This article discusses some of the factors that impact the valuation of reinsurance businesses and how certain trends and expectations for the reinsurance industry may be affecting the market's current valuations of reinsurance companies.
The US reinsurance industry is somewhat concentrated. The number of businesses competing within the industry as reported by IBISWorld declined to 142 from 159 since the previous update, mostly as a result of consolidation. The largest two industry participants, General Re (a division of Berkshire Hathaway) and Reinsurance Group of America, hold approximately 25 percent and 8 percent of market share, respectively. 1 Furthermore, Moody's foresees continued merger and acquisition activity in the sector due to increased consolidation among primary insurers as well as the accelerating inflow of competing alternative capacity. 2
Similar to traditional insurance companies, 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.
Currently, the reinsurance industry faces a continuing soft cycle, and the record issuances of insurance‑linked securities (ILS) have lessened the likelihood of rate increases in the near term. 3 ILS includes a range of financial instruments, most notably catastrophe bonds, which are issued to provide insurance or reinsurance protection to insurers, reinsurers, governments, and corporations. ILS issuances allow investors to be exposed to the unique risk and return profile of reinsurance, which is attractive due to its independence from financial market returns. By selling policies bundled as ILS, reinsurers are able to access a more diversified capital pool and reduce credit risk relative to bearing all liability for the insured losses themselves. 4
Industry experts warn that the reinsurance industry has become commoditized, and firms must either create more specialized offerings or achieve economies of scale if they wish to remain competitive. As a result, collected premiums have remained below prerecession levels while continuing to fall. Additionally, depressed interest rates continue to plague industry participants as they have struggled to achieve satisfactory returns on investments. Furthermore, due to industry consolidation, demand for reinsurance is expected to face headwinds as merged entities have lower-capital requirements through risk diversification. 5
Public Guideline Companies
In the process of analyzing and valuing a company, it can be helpful to look at the recent and expected performance of other companies operating in the same industry. Publicly traded guideline companies can be used to develop a range of valuation multiples that may be applicable to a subject company. 6 Listed below is a group of publicly traded companies (the "Industry Group") that are generally representative of the reinsurance industry.
| Alleghany Corporation (Y) | Maiden Holdings, Ltd. (MHLD) |
| Blue Capital Reinsurance Holdings Ltd. (BCRH) | Munich Re (MUV2) |
| China Reinsurance (Group) Corporation (1508) | Reinsurance Group of America, Incorporated (RGA) |
| Endurance Specialty Holdings Ltd. (ENH) | RenaissanceRe Holdings Ltd. (RNR) |
| Enstar Group Limited (ESGR) | SCOR SE (SCR) |
| Everest Re Group, Ltd. (RE) | Third Point Reinsurance Ltd. (TPRE) |
| Greenlight Capital Re, Ltd. (GLRE) | Validus Holdings, Ltd. (VR) |
| Hannover Rück SE (HNR1) | Swiss Re Ltd. (SREN) |
Market Approach to Valuation
Analysts can calculate a value for a firm by deriving multiples from data on similar publicly traded companies or recent transactions involving similar companies. The resulting multiple can be adjusted as appropriate and applied to the firm being analyzed to arrive at an indication of value.
Data from S&P Capital IQ (a division of Standard and Poor's) can be used to calculate valuation multiples for the Industry Group. A valuation multiple compares 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 can also be calculated based on industry-specific metrics, such as premiums and annuity revenues. However, in the case of reinsurance companies, which assume residual risk, earnings streams tend to be volatile even after making adjustments that are typically applied in valuing other types of carriers. Consequently, earnings-based metrics frequently used in a valuation context, such as the forward price‑to‑earnings ratio, tend to lose their significance. A more common valuation metric used for the reinsurance industry is the price-to-tangible book value ratio ("P/TBV").
Valuation Drivers
While there may be exceptions, for most reinsurers, value is driven by growth, profitability, and risk.
Growth
Companies with greater growth prospects tend to be more valuable than those with less growth potential. However, growth must be considered within the context of risk. For example, a reinsurer may exhibit slower growth than its peers 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 for property and casualty reinsurers, which result in large losses. The specific impact on a given reinsurer depends on many of the following factors.
- Each individual reinsurer's exposure to the product line in which the event occurred
- The magnitude of the insurance event
- 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.
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, policy risk and growth potential need to be considered together in order to assess value.
Current Valuation Trends
Reinsurer capital bounced back to match the first quarter of 2015's record high of $580 billion in the first quarter and has increased nearly 70 percent since 2008 on a cumulative basis. 7 Supporting this growth in capital, global catastrophe losses for 2015 decreased for the fourth consecutive year to $32 billion, the lowest level since 2009. 8 However, as of June 30, 2016, year-to-date catastrophe losses totaled $28 billion, which suggests that 2016 is currently on pace to have the most global insured losses since 2012 due to more frequent severe storms and natural disasters.
A concern raised by major reinsurance brokers during 2016 is the possibility that reinsurance has entered a permanent soft market due to the abundance of available reinsurance capital from both traditional and new sources. Lower-cost underwriting capital is available today through sponsored hedge fund reinsurers, pension funds, and other sources that are willing to accept lower premiums in order to take on the risk and return profile of reinsurance that was previously unavailable to investors not operating in the industry. Previous cycles are explained as market inefficiencies in pricing the probability and impact of future catastrophic events that are much better understood at present. 9 Further, they see overall rate reductions slowing but without any indication of widespread pricing stabilization that could signal the end of a cycle, as well as continuing low investment returns due to low and negative interest rates spurred on by economic uncertainty and political events, including Brexit. 10
Many of these factors have impacted the financial position of reinsurers. As a result, while industry profits have declined to 14.8 percent of revenue in 2016 from 18.4 percent in 2011, this profit level appears to have less year-over-year variability compared to historical averages. 11 Investment income has become scarcer since the last update, making up only 19.6 percent of revenues versus 25 percent before, with interest rates showing no obvious signs of returning to normalized levels during 2016. Due to premiums being set based on metrics such as the London Interbank Offered Rate, reinsurer profitability has experienced downward pressure, particularly when investment returns are not proportionally offset with a bullish equity market such as the first half of 2016. Therefore, the outlook for investment returns for the industry remains largely uncertain in light of the uncertain prospects of interest rates, equity markets, and geopolitical events.
Mergers and acquisitions activity in the industry was extremely robust during the latter half of 2015 with a deal value of 187 percent higher ($89 billion versus $31 billion) than 2014. As discussed previously, consolidation among reinsurers is expected to remain strong due to continued pressure on returns, heightened interest in international exposure, and willingness to accept dilution of tangible book value in exchange for strategic benefits. The current soft market is also likely to drive small and midsize reinsurers to merge in order to benefit from economies of scale. 12
As shown in the following graph, current market valuations (measured using P/TBV) for the Industry Group ranged from a low of 0.86 times to a high of 1.35 times, with an average of 1.03 times. Differences in each company's multiples can be attributed to varying levels of exposure to catastrophe risk along with company-specific factors such as growth strategy, product-line exposure, and profitability.
Insights can also be drawn from observing historical ratios and trends for the Industry Group. We looked at monthly data from January of 2010 to July of 2016. Presented below is the summary of our analysis.
Since January 2010, the Industry Group has traded at an average 0.97 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 company valuation, as an investor could expect to receive a comparable payout in the case of liquidation. Furthermore, one would expect that the average P/TBV of the Industry Group would trend toward 1.0 times, as this would imply that the underlying companies were worth the amount of capital they carried on their books.
The trend line on the graph demonstrates that the Industry Group's average annual P/TBV began to increase from depressed levels in 2012 and converged at 1.02 and 1.03 times book value in 2014 and 2015, respectively. The lack of catastrophic events and a more optimistic market after the end of the recession have likely been the drivers of multiple expansion since 2012. Growth for industry participants is reflected by an approximate 3 percent increase in overall reinsurance capital in the first quarter of 2016 despite premiums remaining near depressed rates. Competing market capacity increased by 1.4 percent over the same period, which includes catastrophe bonds, sidecars, and nontraditional suppliers, including hedge fund reinsurers. Higher-growth expectations typically yield higher valuations. Thus, if the soft market dissipates or catastrophe levels decline from their current uptick, valuations could increase from current levels.
Outlook for 2016
As a result of a number of factors including slightly higher-catastrophe losses, an abundance of underwriting capacity, uncertain economic conditions, commoditization of services, and pricing pressure from alternative capacity, P/TBV multiples have begun to revert toward the 1.0 times benchmark during the first half of 2016. Demand for reinsurance is expected to decline going forward as further consolidation, more advanced risk modeling, and more efficient capital management lead to lower capital requirements. However, the prolonged soft market could come to a close in the event that excess capacity exits the market due to a large catastrophe causing alternative capital to flee the market or global interest rates rise, thereby relieving pricing pressure. 13 Consequently, the unpredictability of these events is reflected in market pricing.
Furthermore, consolidations within the industry, combined with more specialized offerings and disciplined underwriting, are expected to partially offset the effects of lower-expected premiums and investment returns. Accordingly, the overall outlook for the industry and value implications for the industry participants largely depends on whether interest rates rise and financial markets stabilize in the near term. 14
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