Valuation of Reinsurers: 2011

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:

1. 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.

2. Stabilization: Through reinsurance, insurers can reduce fluctuations in loss experience and stabilize a company's overall operating results.

3. 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.

4. 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.

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.

¹IBISWorld Industry Report 52413, Reinsurance Carriers in the United States, December 2010, p. 23.

²Pratt, Shannon P. Valuing a Business: The Analysis and Appraisal of Closely Held Companies. Irwin Professional Pub, 1995.

³Aon Benfield: Reinsurance Market Outlook—Partnerships Renewed, January 2011, p. 1.

⁴Towers Watson: U.S. Reinsurance Marketplace 2011 Perspectives, p. 3.

⁵Willis Re: 1st View—Renewals 2011, January 1, 2011, p. 2.

⁶Willis Re: 1st View—Renewals 2011, January 1, 2011, p. 3.

Note: For updated information, see Valuation of Reinsurers: 2013.