Valuation Insights: Health and Life Insurers

The focus of this article is to give greater insight into the valuation of life and health (L&H) insurers and the market's current pricing of these businesses. When compared to other insurance industry segments, such as property and casualty, the L&H segment of the insurance industry is relatively noncyclical, as there is sufficient data and a large base of similar risks (i.e., people) to accurately predict claims and therefore minimize the risk that the cycle poses to the business.

Insurers collect premiums from policyholders, and then invest the premiums. Some of the income generated from the premiums is shared with policyholders, either through a dividend or income from an annuity. Eventually, policyholders will receive a repayment on their policies upon the policyholder's death or when a policy or an annuity matures. ¹

Below is a group of publicly traded companies (the "Industry Group") that are representative of the L&H insurance segment.

• AFLAC Inc. ("AFL")
• Assurant Inc. ("AIZ")
• Conseco Inc. ("CNO")
• Delphi Financial Group Inc. ("DFG")
• Genworth Financial Inc. ("GNW")
• Lincoln National Corp. ("LNC")
• MetLife, Inc. ("MET")
• Principal Financial Group Inc. ("PFG")
• Prudential Financial Inc. ("PRU")
• StanCorp Financial Group Inc. ("SFG")
• Torchmark Corp. ("TMK")
• Unum Group ("UNM")

Data from Capital IQ, a division of Standard and Poor's, for the Industry Group can be used to calculate valuation multiples. A valuation multiple compares a company's equity value or market value of invested capital (MVIC) (i.e., total interest bearing debt plus the equity value) to an earnings stream such as revenue, earnings before interest, taxes, depreciation and amortization (EBITDA), or net income (earnings). Analysts can calculate a value for a firm by deriving multiples from data on similar publicly traded companies or recent transactions involving similar companies. Depending on the company being valued, adjustments can be made to account for company-specific factors. The resulting multiple can be applied to the firm being analyzed to arrive at an indication of value.

Valuation Drivers—While there may be exceptions, the value of most L&H insurers is driven substantially by growth, profitability, and risk.

Growth—Two important macroeconomic indicators that affect L&H insurance sales are interest rates and demographics. In a period of declining interest rates, growth in net investment income (an important revenue source for an L&H insurer) will slow as yields on insurers' bond portfolios slide. However, falling interest rates also increase the value of the underlying assets (usually fixed-income securities) that produce the investment income. ²

With regard to demographics, the Census Bureau predicts that growth will be low in the 20 to 44 age bracket between 2000 and 2010, with only a modest 3 percent growth for those under the age of 20. The low growth for these age groups will likely weaken demand for more traditional death-benefit products, where policy benefits are often intended to protect families from the loss of a working spouse or parent. ³ However, the "baby boomer" cohort represents a source of growth for health and life insurers. "Baby boomers" generally have a lower level of faith in the Social Security system. Additionally, life expectancies are projected to increase and healthcare costs are on the rise. As such, many individuals have begun turning to life insurers to provide not only traditional death-benefit types of life insurance, but also savings-oriented life insurance products and annuities.

Profitability—L&H insurers' profits consist of two components: underwriting income and investment income. ⁴ Following is an examination of the factors contributing to the overall profitability of L&H insurers.

If a company increases its premium base at a rate greater than the overall industry, that company would appear to be outperforming its peer group. The stock market would generally award that firm with a higher valuation than would be given to some of its lower-growth peers. However, the level of risk should also be considered: if the insurer is achieving premium growth by adopting risky underwriting practices or offering unusually high rates of return on certain investment-oriented life insurance products, "such insurer's valuation would be adjusted downward accordingly." ⁵

Fee income (from fee-based products like annuities) growth is another important factor contributing to the company's profitability. It is important to analyze the sources of profits separately, because growth in fee income may be masked by declining or flat premium growth. ⁶

The level of reinsurance is another factor affecting profitability. Because using less reinsurance allows an insurer to keep more of each premium dollar, a reduced level of reinsurance may enhance year-to-year premium growth comparisons. However, using less reinsurance removes protection and leaves an insurer exposed to greater claims-related risk. ⁷

The largest expense facing most L&H insurers is policyholder benefits. These include death benefits to life insurance policyholders; accident, health, and disability benefits to health insurance policyholders; and annuity benefits. Aside from assorted policyholder benefits, costs to acquire new business, including agent commissions and other related selling expenses, also take a big bite out of insurers' budgets. ⁸

Investment income is an important revenue source for L&H insurers. In some cases, it provides almost half of an insurer's total revenues. While some insurers may exhibit significant levels of investment income, analysts should typically consider the riskiness of the insurer's portfolio by analyzing the asset allocation. Such an analysis will assist in determining whether or not the risk and liquidity of the insurer's portfolio is warranted given the insurer's potential claims-related liability. ⁹

Loss reserves can also have a significant impact on an insurer's financial results. An insurer's prosperity depends largely on its ability to quantify the ultimate cost of claims from the risks that it assumes. ¹⁰ Generally, L&H insurers are able to quantify the potential for loss with more accuracy than other types of insurers, such as those in the property and casualty segment.

Risk—Liquidity is an important performance benchmark to consider when analyzing an insurer given that insurers must be able to pay policyholder claims promptly. An insurer's sources of liquidity include underwriting cash flow, investment cash flow, and asset liquidation cash flow. ¹¹

For L&H insurers, leverage usually measures the extent to which a firm uses its policyholders' surplus or shareholders' equity to produce business. The ratio of premiums to surplus can provide a measure of an insurer's leverage. ¹² Generally, the higher the premiums relative to policyholders' surplus, the greater the insurer's leverage is said to be.

Insurance companies tend to hold the bulk of their investment portfolios in corporate bonds, so an acceleration of corporate bond default rates could erode the value of their investment portfolios significantly.

Current Valuation Trends—Historically, L&H insurers were essentially the sole source of health and life insurance products. However, today, other financial services firms, such as banks and brokerages, offer insurance products. L&H insurance has become a commodity, and, as such, it is marketed primarily on price, resulting in an adverse effect on the valuation of L&H insurers.

The overall aging of the population is turning insurers' attention gradually away from income-protection financial products toward retirement-oriented financial products. Longer life expectancies and concerns about the financial safety net of Social Security have given baby boomers a heightened awareness of the need to save for retirement. Moreover, a shift in pension trends from defined benefit plans to defined contribution plans has given many Americans a greater sense of financial empowerment. Such trends present a growth opportunity for L&H insurers who can provide quality retirement-oriented financial products to the aging population.

The U.S. Longshore and Harbor Workers Compensation Act insurance industry has been in a period of consolidation since the 1990s. The significant number of smaller L&H insurance companies provides numerous merger and acquisition (M&A) candidates for the larger insurance companies. ¹³ Industry consolidation could lead to increased acquisition valuation multiples for smaller L&H insurers.

A graph shows the MVIC-to-EBITDA multiples for the latest 12 months ("LTM") for the Industry Group.

MVIC-to-EBITDA Multiples

The current average valuation for large publicly traded L&H insurers is approximately 7.5 times EBITDA. However, the range varies from a low of 5.4 times EBITDA to a high of 11.7 times EBITDA. These differences can be attributable to a variety of factors including company-specific issues such as growth strategy and risk.

Recent developments in the equity markets have had an impact on the L&H insurance industry. Credit losses in the companies' investment portfolios, lower investment income due to low interest rates, and equity market effects on variable annuities tend to place pressure on earnings and weaken some companies' financial flexibility resulting in a negative impact on the valuation of L&H insurers.