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”).
2
Valuation Principles
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.
3
Valuation Principles
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.
4
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
5
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”
6
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.
7
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
8
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
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
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
Discounted Cash Flow Value
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”
12
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
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
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
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
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
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 …
18
For Valuing an Insurance Company…
Initial Capital represented by Statutory capital and surplus, with certain modifications
19
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
For Valuing an Insurance Company…
20
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
For Valuing an Insurance Company…
21
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%
23
Valuation Results
Model
10 Year
Forecast Period
Terminal Value Total
DCF 67 33 100
EVA 100 0 100
Scenario 1BInitial Capital = $100Hurdle Rate 15%Total Earnings = Hurdle Rate
Table 2Valuation Results
Earnings Growth Rate = 3%
24
Valuation Results
Model
10 Year
Forecast Period
Terminal Value Total
DCF 80 26 106
EVA 105 1 106
Scenario 2AInitial Capital = $100Hurdle Rate 15%Total Earnings > Hurdle Rate
Table 3Valuation Results
Earnings Growth Rate = 0%
25
Valuation Results
Model
10 Year
Forecast Period
Terminal Value Total
DCF 74 36 110
EVA 107 3 110
Scenario 2BInitial Capital = $100Hurdle Rate 15%Total Earnings > Hurdle Rate
Table 4Valuation Results
Earnings Growth Rate = 3%
26
Valuation Results
Model
10 Year
Forecast Period
Terminal Value Total
DCF 70 23 93
EVA 95 (2) 93
Scenario 3AInitial Capital = $100Hurdle Rate 15%Total Earnings < Hurdle Rate
Table 5Valuation Results
Earnings Growth Rate = 0%
27
Valuation Results
Model
10 Year
Forecast Period
Terminal Value Total
DCF 60 30 90
EVA 93 (3) 90
Scenario 3BInitial Capital = $100Hurdle Rate 15%Total Earnings < Hurdle Rate
Table 6Valuation Results
Earnings Growth Rate = 3%
28
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
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
30
Accounting Developments
Codification of SAP (2001)– Deferred taxes– Premium deficiency reserve
Fair Value Accounting
31
Balance Sheet Adjustments
Loss reserve adequacyMarket value of assetsInclusion of non-admitted assetsAccounting goodwillStatutory provision for reinsuranceTax issues
32
Estimating Net Income
After-tax operating earnings– Runoff of existing balance sheet– Future written business
“Below the line” adjustments to surplus
33
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
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
35
Hurdle Rate
Reflect the cost of acquiring capital needed to perform transaction
Typically provided by managementCan be estimated by various security
valuation methods
36
Hurdle Rate Considerations
Risks attributable to business activities of target
Consideration of multiple hurdle ratesMethod of financing acquisitionConsistency with other assumptions
37
Q&A
38