively price policies in an attempt
to gain market share. The change between these two cycles depends highly on
catastrophic activity and investment returns, because unusual spikes in
claims and decreases in investment income hurt reserves and profitability.
The reinsurance industry is currently in a soft cycle and is expected to
remain in the current cycle for the remainder of 2011. Lower growth
expectations typically yield lower valuations; thus, if the market begins to
believe the length of the current soft market will extend well beyond 2011,
valuations could experience a decline from current levels.
In analyzing
industry trends, it can be helpful to look at the recent and expected
performance of other companies operating in the same industry as the subject
company. Additionally, "guideline companies" can be used to develop a range
of valuation multiples that may be applicable to the subject company.2
Listed below is a group of publicly traded companies (the "Industry Group")
that are generally representative of the reinsurance industry.
| Alterra Capital Holdings Limited ("ALTE") | Montpelier Re Holding Ltd. ("MRH") |
| Arch Capital Group Ltd. ("ACGL") | PartnerRe Ltd. ("PRE") |
| Endurance Specialty Holdings Ltd. ("ENH") | Platinum Underwriters Holdings Ltd. ("PTP") |
| Enstar Group Limited ("ESGR") | Reinsurance Group of America Inc. ("RGA") |
| Everest Re Group Ltd. ("RE") | RenaissanceRe Holdings Ltd. ("RNR") |
| Flagstone Reinsurance Holdings Ltd. ("FSR") | Swiss Reinsurance Co. ("RUKN") |
| Greenlight Capital Re, Ltd. ("GLRE") | Transatlantic Holdings Inc. ("TRH") |
| Maiden Holdings, Ltd. ("MHLD") | Validus Holdings, Ltd. ("VR") |
Premise on Market Approach to
Valuation
Data from Capital IQ (a division of Standard and Poor's) for
the Industry Group can be used to calculate valuation multiples, which
compare a company's equity value or market value of invested capital (MVIC)
(i.e., the 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 estimate the value of a company by deriving
valuation multiples from data on similar publicly traded companies, such as
those listed above, or recent transactions involving similar companies.
Depending on the company being valued, adjustments to the multiples may be
necessary to account for differing growth or risk profiles. The resulting
multiple can be applied to the firm being analyzed to arrive at an
indication of value.
Valuation Drivers
While there may be
exceptions, for most reinsurers, value is driven by growth, profitability,
and risk.
Growth
As mentioned previously, companies with greater
growth prospects tend to be more valuable than those with less growth.
However, growth must be considered within the context of risk. For example,
a reinsurer may exhibit slower growth than its peers due to more
conservative underwriting policies, which would normally result in lower
risk. As a result, in determining an appropriate valuation multiple, the
analyst should weigh the value of the reinsurer's more conservative risk
profile against the negative impact of its lower growth prospects.
Profitability
In the reinsurance industry, profitability is generally
driven by the occurrence (or lack) of catastrophic events, such as
hurricanes, which result in large losses to reinsurers. The specific impact
on a given reinsurer depends on many factors, such as the following:
- Each
individual reinsurer's exposure to the product line in which the event
occurred
- The magnitude of the insurance event
- The type of the reinsurance
contract (proportional or excess of loss) the reinsurer has underwritten
In addition to claims-related expenses, policy acquisition/underwriting
costs, overhead costs, and investment income affect profitability. Recently,
lower losses from catastrophes have increased profitability, resulting in
strong balance sheets for many reinsurers. However, the lack of catastrophes
has also resulted in downward pressure on premiums.
Risk
One primary
risk factor for reinsurers is underwritten policies, which, as mentioned
previously, should be considered in the context of the company's outlook for
growth in premiums. While higher-risk policies tend to have a negative
effect on value, they can also provide higher premium growth. Thus, these
two effects would need to be weighed to assess value.
Current Valuation
Trends
Since 2007, the reinsurance industry has been in a period of
increasing capital, declining valuations, and declining return on equity.3
However, the last 9 months of 2010 turned out to be much better than
initially feared after a very poor first quarter. Although the reinsurance
market's underwriting results were down compared to the dramatic rebound in
2009 following the global financial crisis,4 taken
together with further recoveries in investment returns and continuing strong
reserve releases, some analysts believe the industry, as a whole, is
currently overcapitalized.5 While strong
capitalization provides a larger safety net (i.e., lowers risk) and
therefore raises valuations, declining returns on equity could signal
limited growth opportunities, which pushes valuations downward.
As shown
in the graph in Figure 1, current market valuations (measured using the
price-to-next-12-months earnings multiple) for the Industry Group range from
a low of 6.7-times earnings to a high of 12.2-times earnings, with an
average of 8.6-times earnings, which is represented by the horizontal line.
The differences in the multiples for each of the companies in the Industry
Group can be attributed to a variety of company-specific factors, such as
growth strategy, product line exposure, and risk.
Figure 1:
Also influencing valuations, on July 21, 2010, President
Barack Obama signed into law a sweeping overhaul of how financial services
are regulated in the United States. The regulation, known as the Dodd-Frank
Wall Street Reform and Consumer Protection Act of 2010, included a section,
which was a separate bill, to streamline the regulation of reinsurance and
surplus lines insurance. Generally, additional regulation has been viewed
negatively by investors due to concerns over additional future costs and
lower profitability. Any such concerns would be factored into the market
valuations summarized in the graph above.
In addition to the regulatory
changes noted above, new catastrophe models are showing dramatic changes in
loss outputs, which are presenting an increasingly common challenge. In
particular, the forthcoming RMS Version 11.0 release for U.S. Hurricane,
revised to take into account inland losses, is resulting in substantial loss
increases. The greatest changes, mostly for Texas and mid-Atlantic
exposures, have helped reinsurers maintain pricing levels despite great
client pressure for price reductions following a second year with no major
hurricanes. While these new models have provided reinsurers with ammunition
for maintaining pricing levels, due to recent pressure on premiums,
reinsurers may not be generating revenue commensurate with the actual
catastrophe risks they face.6 This may present an
additional risk factor that should be incorporated into assessments of
reinsurer values.
Outlook for 2011
Looking into 2011, an economic
recovery may aide demand for certain types of reinsurance products, but the
industry is still struggling with excess underwriting capacity. Insurance
ratings agency A.M. Best released a 2011 outlook for the reinsurance
business in which it predicted a difficult earnings year and potential
pressure on margins from lower reserve releases and higher catastrophe
losses. Given the negative short-term outlook, there may be some upside
potential to valuations if reinsurers generate greater earnings than
expected. However, current valuations appear to indicate that the market
expects low future growth opportunities and moderate to high risk for
reinsurers.
Note:
For updated information, see
Valuation of Reinsurers: 2013.