How Investment Bankers Value Insurance Companies

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How Investment Bankers Value Insurance Companies

• Valuation of Insurance Operations
• April 10

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In Todays Market
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Two Approaches

• Market Approach
• Fundamental Approach
• Traditional Approach
• Non-traditional Approach

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Market Approach

• Research Analyst
• Buy-side Analyst
• Investor Community

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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

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Market Approach

• Volatility of the industrys results has declined
  over the last twenty years

Volatility of Property Casualty Earnings
4.0x
3.5x
3.0x
2.5x
2.0x
Standard Deviation
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
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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

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Value Drivers
Price/Book Price/Book
Baldwin Lyons, Inc. 0.79x
W.R. Berkley Corporation 0.65
Capitol Transamerica Corp. 1.00
HCC Insurance Holdings, Inc. 1.31
Markel Corporation 1.74
Medical Assurance, Inc. 1.40
NYMAGIC, Inc. 0.52
Penn-America Group, Inc. 0.78
Philadelphia Cons. Holding Co. 1.13
RLI Corp. 0.93
Return on Equity Earnings Consistency Earnings
Growth
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Value Drivers
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Value Drivers
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Value Drivers
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Who Cares about the Actuaries
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Frontier Chart
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Meadowbrook Chart
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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

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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)

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Margin Erosion

• Commodity products (e.g. term insurance, auto)
• New entrants
• Widespread consumer information
• Competitive pressures increasing loss ratios
• High cost distribution systems

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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

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Fundamental Analysis

• We traditionally base our valuation of insurance
  companies on four valuation methodologies
• Analysis of public market comparables
• Private and public market MA transactions
• Discounted cash flow analysis
• Additional areas of value that must be developed
  with potential buyers

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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

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MA 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

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Multiple Analysis
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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

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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.

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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)

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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

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Valuation Summary
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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

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Non-traditional Approach - Example

• The Company stock has not recovered since its 2nd
  Quarter earnings announcement

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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

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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

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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.

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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

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Non-traditional Approach
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Non-traditional Approach
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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

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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

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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

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Non-traditional Approach
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Non-traditional Approach

• An estimated valuation range was generated by
  selecting a discount rate of 7-10 and
  calculating the implied NPV.

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Non-traditional Approach

• A valuation range was selected by applying
  current multiples of public companies and
  multiples from MA transactions to the projected
  results of the company

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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, thats what makes a
  market

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