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How Investment Bankers Value Insurance Companies. Valuation of Insurance Operations April 10. Casualty Actuarial Society. In Today’s Market. Casualty Actuarial Society. Two Approaches. Market Approach Fundamental Approach Traditional Approach Non-traditional Approach.
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How Investment Bankers Value Insurance Companies Valuation of Insurance Operations April 10 Casualty Actuarial Society
In Today’s Market Casualty Actuarial Society
Two Approaches • Market Approach • Fundamental Approach • Traditional Approach • Non-traditional Approach Casualty Actuarial Society
Market Approach • Research Analyst • Buy-side Analyst • Investor Community Casualty Actuarial Society
Market Approach • Valuations for property casualty insurance companies have declined significantly during the past year • The decline in the property casualty sector is the result of deterioration in the industry fundamentals that drive value Casualty Actuarial Society
Market Approach • Volatility of the industry’s results has declined over the last twenty years Volatility of Property & Casualty Earnings 4.0x 3.5x 3.0x 2.5x Standard Deviation 2.0x 1.5x 1.0x 0.5x 0.0x 1942- 1947- 1952- 1957- 1962- 1967- 1972- 1977- 1982- 1987- 1992- 46 51 56 61 66 71 76 81 86 91 96 Casualty Actuarial Society
Which operating factors drive stock market values? • Profitability, as measured by return on equity • Profit margin • Operating leverage • Earnings consistency • Standard deviation of change in earnings • Reserve development • In other words, the market rewards risk adjusted returns on capital Casualty Actuarial Society
Value Drivers Return on Equity Earnings Consistency Earnings Growth Casualty Actuarial Society
Value Drivers Casualty Actuarial Society
Value Drivers Casualty Actuarial Society
Value Drivers Casualty Actuarial Society
Who Cares about the Actuaries Casualty Actuarial Society
Frontier Chart Casualty Actuarial Society
Meadowbrook Chart Casualty Actuarial Society
Consolidation and the Need for Economies of Scale • Opportunities for convergence • Need for multiple distribution channels • Need for broader line of products • Need to achieve greater efficiencies • Need to minimize rating pressures • Need for improved access to capital Casualty Actuarial Society
Increased Consumer Awareness • Consumers more informed through internet • More product choices and distribution methods increase awareness • Privacy issues becoming more significant • Consumers becoming informed about structural alternatives (such as demutualization) Casualty Actuarial Society
Margin Erosion • Commodity products (e.g. term insurance, auto) • New entrants • Widespread consumer information • Competitive pressures – increasing loss ratios • High cost distribution systems Casualty Actuarial Society
Rating Pressures and Capital Requirements • Eroding profits or growth rates put pressure on ratings • Low rates of return on equity • Some companies have high loss ratios – reserves need strengthening Casualty Actuarial Society
Fundamental Analysis • We traditionally base our valuation of insurance companies on four valuation methodologies: • Analysis of public market comparables • Private and public market M&A transactions • Discounted cash flow analysis • Additional areas of value that must be developed with potential buyers Casualty Actuarial Society
Comparable Company Analysis • We focus our multiple analysis on Price/Earnings and Price/Book multiples. In analyzing these multiples, we consider the following factors: • Core earnings power of the Company • Earnings growth compared to the comparable companies • Relationship between price to book value and return on equity Casualty Actuarial Society
M&A Transactions Analysis • Additionally, we analyze recent private and public market transactions for companies within comparable sectors • We look closely at the specific characteristics of each transaction in order to find the most comparable multiples Casualty Actuarial Society
Multiple Analysis Casualty Actuarial Society
Discounted Cash Flow Analysis • A discounted cash flow approach offers a good proxy for value due to the following: • Multiple analyses may be too weighted to the historical performance, which in some cases is limited • Discounted cash flow approach captures both growth and operating profitability Casualty Actuarial Society
Discounted Cash Flow Analysis • The discounted cash flow analysis captures the value of both the value of the existing balance sheet and the value of new business. Casualty Actuarial Society
Discounted Cash Flow Analysis • In valuing the existing balance sheet, we focus on the following components: • The existing surplus (pro forma for any reserve strengthening or other adjustments) • The value of the runoff of the reserves (actuarially determined payout pattern) • Any value/equity in the unearned premium reserve (value of deferred acquisition cost) Casualty Actuarial Society
Discounted Cash Flow Analysis • In valuing the new business, we focus on the following factors: • The premium growth potential • The potential to introduce new products • The projected combined ratio for the business • The expected payout of the future reserves and associated investment income Casualty Actuarial Society
Valuation Summary Casualty Actuarial Society
Non-traditional Approach • Due to the uncertainty of the quality of the Company's earnings, We value some of the Companies based on an analysis of the various components of the company Casualty Actuarial Society
Non-traditional Approach - Example • The Company stock has not recovered since its 2nd Quarter earnings announcement Casualty Actuarial Society
Non-traditional Approach • As a starting point we attempt to determine the tangible book value of the company: • Eliminated the goodwill from previous transactions • Estimated the current adequacy of loss reserves Casualty Actuarial Society
Non-traditional Approach • We add to the current book value an estimate of the value of the premium using two approaches: • Value based on projected cash flows from the in-force book of business • Estimated cost to purchase a book of business of that size Casualty Actuarial Society
Non-traditional Approach • We also attempt to assess the value of the runoff of the loss reserves by estimating the payout of the liabilities and the associated investment income earned on the runoff. Casualty Actuarial Society
Non-traditional Approach • The final component of value that we included was the value of any non-risk bearing segments • Value of service businesses are sometimes incorporated in the book value of the company • Estimated value from future earnings on the business or estimated sale value of the business Casualty Actuarial Society
Non-traditional Approach Casualty Actuarial Society
Non-traditional Approach Casualty Actuarial Society
Non-traditional Approach • The value of new business was projected out over 30 years. The underwriting performance assumptions were as follows: • Base Case: • 118% combined ratio, decreasing to 117% in 2002 • Loss ratio of 95% • Expense ratio of 23% Casualty Actuarial Society
Non-traditional Approach • Case 2: • 115.7% combined ratio, decreasing to 114.7% in 2002 • Loss ratio of 95%, decreasing to 94% in 2002 • Expense ratio of 20.7% Casualty Actuarial Society
Non-traditional Approach • Gross written premium is projected to decrease 20% in 2000, increase at an annual rate of 5% from 2001 to 2004, slow to a growth rate of 2.5% from 2005 to 2009, and then grow at a rate of 1% for each year thereafter • A valuation range was obtained by applying discount rates to both scenarios Casualty Actuarial Society
Non-traditional Approach Casualty Actuarial Society
Non-traditional Approach • An estimated valuation range was generated by selecting a discount rate of 7-10% and calculating the implied NPV. Casualty Actuarial Society
Non-traditional Approach • A valuation range was selected by applying current multiples of public companies and multiples from M&A transactions to the projected results of the company Casualty Actuarial Society
Conclusion • Why are you doing the valuation? • For whom are you doing the valuation? • What changes may occur at the target or the investment? • Everybody has an opinion, that’s what makes a market Casualty Actuarial Society