Insurance Industry Mergers and Acquisitions

Question 1

Challenges in determining the value of an insurance company (9)

Answer 1

1. Long duration of liabilities
2. Sensitivity to interest rate fluctuations and the performance of capital markets
3. Subjective art of loss reserving
4. Cyclical nature of insurance
5. Impact of reinsurance recoverables
6. Challenges associated with non-market competitors, such as state funds
7. Varying state and sometimes federal regulations
8. Impact of statutory accounting on operational decisions
9. Influence of rating agencies

Question 2

Techniques used by investment bankers to determine the value of a company (3)

Answer 2

1. Comparable company analysis - the value of the company is estimated based on the values of a peer group of comparable companies
2. Comparable transaction analysis - the value is estimated based on results of recent insurance mergers that are similar
3. Discounted cash flow analysis - the projected cash flows and terminal values are discounted to a net present value using the WACC

Question 3

Formulas for using a discounted cash flow analysis in an actuarial appraisal

Answer 3

1. An actuarial appraisal is a discounted cash flow analysis
2. Actuarial appraisal value = PV(distributable cash flows)
3. Distributable cash flow = after-tax earnings - increase in required capital
4. The discount rate is the weighted average cost of capital (WACC) from the Capital Asset Pricing Model
5. WACC = r = rD * %debt + rE * %equity, where
   rD = required after-tax return on debt
   rE = expected return on equity = rF + beta * (rM - rF)
   rF = risk-free rate of return
   beta = the risk level of a company’s stock
   rM = expected rate of return for the market as a whole
   %debt = D / (D + E)
   %equity = E / (D + E)
   D = market value of a company’s debt
   E = market value of a company’s equity

Question 4

Components of the actuarial appraisal value (3)

Answer 4

1. Adjusted book value - the net worth of the insurance company on a statutory basis, adjusted for the value of misc. items not captured elsewhere (see separate list)
2. Value of inforce business - the present value of future profits arising from business that is on the books as of the valuation date. An adjustment is included to reflect the cost of capital
3. The value of future business capacity - the present value of future profits arising from business that is expected to be written following the valuation date. An adjustment is included to reflect the cost of capital.

Question 5

Uses of an actuarial appraisal (4)

Answer 5

1. Help value the company - potential buyers will make adjustments to the actuarial appraisal based on their internal views (see separate list)
2. Form the basis for alternate accounting methods for cross-border transactions
3. Can be adjusted to calculate pro forma earnings and to establish the opening purchase GAAP balance sheet
4. Measure ongoing performance after the acquisition

Question 6

Adjustments to the actuarial appraisal made by potential buyers (14)

Answer 6

1. Discount rate - buyer will reflect its internal view of the appropriate discount rate
2. Experience and product management assumptions - a buyer may adjust certain assumptions based on its internal views.
3. New business values - a buyer may adjust new business values based on its view of future business capacity
4. Synergies - buyer may reflect the benefits from anticipated synergies or cost savings
5. Structure - buyer may reflect the impact on the business of the buyer’s tax and capital structure
6. Company size
7. The company’s other LOBs
8. Effectiveness in managing admin expenses
9. Marketing distribution channels
10. Ability to negotiate competitive provider reimbursement arrangements
11. Effectiveness in managing claim costs
12. Geographical location
13. Experience in merging blocks of business
14. Strategic value of purchasing the block of business

Question 7

Assumptions needed for actuarial appraisals (15)

Answer 7

1. Mortality - typically based on company experience compared to an industry standard
2. Morbidity - also based on company experience
3. Persistency - lapse assumptions and any shock lapses should be considered
4. Investment returns and spreads - consider expected investment returns, reinvestment rates, and interest rates credited on insurance policies
5. Operating expenses - this assumption could be based on various approaches (most commonly based on target unit expenses plus an unallocated expense)
6. Discount rate - seller typically gives a range of reasonable rates instead of a specific rate (the CAPM may be used to determine this rate)
7. Cost of required capital - the company will have an opportunity cost associated with setting aside capital to comply with required capital regulations
8. Taxes - the actuarial appraisal should reflect a deduction for federal income taxes
9. Premiums
10. Rate increases
11. Claim reserves and liabilities
12. Unearned premium reserves
13. Active life reserves
14. Commissions
15. Reinsurance

Question 8

Components of the adjusted book value (or net worth) of an insurance company (9)

Answer 8

1. Capital and surplus - includes statutory capital stock, contributed surplus, and retained earnings
2. Asset valuation reserve (AVR) - this liability is part of surplus and is allocated to the lines of business
3. Interest maintenance reserve (IMR) - this liability represents past interest-related capital gains not yet amortized into income
4. Deferred tax asset - the admitted portion of the statutory deferred tax asset is deducted from adjusted book value
5. Non-admitted assets - the realizable value of assets that were non-admitted for statutory purposes, if they will contribute to earnings over time
6. Surplus notes and other debt - a reduction is appropriate for any debts owed to another party
7. Mark-to-market on assets allocated to adjusted book value - this component reflects some riskier assets that are allocated to adjusted book value
8. Adjustment in the value of certain admitted assets that the user values differently than the reported statutory value
9. Adjustment in the value of certain liabilities that the user values differently than the reported statutory value (for example, claim reserves)

Question 9

Approaches for using reinsurance to sell a block of business (3)

Answer 9

1. Assumption reinsurance - contracts are transferred from the seller’s books to the buyer’s books. The policyholder must be notified, and some states require policyholder consent to transfer the policy.
2. Indemnity coinsurance - the financial interest is transferred to the buyer, but the policy stays with the seller. The policyholders do not need to be notified, but the seller remains in the middle of future transactions.
3. Modified coinsurance - similar to indemnity coinsurance, except that the assets backing the liabilities remain with the selling company

Question 10

Other rates for discount rate (3)

Answer 10

1. ) Internal company targets - internal hurdle rates.
2. ) Cost of funds for transaction
3. ) MA marketplace discount rates - reflect supply and demand, nature of buyers, cost of financing and type of business sold.

Question 11

Sellers typically include additional info with actuarial appraisal (8)

Answer 11

1. ) Descriptions of scope of assignment and intended use
2. ) Methodology and assumptions
3. ) Validation techniques and results
4. ) Adj to value net worth
5. ) Provisions for COC
6. ) Any deviations from the standard
7. ) Any reliances and limitations placed on work product
8. ) Determination of fed income taxes