The Application Of Fundamental Valuation
Principles To Property/Casualty Insurance Companies
Derek A. Jones, FCAS
Joy A. Schwartzman, FCAS
Valuation Principles
1.
The value of any business has two
determining factors:
The future earnings stream generated
by a company’s assets and liabilities.
ii. The risk (or “volatility”) of the stream of
earnings.
i.
This risk is reflected in the cost to the
entity of acquiring capital, measured by
the investors’ required rate of return
(“hurdle rate”).
2
Valuation Principles
2.
For a given level of future risk, the
greater the PV of expected profits the
greater the value.
3.
For a given level of future profitability, the
greater the volatility (i.e., the higher the
hurdle rate), the lower the value of the
business.
3
Valuation Principles
4.
A company has value in excess of its invested
capital only when future returns are in excess of
the hurdle rate.
5.
When a company is expected to produce an
earnings stream that yields a return on invested
capital that is less than the hurdle rate, the
economic value of the required capital is less
than its face value.
In this case, the logical action would be to
liquidate assets.
4
Valuation
Financial Professionals
Value = PV of Future Cash Flows
Where cash flows represent
dividendable earnings or earnings
that can be released to investors
Actuaries
Value = ANW + PV of Future Earnings – COC
Where ANW = adjusted net worth
PV = Present Value
COC = Cost of Capital
5
Valuation Literature
1.
Discounted Cash Flows “DCF”
A DCF model discounts free cash flows at
the hurdle rate to determine value
2.
Economic Value Added “EVA”
An EVA model defines
Value =
Initial capital invested
+
PV of “Excess returns”
6
To Value An Entity…

Financial Professionals Commonly use
DCF Methodology

Actuaries commonly use EVA
Methodology

When the underlying assumptions are
common, the two methodologies yield
identical results.
7
What are these assumptions…
I.
Starting capital
II.
After-tax annual operating income
III.
Capital required at the beginning of each
year to support operations
IV.
The hurdle rate
8
Discounted Cash Flow Value

Represents the PV of distributable
earnings

PV is based on hurdle rate, which is
the return required by investors to
provide capital
9
Discounted Cash Flow Value

Distributable earnings are based on
after tax operating earnings of the entity
plus any additional capital releases,
minus any capital infusions

Capital releases or infusions are a
function of the capital needed to
support the following years’ operations.
10
Discounted Cash Flow Value

Company’s initial capital is reflected only
to the extent:
a) it is released
or
b) it generates operating earnings
11
Discounted Cash Flow Value

Distributable earnings often projected
in two components
a) Value of an explicit forecast period
– say 5 to 10 years
b) Value associated with the entity
after the explicit forecast period:
the “Terminal Value”
12
Discounted Cash Flow Value

Value of explicit forecast period based on
detailed annual earnings projections reflecting
a) Revenues (premiums)
b) Loss and Loss Adjustment Expenses
c) Acquisition and Operating Expenses
d) Investment Income
e) Taxes
f) Assets
g) Liabilities
h) Initial Capital to Support Operations
i) Capital Infusions or Releases to Support
Operations
13
Discounted Cash Flow Value

Terminal Value (“TV”) represents the
value of the company associated with
earnings after the explicit earnings
period, discounted back to the valuation
date.

TV often calculated from earnings from
last year of explicit forecast period,
multiplied by a P/E factor.
14
Discounted Cash Flow Value

The P/E factor can be based on sale prices of
recent insurance company transactions.

Any P/E factor can be mathematically distilled
to an implicit earnings growth rate (“g”) and
hurdle rate (“h”)

P/E =

For example, with a growth rate of 5% and
hurdle rate of 15%, P/E =
15
Discounted Cash Flow Value
In summary inputs to compute DCF value are…

Starting capital of the entity less initial capital
required to determine free cash flow (at T=0)
 Annual after-tax operating earnings
 Marginal capital required at the start of each
earnings period
 The hurdle rate
DCF Value = Free Capital +
16
Economic Value Added

Value
= Initial Capital
+ PV “Excess Returns”:
Where excess returns
= after-tax operating earnings
– (hurdle rate x capital invested)

Therefore, Value EXCEEDS initial capital only
if earnings EXCEED investors’ required return
(the “hurdle rate”)
17
For Valuing an Insurance
Company …

Value = ANW + PVFE – COC
“ANW” represents Initial Capital
“PVFE – COC” represents excess
returns
PVFE = PV [after tax operating
earnings]
COC = PV [each period starting
capital x hurdle rate]
18
For Valuing an Insurance
Company…

Initial Capital represented by
Statutory capital and surplus, with
certain modifications
19
For Valuing an Insurance
Company…

Statutory earnings form the basis of
after-tax operating earnings. Earnings
include:
i.
ii.
iii.
Runoff of existing balance sheet
assets and liabilities
Earnings contributions from renewal
business
Earnings contributions from new
business
20
For Valuing an Insurance
Company…

Cost of capital is computed as:
PV (hurdle rate x the starting
capital in each period)

PV of statutory earnings and cost
of capital computed using the
hurdle rate
21
In Summary Inputs to Compute EVA
Value and to Value an Insurance
Company are …

Starting capital of the entity

Required capital at the start of each
earnings period

Annual after-tax operating earnings

The hurdle rate
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Valuation Results
Scenario 1A
Initial Capital = $100
Hurdle Rate 15%
Total Earnings = Hurdle Rate
Table 1
Valuation Results
Earnings Growth Rate = 0%
Model
DCF
EVA
10 Year
Terminal
Value
Forecast Period
75
100
23
25
0
Total
100
100
Valuation Results
Scenario 1B
Initial Capital = $100
Hurdle Rate 15%
Total Earnings = Hurdle Rate
Table 2
Valuation Results
Earnings Growth Rate = 3%
10 Year
Forecast Period
Terminal
Value
Total
DCF
67
33
100
EVA
100
0
100
Model
24
Valuation Results
Scenario 2A
Initial Capital = $100
Hurdle Rate 15%
Total Earnings > Hurdle Rate
Table 3
Valuation Results
Earnings Growth Rate = 0%
10 Year
Forecast Period
Terminal
Value
Total
DCF
80
26
106
EVA
105
1
106
Model
25
Valuation Results
Scenario 2B
Initial Capital = $100
Hurdle Rate 15%
Total Earnings > Hurdle Rate
Table 4
Valuation Results
Earnings Growth Rate = 3%
10 Year
Forecast Period
Terminal
Value
Total
DCF
74
36
110
EVA
107
3
110
Model
26
Valuation Results
Scenario 3A
Initial Capital = $100
Hurdle Rate 15%
Total Earnings < Hurdle Rate
Table 5
Valuation Results
Earnings Growth Rate = 0%
10 Year
Forecast Period
Terminal
Value
Total
DCF
70
23
93
EVA
95
(2)
93
Model
27
Valuation Results
Scenario 3B
Initial Capital = $100
Hurdle Rate 15%
Total Earnings < Hurdle Rate
Table 6
Valuation Results
Earnings Growth Rate = 3%
10 Year
Forecast Period
Terminal
Value
Total
DCF
60
30
90
EVA
93
(3)
90
Model
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Practical Considerations

Accounting Standard

How to Modify Initial Capital & Surplus

Composition of Free Cash Flow (DCF)
or Increments of Added Value (EVA)

Hurdle rate
29
Accounting Standard
ASOP 19: based on “regulatory
earnings”
 Constraints on dividends to equity
owners:

– Accumulated earnings
– Minimum capital and surplus
requirements

SAP is current starting point
30
Accounting Developments

Codification of SAP (2001)
– Deferred taxes
– Premium deficiency reserve

Fair Value Accounting
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Balance Sheet Adjustments
Loss reserve adequacy
 Market value of assets
 Inclusion of non-admitted assets
 Accounting goodwill
 Statutory provision for reinsurance
 Tax issues

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Estimating Net Income

After-tax operating earnings
– Runoff of existing balance sheet
– Future written business

“Below the line” adjustments to surplus
33
Runoff of Existing Balance Sheet

Earnings are related to:
– Underwriting profit in UEPR
– Investment income on assets supporting
loss reserves and UEPR
– Investment income on capital supporting
the runoff
34
Future Written Business
New and renewal business is not
usually split for P&C (unlike Life)
 Personal Lines is an exception
 Projections typically made at LOB level

35
Hurdle Rate
Reflect the cost of acquiring capital
needed to perform transaction
 Typically provided by management
 Can be estimated by various security
valuation methods

36
Hurdle Rate Considerations
Risks attributable to business activities
of target
 Consideration of multiple hurdle rates
 Method of financing acquisition
 Consistency with other assumptions

37
Q&A
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