the application of fundamental valuation principles to property/casualty insurance companies derek...

The Application Of Fundamental Valuation Principles To Property/Casualty Insurance Companies

Derek A. Jones, FCASJoy A. Schwartzman, FCAS

Valuation Principles

1. The value of any business has two determining factors:

i. The future earnings stream generated by a company’s assets and liabilities.

ii. 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”).

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2. For a given level of future risk, the greater the PV of expected profits the greater the value.

3. 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.

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4. A company has value in excess of its invested capital only when future returns are in excess of the hurdle rate.

5. 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.

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ValuationFinancial ProfessionalsValue = PV of Future Cash Flows

Where cash flows represent dividendable earnings or earnings that can be released to investors

ActuariesValue = ANW + PV of Future Earnings – COC

Where ANW = adjusted net worth PV = Present ValueCOC = Cost of Capital

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Valuation Literature

1. Discounted Cash Flows “DCF”

A DCF model discounts free cash flows at the hurdle rate to determine value

2. Economic Value Added “EVA”

An EVA model defines

Value = Initial capital invested

+

PV of “Excess returns”

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To Value An Entity…

Financial Professionals Commonly use DCF Methodology

Actuaries commonly use EVA Methodology

When the underlying assumptions arecommon, the two methodologies yieldidentical results.

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What are these assumptions…

I. Starting capital

II. After-tax annual operating income

III. Capital required at the beginning of each year to support operations

IV. The hurdle rate

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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

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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.

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Company’s initial capital is reflected only to the extent:

a) it is released

or

b) it generates operating earnings

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Distributable earnings often projected in two components

a) Value of an explicit forecast period – say 5 to 10 years

b) Value associated with the entity after the explicit forecast period: the “Terminal Value”

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Discounted Cash Flow Value Value of explicit forecast period based on

detailed annual earnings projections reflectinga) Revenues (premiums)b) Loss and Loss Adjustment Expensesc) Acquisition and Operating Expensesd) Investment Income e) Taxesf) Assetsg) Liabilitiesh) Initial Capital to Support Operationsi) Capital Infusions or Releases to Support

Operations13


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.

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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 =

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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 +

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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”)

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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]

For Valuing an Insurance Company …

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For Valuing an Insurance Company…

Initial Capital represented by Statutory capital and surplus, with certain modifications

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Statutory earnings form the basis of after-tax operating earnings. Earnings include:

i. Runoff of existing balance sheet assets and liabilities

ii. Earnings contributions from renewal business

iii. Earnings contributions from new business


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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


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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 rate22

Valuation ResultsScenario 1AInitial Capital = $100Hurdle Rate 15%Total Earnings = Hurdle Rate

Model

10 Year

Forecast Period

Terminal Value Total

DCF 75 25 100

EVA 100 0 100

Table 1Valuation Results

Earnings Growth Rate = 0%

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Valuation Results

Model

10 Year

Forecast Period


DCF 67 33 100

EVA 100 0 100

Scenario 1BInitial Capital = $100Hurdle Rate 15%Total Earnings = Hurdle Rate



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Valuation Results

Model

10 Year

Forecast Period


DCF 80 26 106

EVA 105 1 106

Scenario 2AInitial Capital = $100Hurdle Rate 15%Total Earnings > Hurdle Rate



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Valuation Results

Model

10 Year

Forecast Period


DCF 74 36 110

EVA 107 3 110

Scenario 2BInitial Capital = $100Hurdle Rate 15%Total Earnings > Hurdle Rate



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Valuation Results

Model

10 Year

Forecast Period


DCF 70 23 93

EVA 95 (2) 93

Scenario 3AInitial Capital = $100Hurdle Rate 15%Total Earnings < Hurdle Rate



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Valuation Results

Model

10 Year

Forecast Period


DCF 60 30 90

EVA 93 (3) 90

Scenario 3BInitial Capital = $100Hurdle Rate 15%Total Earnings < Hurdle Rate



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Practical Considerations

Accounting Standard

How to Modify Initial Capital & Surplus

Composition of Free Cash Flow (DCF) or Increments of Added Value (EVA)

Hurdle rate

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Accounting Standard

ASOP 19: based on “regulatory earnings”

Constraints on dividends to equity owners:– Accumulated earnings– Minimum capital and surplus

requirementsSAP is current starting point

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Accounting Developments

Codification of SAP (2001)– Deferred taxes– Premium deficiency reserve

Fair Value Accounting

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Balance Sheet Adjustments

Loss reserve adequacyMarket value of assetsInclusion of non-admitted assetsAccounting goodwillStatutory provision for reinsuranceTax issues

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Estimating Net Income

After-tax operating earnings– Runoff of existing balance sheet– Future written business

“Below the line” adjustments to surplus

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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

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Future Written Business

New and renewal business is not usually split for P&C (unlike Life)

Personal Lines is an exceptionProjections typically made at LOB

level

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Hurdle Rate

Reflect the cost of acquiring capital needed to perform transaction

Typically provided by managementCan be estimated by various security

valuation methods

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Hurdle Rate Considerations

Risks attributable to business activities of target

Consideration of multiple hurdle ratesMethod of financing acquisitionConsistency with other assumptions

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Q&A

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