The Application Of Fundamental Valuation Principles To Property/Casualty Insurance Companies Derek A. Jones, FCAS Joy A

1. The Application Of Fundamental Valuation Principles To Property/Casualty Insurance CompaniesDerek A. Jones, FCASJoy A. Schwartzman, FCAS

2. Valuation Principles • The value of any business has two determining factors: • The future earnings stream generated by a company’s assets and liabilities. • The risk (or “volatility”) of the stream of earnings. This risk is reflected in the cost to the entity of acquiring capital, measured by the investors’ required rate of return (“hurdle rate”). 2

3. Valuation Principles • For a given level of future risk, the greater the PV of expected profits the greater the value. • For a given level of future profitability, the greater the volatility (i.e., the higher the hurdle rate), the lower the value of the business. 3

4. Valuation Principles • A company has value in excess of its invested capital only when future returns are in excess of the hurdle rate. • When a company is expected to produce an earnings stream that yields a return on invested capital that is less than the hurdle rate, the economic value of the required capital is less than its face value. In this case, the logical action would be to liquidate assets. 4

5. Valuation Financial Professionals Value = PV of Future Cash Flows Where cash flows represent dividendable earnings or earnings that can be released to investors Actuaries Value = ANW + PV of Future Earnings – COC Where ANW = adjusted net worth PV = Present Value COC = Cost of Capital 5

6. Valuation Literature • Discounted Cash Flows “DCF” A DCF model discounts free cash flows at the hurdle rate to determine value • Economic Value Added “EVA” An EVA model defines Value = Initial capital invested + PV of “Excess returns” 6

7. To Value An Entity… • Financial Professionals Commonly use DCF Methodology • Actuaries commonly use EVA Methodology • When the underlying assumptions are common, the two methodologies yield identical results. 7

8. What are these assumptions… • Starting capital • After-tax annual operating income • Capital required at the beginning of each year to support operations • The hurdle rate 8

9. Discounted Cash Flow Value • Represents the PV of distributable earnings • PV is based on hurdle rate, which is the return required by investors to provide capital 9

10. Discounted Cash Flow Value • Distributable earnings are based on after tax operating earnings of the entity plus any additional capital releases, minus any capital infusions • Capital releases or infusions are a function of the capital needed to support the following years’ operations. 10

11. Discounted Cash Flow Value • Company’s initial capital is reflected only to the extent: a) it is released or b) it generates operating earnings 11

12. Discounted Cash Flow Value • Distributable earnings often projected in two components • Value of an explicit forecast period – say 5 to 10 years • Value associated with the entity after the explicit forecast period: the “Terminal Value” 12

13. Discounted Cash Flow Value • Value of explicit forecast period based on detailed annual earnings projections reflecting • Revenues (premiums) • Loss and Loss Adjustment Expenses • Acquisition and Operating Expenses • Investment Income • Taxes • Assets • Liabilities • Initial Capital to Support Operations • Capital Infusions or Releases to Support Operations 13

14. Discounted Cash Flow Value • Terminal Value (“TV”) represents the value of the company associated with earnings after the explicit earnings period, discounted back to the valuation date. • TV often calculated from earnings from last year of explicit forecast period, multiplied by a P/E factor. 14

15. Discounted Cash Flow Value • The P/E factor can be based on sale prices of recent insurance company transactions. • Any P/E factor can be mathematically distilled to an implicit earnings growth rate (“g”) and hurdle rate (“h”) • P/E = • For example, with a growth rate of 5% and hurdle rate of 15%, P/E = 15

16. Discounted Cash Flow Value In summary inputs to compute DCF value are… • Starting capital of the entity less initial capital required to determine free cash flow (at T=0) • Annual after-tax operating earnings • Marginal capital required at the start of each earnings period • The hurdle rate DCF Value = Free Capital + 16

17. Economic Value Added • Value = Initial Capital + PV “Excess Returns”: Where excess returns = after-tax operating earnings – (hurdle rate x capital invested) • Therefore, Value EXCEEDS initial capital only if earnings EXCEED investors’ required return (the “hurdle rate”) 17

18. For Valuing an Insurance Company … • Value = ANW + PVFE – COC “ANW” represents Initial Capital “PVFE – COC” represents excess returns PVFE = PV [after tax operating earnings] COC = PV [each period starting capital x hurdle rate] 18

19. For Valuing an Insurance Company… • Initial Capital represented by Statutory capital and surplus, with certain modifications 19

20. For Valuing an Insurance Company… • Statutory earnings form the basis of after-tax operating earnings. Earnings include: • Runoff of existing balance sheet assets and liabilities • Earnings contributions from renewal business • Earnings contributions from new business 20

21. For Valuing an Insurance Company… • Cost of capital is computed as: PV (hurdle rate x the starting capital in each period) • PV of statutory earnings and cost of capital computed using the hurdle rate 21

22. In Summary Inputs to Compute EVA Value and to Value an Insurance Company are … • Starting capital of the entity • Required capital at the start of each earnings period • Annual after-tax operating earnings • The hurdle rate 22

23. Valuation Results Scenario 1A Initial Capital = $100 Hurdle Rate 15% Total Earnings = Hurdle Rate Table 1 Valuation Results Earnings Growth Rate = 0% 23

24. Valuation Results Scenario 1B Initial Capital = $100 Hurdle Rate 15% Total Earnings = Hurdle Rate Table 2 Valuation Results Earnings Growth Rate = 3% 24

25. Valuation Results Scenario 2A Initial Capital = $100 Hurdle Rate 15% Total Earnings > Hurdle Rate Table 3 Valuation Results Earnings Growth Rate = 0% 25

26. Valuation Results Scenario 2B Initial Capital = $100 Hurdle Rate 15% Total Earnings > Hurdle Rate Table 4 Valuation Results Earnings Growth Rate = 3% 26

27. Valuation Results Scenario 3A Initial Capital = $100 Hurdle Rate 15% Total Earnings < Hurdle Rate Table 5 Valuation Results Earnings Growth Rate = 0% 27

28. Valuation Results Scenario 3B Initial Capital = $100 Hurdle Rate 15% Total Earnings < Hurdle Rate Table 6 Valuation Results Earnings Growth Rate = 3% 28

29. Practical Considerations • Accounting Standard • How to Modify Initial Capital & Surplus • Composition of Free Cash Flow (DCF) or Increments of Added Value (EVA) • Hurdle rate 29

30. Accounting Standard • ASOP 19: based on “regulatory earnings” • Constraints on dividends to equity owners: • Accumulated earnings • Minimum capital and surplus requirements • SAP is current starting point 30

31. Accounting Developments • Codification of SAP (2001) • Deferred taxes • Premium deficiency reserve • Fair Value Accounting 31

32. Balance Sheet Adjustments • Loss reserve adequacy • Market value of assets • Inclusion of non-admitted assets • Accounting goodwill • Statutory provision for reinsurance • Tax issues 32

33. Estimating Net Income • After-tax operating earnings • Runoff of existing balance sheet • Future written business • “Below the line” adjustments to surplus 33

34. Runoff of Existing Balance Sheet • Earnings are related to: • Underwriting profit in UEPR • Investment income on assets supporting loss reserves and UEPR • Investment income on capital supporting the runoff 34

35. Future Written Business • New and renewal business is not usually split for P&C (unlike Life) • Personal Lines is an exception • Projections typically made at LOB level 35

36. Hurdle Rate • Reflect the cost of acquiring capital needed to perform transaction • Typically provided by management • Can be estimated by various security valuation methods 36

37. Hurdle Rate Considerations • Risks attributable to business activities of target • Consideration of multiple hurdle rates • Method of financing acquisition • Consistency with other assumptions 37

38. Q&A 38