Life Insurance Company Valuations and Interest Rates

Valuation Framework

Below is a simple formula that can be used as a framework for considering the relevant issues in analyzing the relationship between interest rates and a firm's equity value:

Equity Value = Asset Value – Liability Value

Life insurance assets are primarily financial in nature and are composed primarily of bonds and stocks. ² On the other hand, life insurance liabilities mostly consist of obligations relating to the policies sold to various individuals. Life insurers effectively incur liabilities by "borrowing" premiums from policy owners and investing in stocks and bonds to generate returns through investment income and capital gains. ³

Equity value is the residual claim of the owners in the assets of the company after deduction of the company's liabilities. ⁴ Generally, the value of a company's equity value is driven by its growth prospects, risk profile, and expected profitability. Generally, all else being equal, companies with higher growth, greater profitability, and lower risk will have higher valuations.

One metric that captures these elements and is utilized by insurance industry analysts to assess equity valuations is the price-to-earnings (P/E) multiple. The P/E multiple represents the value of a firm's equity per dollar of earnings and can be based on historical earnings, such as net income during the latest 12 months, or forward earnings, such as net income expected in the next 12 months. By analyzing trends in valuation multiples, analysts can gain a better understanding of the market's assessment of a company's growth prospects and risk profile, both of which could be affected by the interest rate environment.

Effects of Interest Rate Risk on Life Insurance Company Valuations

The conceptual framework introduced above suggests that, to understand a company's exposure to interest rate risk (i.e., how changes in interest rates affect its equity value), it is important to appreciate the impact of interest rates on both the value of the firm's assets as well as its liabilities. In the case of life insurers, the sensitivity to interest rate changes of both investment assets as well as policyholders' claims (i.e., liabilities) could have a significant impact on equity value.

As seen during 2010, low interest rate environments can result in depressed crediting rates, ⁵ thus potentially decreasing the insurer's future obligation on the policy (i.e., the liability). However, lower crediting rates can also reduce the attractiveness of interest rate–sensitive products. ⁶ As a result, while liability growth may decline, the insurer's asset growth may also fall as sales growth slows and the insurer receives less premium income that could be reinvested. The net impact on equity value will depend, as illustrated by the formula above, on how sensitive to changes in interest rates the growth prospects of the assets are relative to those of the liabilities.

In addition to influencing growth, interest rates clearly have an impact on an insurer's risk profile, notably via exposure to interest rate risk. For example, with respect to the asset side of the balance sheet, managers in the life insurance industry face the challenge of structuring their investment portfolio so that the firm can meet its future obligations on policies written. ⁷

As noted in MetLife's Form 10-K filed with the U.S. Securities and Exchange Commission on February 25, 2011, one risk factor inherent in the investment structuring process is disintermediation risk, which refers to the potential that policyholders may relinquish policies due to rising interest rates. If interest rates rise too rapidly, then policyholders may surrender policies faster than expected, potentially resulting in cash flow obligations that exceed returns on investment assets. Alternatively, during persistent periods of low interest rates when policy surrender rates tend to decrease, insurers face the risk that investment returns will decline to the point that they are unable to service ongoing liabilities. In either scenario, the sensitivity of investment income and policy obligations to interest rate changes could have a considerable impact on equity value.

Duration Matching

By influencing a company's perceived growth prospects, risk, and profitability, interest rates have the potential to influence equity valuations. However, life insurers can employ a "variety of hedging techniques, such as matching asset and liability durations," ⁸ to help insulate firm value from changes in interest rates. ⁹ Duration for a bond investment is defined as "the number of years until the investor receives the present value of all income from a bond (including interest and principal) and is used to gauge a bond's sensitivity to interest rate changes." ¹⁰ That is, the higher the duration, the greater the sensitivity to interest rate changes. Similarly, the duration of a liability would measure the liability's sensitivity to changes in interest rates. Accordingly, if the durations of both assets and liabilities are equal, changes in the interest rate environment should impact both the assets and liabilities equally (on a percentage basis), thus limiting the impact on the value of equity.

With this in mind, many insurers employ an "immunization" strategy in order to reduce the risk of loss in a changing interest rate environment. ¹¹ While the concept of duration matching seems simple enough, in practice, a perfect hedge against interest rates is difficult to attain for life insurers. As a result, equity values for life insurers tend to be subject to at least some level of interest rate risk.

Trends in Valuation Multiples

By analyzing the historical trend in valuation multiples for life insurers, analysts can observe the current relationship between value and interest rates in the industry. Shown below is a graphical analysis of the trends in P/E multiples (defined previously) and interest rates for the period from January 1, 2010, through July 1, 2011. The P/E multiples represent the averages for the following companies (the "Life Insurance Industry Group") that operate in the life insurance industry:

1. AFLAC Inc. ("AFL")
2. Assurant Inc. ("AIZ")
3. Conseco Inc. ("CNO")
4. Delphi Financial Group Inc. ("DFG")
5. Lincoln National Corp. ("LNC")
6. MetLife, Inc. ("MET")
7. Principal Financial Group Inc. ("PFG")
8. StanCorp Financial Group Inc. ("SFG")
9. Torchmark Corp. ("TMK")
10. Unum Group ("UNM")

Figure 1: P/E Multiples versus Interest Rates

As exhibited in the chart above, it appears the trend in interest rates closely tracks the average P/E multiples during the illustrated time frame, which was generally characterized by low interest rates relative to historical standards. As noted previously, during periods of sustained low interest rates, life insurance companies potentially face the risk of experiencing falling investment returns and, thus, reduced cash flows. As shown in the graph, during the same time period that interest rates were declining, P/E multiples were also falling, which could be a function of increased perceived risk in the marketplace. Notably, when interest rates began rising around October 2010, Standard & Poor's suggested that the market became less concerned that life insurers' financial stability was at risk. ¹²

Outlook

The current economic environment and associated uncertainties about the future pose a number of challenges for life insurers. ¹³ With some analysts indicating that interest rates are "unlikely to increase meaningfully any time soon," ¹⁴ disintermediation could remain a risk to life insurance companies in the near future, potentially placing downward pressure on equity valuations. To properly assess and manage interest rate risk, it is important to understand how both the assets as well as the liabilities of the business can be affected in various interest rate environments.