Insurance Valuation Questions Flashcards
How do you screen for Public Comps and Precedent Transactions for an insurance company?
You use criteria such as Total Assets, Written Premiums, or Earned Premiums rather than Revenue or EBITDA; geography is also very important due to regulations, as is the subsector of the companies (you should not compare diversified insurance firms to ones that only do Life or P&C).
What other multiples might you use for insurance firms in addition to P / E, P / BV, and P / TBV?
If the insurance firms you’re analyzing do not mark their Balance Sheets to fair market value, you could also use P / NAV (Equity Value / Net Asset Value). Other options include the P / GWP (Equity Value / Gross Written Premiums) and P / NWP (Equity Value / Net Written Premiums) multiples, which are similar to revenue or bookings multiples for normal companies. On the Life Insurance side, there’s also Embedded Value and Embedded Value-based multiples such as P / EV (see the Embedded Value questions below).
Why might the P / E and P / BV multiples be misleading for insurance firms?
Just like commercial banks can distort these multiples by over- or under-provisioning, insurance firms can do the same thing with their reserves, such as the Loss & LAE or Claims Reserve. If the company keeps recording aggressive Claims expenses on the Income Statement, for example, its Net Income will be lower, and so will its Book Value (since its Reserves on the L&E side will be higher). Those changes, in turn, will increase its P / E and P / TBV multiples.
How does a Dividend Discount Model (DDM) work for an insurance company?
The basic setup is similar to the one for commercial banks: You “back into” the firm’s Dividends based on its targeted Regulatory Capital, but with insurance, that target is based on the SCR Coverage Ratio or Solvency Ratio rather than the CET 1 or Tier 1 Ratio. You start by assuming an Asset Growth Rate or Premiums Growth Rate and using that as the key driver; you might base the company’s Net Income on ROA, ROE, or related metrics. You then make assumptions for the firm’s Required Capital and Available Capital, often linking them to firm’s Total Assets and Statutory Capital & Surplus, respectively. Then, you back into the Dividends by assuming that the firm meets the minimum SCR Coverage Ratio or Solvency Ratio it is targeting. Finally, you discount all the Dividends to their Present Value, add them up, calculate the Terminal Value with P / E, P / BV, or P / TBV, discount that to its Present Value, and add it to the Sum of the PV of Dividends to determine the firm’s Implied Equity Value.
Walk me through a Net Asset Value (NAV) Model for an insurance firm.
First, you adjust everything on the Assets side up or down based on its fair market value. Goodwill & Other Intangibles usually goes to $0, and Reinsurance Recoverables are often discounted because of the risk of a reinsurer not paying out Claims; investments may also be marked to market. Next, you adjust the firm’s Liabilities, and you may discount some of the Reserves depending on the trends in Premiums and Claims. Then, you subtract the Adjusted Liabilities from the Adjusted Assets to calculate the Net Asset Value. You may make another adjustment at this stage if there’s Excess or Deficit Capital (e.g., the firm is targeting a 200% SCR Coverage Ratio but is only at 150% currently). Finally, you divide the NAV by the Shares Outstanding to get NAV per Share, which you can then compare to the company’s current share price.
Walk me through an Embedded Value model for a Life Insurance firm.
Embedded Value = Net Asset Value + Present Value of Future Cash Profits from Current Policies. You start by calculating the firm’s Net Asset Value, marking everything to market value (if the firm doesn’t already do that), and then subtracting all the Liabilities from all the Assets. Then, you assume that the insurance company writes no new policies in future years so that its expected after-tax cash flows all depend on its policies as of today. You project the firm’s revenue based on its Net Earned Premiums and “Lapse Rate,” which represents cancellations (remember, no new policies), plus Interest and Investment Income. The main expenses include Cash Claims, Cash Commissions, and other Cash Operating Expenses. You might estimate these with the changes in the company’s Reserves in past years. Then, you multiply Pre-Tax Income by (1 – Tax Rate) to calculate the After-Tax Cash Flow from the policies in each year; if the company needs more or less capital, you also factor that in, along with the after-tax interest on it. You project these figures until the policies “run out” (i.e., until their terms end or cancellations reduce revenue to $0). Then, you take the Present Value of those After-Tax Cash Flows, using Cost of Equity for the Discount Rate, and add it to the firm’s Net Asset Value to determine its Embedded Value. You might project Embedded Value in a model by assuming that the company writes new policies each year, but Embedded Value in a specific year is always based on just the firm’s policies as of that year.
Why does Embedded Value only apply to Life Insurance firms?
Life Insurance companies have extremely long-term policies (20-30 years or more), so policies written today may still be generating cash flows decades into the future, and they’ll contribute significantly to a firm’s Implied Equity Value. Embedded Value doesn’t make sense for P&C Insurance firms because their current policies might only last for 1-3 years. So, very little of the firm’s Implied Equity Value would come from the Present Value of Future Cash Profits from Current Policies. You’d have to assume that the P&C Insurance firm keeps writing new policies in future years for the analysis to make sense, and if you do that, you might as well just use a Dividend Discount Model.
How do you calculate Embedded Value Profit, an alternative to Net Income?
Embedded Value Profit = Value of New Business + Unwind of Discount Rate Value of New Business: Let’s say that a firm writes a new set of policies and that the Present Value of Future Profits from them is $500 when the firm initially writes them. In the next year after that initial year, the Value of New Business would be $500 because that’s the “new business” that the company just wrote. Unwind of the Discount Rate: This is the Discount Rate * the PV of Future Profits from that initial year. So, if the Discount Rate is 10%, the Unwind of the Discount Rate is $50 here. The Embedded Value Profit, therefore, is $550. This number is an “alternative way” of viewing the firm’s profitability; unlike Net Income, it is based on expected future cash flows. Cash Profit vs. Embedded Value Profit for a single policy over a 20-year time frame looks like this:
If a Life Insurance firm keeps growing and writing new policies each year, how does its Embedded Value Profit change over time?
All else being equal, the Embedded Value Profit keeps increasing because the Value of New Business keeps increasing if the company is growing. In the graph above, the Embedded Value Profit decreases from Year 1 to Year 2 because it corresponds to one policy written in a single year, and we assumed that the firm writes no new policies.
Will the Embedded Value and Shareholders’ Equity (or NAV) of a Life Insurance firm ever converge on the same value?
They will converge only if the firm stops writing policies, or if you’re only calculating the cash flows for a single policy written in a single year (as in the example above). They will converge in the year that the policy’s cash profit goes to $0. Here’s what it looks like if that happens in Year 20 (assuming the firm only writes new policies once in the beginning):
Are Embedded Value and EV Profit more conservative or more aggressive than traditional metrics like Shareholder’s Equity and Net Income?
They’re more aggressive because they are based on the Present Value of expected future profits. The total profits over the term of a policy are the same, but under Embedded Value, the firm recognizes them earlier on.
How do Market Consistent Embedded Value (MCEV) and European Embedded Value (EEV) differ from normal Embedded Value?
With EEV, you also adjust for Net Unrealized Gains when calculating the Net Asset Value of a company. And rather than just discounting and summing up future profits, you also factor in the Cost of Capital and the Value of Options and Guarantees (by subtracting both). With MCEV, you discount the cash flows at different rates, and you also recognize investment returns above the risk-free rate as they’re earned, rather than entirely upfront.
