This article discusses some of the factors that impact the valuation of businesses and how certain trends and expectations for the reinsurance industry may be affecting the market's current valuations of reinsurance companies.
Reinsurance is the business of insuring insurance policies. Through reinsurance, direct insurers are able to transfer portions of their risk portfolios and mitigate the risk of concentrated claims and catastrophic losses. Reinsurance companies enter into transactions in which they indemnify, for a premium, another insurance company against all or part of the loss that it may sustain under its policy or policies of insurance.
Depending on the contract, reinsurance can enable the insurer to improve its capital position, expand its business, limit losses, and stabilize cash flows. Reinsurers draw experience from a significant number of primary insurers and therefore usually have a larger collection of information for assessing risks. Reinsurance can take a variety of forms. It may represent a layer of risk or a sharing of both losses and profits for a certain type of business.
Types of Reinsurance
Reinsurance contracts fall into two broad groups: treaty contracts and facultative contracts. Treaty contracts are written so that the reinsurer assumes risk associated with a group of policies within a certain business class or classes. Facultative contracts are written so that the reinsurer assumes the risk of all or part of an individual policy. Facultative contracts are often used to cover catastrophic and unusual risk exposures or to cover risks specifically excluded in treaty contracts. 1
In addition to the two types of contracts, there are two types of coverage: proportional and nonproportional. Proportional contracts provide primary insurers with coverage for a determined percentage of losses incurred. Nonproportional contracts, also known as "excess of loss" contracts, include a predetermined level of retention, or deductible, and losses in excess of the set deductible are covered by the reinsurer up to the limits of the contract.
There are four primary reasons direct insurers seek reinsurance 2:
- Limiting liability: by providing a mechanism through which insurers limit their loss exposure to levels commensurate with their net assets, reinsurance enables insurance companies to offer coverage limits considerably higher than they could otherwise provide.
- Stabilization: through reinsurance, insurers can reduce fluctuations in loss experience and stabilize a company's overall operating results.
- Catastrophe protection: reinsurance protects against catastrophic financial loss resulting from a single event, as well as against the aggregation of many smaller claims resulting from a single event that affects many policyholders simultaneously.
- Increased capacity: the insurer shares a portion of its underwriting expenses with its reinsurer and reduces the drain on surplus, thus increasing its capacity to underwrite more contracts.
The Reinsurance Market
In assessing the value of any company, it is important to consider the market in which the subject company operates. Industry factors and trends can affect the expectations for a company's future performance and, in turn, the valuation for that business.
The worldwide reinsurance industry is somewhat concentrated. In 2012, the top 4 reinsurers accounted for between 40 and 70 percent of market share according to U.S. Census data and IBISWorld estimates. Industry concentration is expected to intensify as companies consolidate in order to build higher capital levels. 3
Similar to traditional insurance, reinsurers generate income from policy premiums and investment returns. Generally, premiums are affected by changes in policy counts and pricing, which fluctuate between hard and soft cycles. During hard pricing cycles, prices rise as insurers try to build reserves and maximize underwriting profits. In contrast, soft cycles occur when prices fall, as reinsurers competitively price policies in an attempt to gain market share. The change between these two cycles depends highly on catastrophic activity and investment returns, as unusual spikes in claims and decreases in investment income curtail reserves and profitability.
The reinsurance industry is currently in a soft cycle and is expected to remain in the current cycle for the remainder of 2013. Lower growth expectations typically yield lower valuations; thus, if the market begins to believe the length of the current soft market will extend well beyond 2013, valuations could experience a decline from current levels.
In analyzing a "subject company," it can be helpful to look at the recent and expected performance of other companies operating in the same industry. Additionally, "guideline companies" can be used to develop a range of valuation multiples that may be applicable to the subject company. 4 Listed below is a group of publicly traded companies (the "Industry Group") that are generally representative of the reinsurance industry.
- Alterra Capital Holdings Limited ("ALTE")
- Endurance Specialty Holdings Ltd. ("ENH")
- Enstar Group Limited ("ESGR")
- Everest Re Group Ltd. ("RE")
- Greenlight Capital Re, Ltd. ("GLRE")
- Maiden Holdings, Ltd. ("MHLD")
- Montpelier Re Holding Ltd. ("MRH")
- PartnerRe Ltd. ("PRE")
- Platinum Underwriters Holdings Ltd. ("PTP")
- Reinsurance Group of America Inc. ("RGA")
- RenaissanceRe Holdings Ltd. ("RNR")
- Swiss Re Ltd ("SREN")
- Validus Holdings, Ltd. ("VR")
Premise on Market Approach to Valuation
When utilizing a market approach, data for the Industry Group is often used to calculate valuation multiples, which compare a company's equity value or market value of invested capital (i.e., total interest-bearing debt plus the equity value) to an earnings stream such as revenue; earnings before interest, taxes, depreciation, and amortization; or net income (earnings). Valuation multiples are also calculated based on industry-specific metrics, such as premiums and annuity revenues.
Analysts estimate the value of a company by deriving valuation multiples from data on similar publicly traded companies, such as those listed above, or recent transactions involving comparable companies. Depending on the company being valued, adjustments to the multiples may be necessary to account for differing growth or risk profiles. The resulting adjusted multiple is then applied to the firm being analyzed to arrive at an indication of value.
Valuation Drivers
While there may be exceptions, for most reinsurers, value is driven by growth, profitability, and risk.
Growth
As mentioned previously, companies with greater growth prospects tend to be more valuable than those with less growth are. However, growth must be considered within the context of risk. For example, a reinsurer may exhibit slower growth than its peers do due to more conservative underwriting policies, which would normally result in lower risk. As a result, in determining an appropriate valuation multiple, the analyst should weigh the value of the reinsurer's more conservative risk profile against the negative impact of its lower growth prospects.
Profitability
In the reinsurance industry, profitability is generally driven by the occurrence (or lack) of catastrophic events, such as hurricanes, which result in large losses to reinsurers. The specific impact on a given reinsurer depends on many factors such as the following:
- each individual reinsurer's exposure to the product line in which the event occurred;
- the magnitude of the insurance event; and
- the type of the reinsurance contract (proportional or excess of loss) the reinsurer has underwritten.
In addition to claims-related expenses, profitability is affected by policy acquisition/underwriting costs, overhead costs, and investment income.
In recent years, softening prices, low investment returns, and larger claims resulting from increased catastrophe occurrences have outweighed the benefits of underwriting discipline and higher capital levels and have stagnated growth in profitability. 5
Risk
One primary risk factor for reinsurers is the risk of underwritten policies, which, as mentioned previously, should be considered in the context of the company's outlook for growth in premiums. While higher-risk policies tend to have a negative impact on value, they can also provide higher premium growth. Thus, these two effects need to be weighed in order to assess value.
Current Valuation Trends
Despite substantial catastrophe activity in 2011 and Hurricane Sandy in the fourth quarter of 2012, reinsurer capital has continued to exhibit strong growth. Reinsurance companies were able to maintain a profit in 2011, and 2012 is expected to see higher returns with only slightly above average catastrophe claims after factoring in the events of Hurricane Sandy. Reinsurer capital reached record levels in the third quarter of 2012, driven by growing investor interest in catastrophe bonds and similar financial derivatives. Over the same period, growth in demand for insurance and reinsurance has slowed. Excess capital has incentivized primary insurers to retain parts of their risk portfolios, resulting in an excess supply of reinsurance and allowing direct insurers to exert downward pressure on reinsurance pricing. These factors have pushed the valuation of many reinsurance companies downward. 6, 7
As shown in the graph below, current market valuations (measured using the price-to-next months' earnings multiple) for the Industry Group range from a low of 7.9 times earnings to a high of 26.8 times earnings, with an average of 18.8 times earnings, which is represented by the horizontal line (excluding the multiple of ENH, as it was considered an outlier, and SREN, where forward price-to-earnings multiples were not available). Differences in each company's multiples can be attributed to varying levels of exposure to damages resulting from Hurricane Sandy along with company-specific factors, such as growth strategy, product-line exposure, and risk. Companies with more exposure have projected lower earnings for the next 12 months due to increased claims. As a result, forward price-to-earnings ratios have been distorted.
Figure 1: Forward Price-to-Earnings Ratios
Insight can also be drawn from observing the price-to-net tangible book value ratios (calculated as total assets less intangible assets and liabilities) for the Industry Group. On average, reinsurers are trading at 0.94 times their net tangible book value, which is represented by the horizontal line in the graph shown above. Theoretically, net tangible book value should serve as a lower bound on the valuation company as an investor could expect to receive a comparable payout in the case of liquidation. However, an abundance of overwriting capacity, uncertain economic conditions, and the increasing frequency of natural catastrophes have influenced investors to expect lower premium revenues, inferior investment returns, and higher losses in the future. Differences in the multiples for each of the companies in the Industry Group can be attributed to a variety of company-specific factors such as growth strategy, product line exposure, and risk.
Figure 2: Price-to-Net Tangible Book Value
Transactions completed in 2012 were centered on the consolidation of reinsurance companies seeking to gain market share and diversify their risk portfolios. Mergers and acquisitions activity is expected to be robust in 2013. Consolidation among direct insurers will likely carry into the reinsurance industry as new, larger insurance companies will seek to do business with larger reinsurance counterparts. The continuing soft cycle may also drive small and midsize reinsurers to merge in order to benefit from economies of scale. Additionally, persistently low valuations make reinsurers targets for private equity funds and hedge funds seeking permanent capital. 8
Outlook for 2013
All major credit rating agencies have maintained a stable outlook for the reinsurance industry in 2013. Growth in premiums and strong capitalization will work in the industry's favor. However, excess underwriting capacity is expected to continue while capitalization outpaces growth in demand. Profitability is anticipated to decrease while pressure on premium prices and low investment yields persist. 9
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