Insurance Industry Valuation Insights: Recent Trends 2008
Jeff Balcombe | August 1, 2008
The general focus of this article is to analyze the direct and indirect impacts of recent economic trends on the valuation of companies operating in the insurance industry. Key trends recently impacting insurance companies are the subprime mortgage crisis, soft market conditions, and significant catastrophe losses, each of which affects the valuation of insurance entities. Notably, these recent trends have negatively impacted the valuation of companies operating in the insurance industry.
The discussion in this article is presented in the context of impacts on valuation drivers of the business. Generally, the value of a firm in the insurance industry is driven by three broad drivers: expected growth, profitability, and risk. Below are a few examples outlining the relationship between the insurance business and these three broad valuation drivers.
Property and casualty (P&C) insurers generate growth either by increasing underwriting volume or by increasing premiums. Health and life (H&L) insurers, however, generate growth through increases in investment income from the company's invested premiums.
The profitability of P&C insurers and reinsurers is primarily driven by the occurrence of catastrophic events, while H&L insurers' bottom lines are generally affected more by underwriting income and investment income, which is offset by policyholder benefits (i.e., death benefits; accident, health, and disability benefits; and annuity benefits) either partially or completely, depending on the company's profitability.
Risk of an insurance company is driven by numerous factors including liquidity and leverage. Liquidity allows a business to shield itself from unexpected downturns, which can put severe strain on a company's needs for cash. With greater liquidity, there is less risk that the company will not be able to meet its obligations. Leverage allows a company's equity holders to benefit from another source of financing; however, it can also put the company in a riskier position with respect to not being able to service debt payments. In addition, insurance companies are subject to additional risks relating to underwritten premiums and the insurer's investment portfolio.
Economic Trends and the Effect on Valuation Drivers
Three key factors have driven financial performance during 2008: (1) the impact of the housing and credit crisis on mortgage and financial guarantee insurers and the resulting effect on the overall P&C insurance industry sector's financial results; (2) the continuation of soft market conditions through the industry; and (3) a surge in catastrophe losses. 1
Subprime Mortgage Crisis
The effects of the subprime mortgage crisis have reached far beyond the residential real estate industry. In fact, insurance companies have recently felt an impact rippling from the crisis. Standard & Poor's (S&P) indicated that it was concerned that the slowdown in the economy and a broad-based deterioration in the corporate credit market would limit earnings growth of insurance companies. For example, S&P noted that higher bond defaults may potentially result in a decline in the quality of the insurance industry's bond portfolios. Furthermore, the low interest rate environment and the relatively flat yield curve may make it more difficult for the life insurance industry to continue to post strong earnings growth. 2 With concerns of decreasing investment income, insurance companies are at risk of generating less cash flow, which, holding all else equal, would generally warrant a reduced value.
Another related factor recently affecting the insurance industry is litigation losses stemming from the U.S. subprime mortgage crisis. The P&C segment's primary loss exposure is expected to be from financial institutions' claims to recover losses under their directors and officers, and errors and omissions coverages. Insurers may also face claims under other potentially applicable coverage such as fiduciary liability and comprehensive general liability. 3
The long-term impact of the credit crisis on the U.S. life insurance industry could arise via lawsuits over whether insurance companies have a fiduciary responsibility to their customers with respect to any financial losses customers may incur on the investment options within their insurance policies. 4
While P&C insurers are by no means immune to the effects of the current economic downturn, the impact in terms of growth and profitability will be somewhat limited. With respect to revenue, P&C insurers are distinct from more economically vulnerable sectors such as homebuilders or carmakers. This is because approximately 98 to 99 percent of insurer growth is tied to renewal business. Insurance is, in effect, an economic necessity, not a discretionary purchase. Homes, cars, businesses and workers all need to be insured irrespective of the state of the economy. 5 These factors suggest that the negative impact of the subprime mortgage crisis on the valuation of P&C insurance companies would be relatively limited.
Soft Market Conditions
The P&C segment reported an annualized statutory rate of return on average surplus of 6.4 percent in the first quarter of 2008, a decline of more than 50 percent from the 13.2 percent in the first quarter of 2007. The sharp decline in profitability reflects the substantial deterioration in underwriting performance in the mortgage and financial guaranty segments of the industry. Net written premium growth, which in 2007 turned negative for the first time since 1943, continued its downward trend during the first quarter of 2008. 6 The industry has moved into a cyclical downturn in terms of profitability. 7 A decline in profitability and growth of insurance companies will tend to have a negative impact on the valuation.
Due to volatility in the securities markets, the industry's total investment gain declined by 18.8 percent to $12 billion during the first quarter of 2008 from $15 billion during the first quarter of 2007. 8 The first quarter was very volatile for capital markets, which were affected by waves of bad news related to the credit markets, skyrocketing oil prices and economic weakness. The S&P 500 Index lost 9.7 percent during the first quarter of 2008 (and 14.7 percent through July 28, 2008). Approximately 17 percent of P&C insurer-invested assets are equities while two-thirds are bonds. 9 This trend would have a negative effect on the valuation of insurers that derive a substantial portion of their income from investment activities.
Catastrophe Losses
Catastrophe losses in the first quarter of 2008, at $3.4 billion, reached the highest level for any first quarter since 1994 and continued through the second quarter. As of June 20, 2008, total catastrophe losses for the year were at $8.3 billion, $1.6 billion more than for 12 months of 2007. 10 Catastrophe losses during the first half of 2008 were caused by record-breaking tornado activity, severe hail and wind damage. Additionally, during the second quarter of 2008, the Midwest suffered its most severe floods since 1993, which cost private insurers $600 million. 11 The surge in the level of catastrophe losses will have greater negative effect on the valuation of insurers, because insurers' ability to cope with such losses has substantially declined due to the current soft market conditions.
Impact on Valuation of Insurance Companies
Exhibit 1 illustrates a declining trend in the average price-to-earnings multiples for various segments of the insurance industry from April 2007 through July 2008. The average multiples were calculated using data provided by Capital IQ.
Exhibit 1
The pace of merger and acquisition (M&A) activity in the U.S. life insurance sector slowed in 2006 and 2007 compared with 2005. 12 Despite the softening market, P&C M&A deal volume in the first quarter of 2008 remained relatively constant compared to the first quarter of 2007, although M&A valuations decreased. 13 Equity analysts covering the insurance industry are predicting an increase in M&A activity in 2008, with nearly 90 percent of U.S. analysts expecting a rise in deal volume, according to a survey. 14 One factor that may contribute to growth in M&A volume is declining valuations of insurers.
Conclusion
The weak economy, soft market conditions, and deterioration in the credit markets appears to be limiting the growth of insurance companies. Additionally, the recent volatility in the securities markets (not unrelated to the state of the economy and the credit markets) contributed to a decline in the industry's total investment gain. The combination of these factors has negatively affected growth and profitability for insurance companies, and, in some ways, such as the potential for litigation, recent trends have subjected the insurance industry to a greater risk. The current environment suggests decreased valuations relative to historical levels, which is consistent with the stock market's recent assessment of insurance companies.
Note: See the August 2009 update, Recent Trends in Valuation of P&C Insurers: 2009.
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Footnotes
KPMG, Insurance M&A Monthly, June 2008.
