Trends in the Valuation of P&C Insurers: 2009

Growth

Generally, companies with greater prospects for growth are more valuable than companies with less growth potential, holding all else equal. P&C insurers generate growth by underwriting more insurance policies and/or through rising premiums.

The insurance industry's cyclicality is driven largely by market conditions. In soft market conditions, P&C insurers are forced to provide coverage at low premiums and utilize aggressive underwriting practices to generate capital. In hard market conditions, insurers are able to demand higher premiums due to increasing demand for insurance products. This, however, brings new competition into the industry, leading to lower premiums and aggressive underwriting practices. ¹

Therefore, to mitigate losses and generate growth, the ability to manage the cycle efficiently is critical for P&C insurers' success. Given that most insurers in the industry will be affected by the industry's cyclicality, growth resulting from improving industry conditions will normally not affect the relative growth prospects of a certain insurer.

Because high premium growth rates can be achieved by following risky underwriting practices, such as underpricing policies to gain market share or writing a great deal of business in a high-risk coverage line avoided by other insurers, the insurer's valuation would have to be adjusted to consider the increased risk associated with its policies. Accordingly, a lower risk of the insurer must be considered if the firm is growing slower than its peers due to more conservative underwriting policies.

Profitability

The main drivers of profitability for the P&C insurer are the number of written contracts, the amount of premiums, the level of investment returns, and the occurrence of catastrophic events. While these events generally affect most P&C insurers, the ultimate impact on the valuation depends on each individual insurer's exposure to the product line in which the event occurred. In general, changes in profitability relating to claims-related payments are not controllable by the companies.

Overall, net written premiums dropped 3.6 percent during the first 3 months of 2009 compared to the same period in 2008. This was the largest decline in the industry for any quarter since the beginning of Insurance Services Office Inc.'s quarterly reports. Market surveys and government data indicated that deteriorating demand for insurance products (partially a result of economic recession and forecasted moderate hurricane season) and lower prices for commercial insurance were the primary drivers for this decline. ² Soft market conditions have had an impact on the profitability of P&C insurers; however, some companies performed better than others.

Aside from claims-related expenses, the profitability of insurers is affected by expenses such as commissions paid to brokers/agents and overhead costs. A company that is able to generate premiums with lower overhead costs than its peers will tend to be valued higher.

Investment income also contributes to the insurer's profits. Typically, insurers will maintain relatively liquid portfolios so that claims can be paid as quickly as necessary. Some insurers have become completely reliant on investment income to generate positive earnings. These companies may be less valuable than other insurers, depending on the risk of the company's investment portfolio. For instance, a company that generates negative underwriting profits, yet produces a positive net income due to the income from its highly risky investment portfolio, would normally be less valuable than a company in a similar situation with a less risky portfolio. The industry's net investment income, primarily dividends from stocks and interest from bonds, fell 8.7 percent for the first 3 months of 2009. ³

Risk

There are several risk factors that are important when analyzing a company in the P&C industry, including the risk of underwritten premiums, the effects of reinsurance of the company's exposure to claims-related expenses, and the risks associated with the insurer's investment portfolio. Additionally, analyses of the company's liquidity and leverage provide additional insight into the overall risk of the company.

The risk of underwritten policies should generally be considered in the context of the company's growth in premiums written. As already explained, higher risk policies will tend to have a negative effect on the value of the insurer. However, the benefit of higher growth associated with underwriting riskier policies will generally have a positive effect on value. Thus, an analyst would often weigh these two effects in the valuation analysis. A helpful tool in analyzing this risk is the loss ratio. The loss ratio measures the historical amount of losses relative to premiums earned and is typically between 60 percent and 80 percent. ⁴ During periods of catastrophic events, loss ratios in the industry can rise significantly.

A factor that can reduce the risk of an insurer is the utilization of reinsurance. Greater use of reinsurance generally lowers the risk of an insurer and will have a positive effect on value. However, a higher level of reinsurance means that premiums which the company would otherwise receive are shared with a reinsurance company.

Insurers are also exposed to risk associated with their investment portfolios. While higher risk may result in greater investment income, it could also result in less investment income depending on market performance. Typically, insurers will hold relatively liquid investments, allowing the company to access the funds quickly if needed for claims-related expenses. Given that catastrophic events can quickly and significantly change the insurer's need for cash, liquidity can be an important factor with respect to the company's risk profile. An insurer with greater resources and cash flow to cover its potential claims and other liabilities will likely be more valuable. The increase in the company's leverage, while allowing its equity holders to benefit from additional source of financing, increases the company's risk profile by creating an additional layer of cash outflow required to service its debt.

Current Valuation Trends

The following is a list of publicly traded companies (the "Industry Group") that are representative of the P&C insurance segment of the insurance industry.

• The Chubb Corporation ("CB")
• Cincinnati Financial Corp. ("CINF")
• Donegal Group Inc. ("DGIC.B")
• Erie Indemnity Co. ("ERIE")
• First American Corp. ("FAF")
• Hallmark Financial Services Inc. ("HALL")
• Harleysville Group Inc. ("HGIC")
• Mercer Insurance Group Inc. ("MIGP")
• Progressive Corp. ("PGR")
• RLI Corp. ("RLI")
• Safety Insurance Group Inc. ("SAFT")
• Selective Insurance Group Inc. ("SIGI")
• Specialty Underwriters' Alliance Inc. ("SUAI")
• The Hanover Insurance Group Inc. ("THG")
• The Travelers Companies Inc. ("TRV")
• Tower Group Inc. ("TWGP")
• W.R. Berkley Corporation ("WRB")
• Alleghany Corp. ("Y")

Price-to-earnings ("P/E") multiples are commonly used valuation metrics for the insurance industry. Figure 1 presents a current snapshot of forward P/E multiples. Because the investors' investment decision-making process is forward-looking in nature, multiples based on forecasted earnings provide a better indication for current valuation trends. The forward P/E multiples shown below are based on the Industry Group's forecasted calendar 2009 earnings. The range of P/E multiples is wide, with SUAI having the highest multiple of 18.9 times, and HALL having the lowest multiple of 5.4 times. The average forward P/E multiple for the Industry Group was 12.2 times.

Figure 1:

These differences can be attributable to a variety of valuation factors already discussed. One of these factors is the operating margin. The Industry Group's operating margin, ranged from negative 2.0 percent to positive 20.0 percent with an average of 8.7 percent during the previous 12 months. Another factor is the leverage. Debt-to-capital ratios (a measure of leverage) ranged from 0 to 38.6 percent. Capital IQ reports the expected long-term growth rate for the P&C insurers. This measure is based on the 5-year expected growth in earnings. The Industry Group's expected growth rate ranged from 7.2 percent to 22.5 percent, with the average of 11.2 percent. To determine the appropriate multiple for valuation of a privately held P&C insurer, an analyst, as a starting point of analysis, would analyze the insurer's profitability, leverage, and growth rate relative to the Industry Group. Additionally, other risk factors specific to the insurer are typically considered.

Figure 2 presents the trend in the average forward P/E multiples for the Industry Group since April 2008. Similar to the overall stock market performance, the average multiples have been volatile over the past 5 quarters with a high of 12.7 times and a low of 8.4 times forward earnings. After a substantial decline during the first quarter of 2009, the average forward P/E multiples for the Industry Group expanded consistent with the stock market recovery. Current valuation levels appear to be at the high end of the observed range during the past 5 quarters.

Figure 2:

Conclusion

The insurance industry has been facing significant challenges due to the turbulent economic environment during the past year. The effect of a decline in net written premiums and net investment income was partially offset by an expectation of a moderate hurricane season. Additionally, the expansion in market multiples during the second quarter of 2009 reflects a long-term forecast for an average of 11.2 percent growth in earnings for the Industry Group.

As previously noted, there are many factors that affect the valuation of P&C insurance companies, and with the recent volatility of market conditions, there is high speculation regarding the future of the insurance industry. Overall, companies that manage cyclicality effectively, consistently practice conservative underwriting, and diversify investments to minimize risk will outperform others in their industry.