How To Value An Insurance Company: It is obvious that Most investors avoid trying to value financial firms due to their complicated nature. However, some straightforward valuation techniques and metrics can help them quickly decide whether digging deeper into valuation work will be worth the effort. These straightforward techniques and metrics also apply to insurance companies, though there are also a number of more specific industry valuation measures. The following was given by investopadia
A Brief Introduction to Insurance
On the face of it, the concept of an insurance business is pretty straightforward. An insurance firm pools together premiums that customers pay to offset the risk of loss. This risk of loss can apply to many different areas, which explains why health, life, property and casualty (P&C) and specialty line (more unusual insurance where risks are more difficult to evaluate) insurers exist. The difficult part of being an insurer is properly estimating what future insurance claims will be and setting premiums at a level that will cover these claims, as well as leave an ample profit for shareholders.
Beyond the above core insurance operations, insurers run and manage investment portfolios. The funds for these portfolios come from reinvesting profits (such as earned premiums, where the premium is kept because no claim occurred during the policy’s duration) and from premiums before they get paid out as claims. This second category is a concept known as float and is important to understand. Warren Buffett frequently explains what float is in Berkshire Hathaway’s annual shareholder letters. Back in 2000 he wrote:
“To begin with, float is money we hold but don’t own. In an insurance operation, float arises because premiums are received before losses are paid, an interval that sometimes extends over many years. During that time, the insurer invests the money. This pleasant activity typically carries with it a downside: The premiums that an insurer takes in usually do not cover the losses and expenses it eventually must pay. That leaves it running an “underwriting loss”, which is the cost of float.
An insurance business has value if its cost of float over time is less than the cost the company would otherwise incur to obtain funds. But the business is a lemon if its cost of float is higher than market rates for money.”
Buffett also touches on what makes valuing an insurance company difficult. An investor has to trust that the firm’s actuaries are making sound and reasonable assumptions that balance the premiums they take in with the future claims they will have to pay out as insurance payments. Major errors can ruin a firm, and risks can run many years out, or decades in the case of life insurance.
Insurance Valuation Insight
A couple of key metrics can be used to value insurance companies, and these metrics happen to be common to financial firms in general. These are price to book (P/B) and return on equity (ROE). P/B is a primary valuation measure that relates the insurance firm’s stock price to its book value, either on a total firm value or a per-share amount. Book value, which is simply shareholders’ equity, is a proxy for a firm’s value should it cease to exist and be completely liquidated.
Price to tangible book value strips out goodwill and other intangible assets to give the investor a more accurate gauge on the net assets left over should the company close shop. A quick rule of thumb for insurance firms (and again, for financial stocks in general) is that they are worth buying at a P/B level of 1 and are on the pricey side at a P/B level of 2 or higher. For an insurance firm, book value is a solid measure of most of its balance sheet, which consists of bonds, stocks and other securities that can be relied on for their value given an active market for them.
ROE measures the income level an insurance firm is generating as a percentage of shareholders equity, or book value. An ROE around 10% suggests a firm is covering its cost of capital and generating an ample return for shareholders. The higher the better, and a ratio in the mid-teens is ideal for a well-run insurance firm.
Other comprehensive income (OCI) is also worth a look. This measure shows the implications of investment portfolio on profits. OCI can be found on the balance sheet, but the measure is also now on its own statement in an insurance firm’s financial statements. It gives a clearer indication of unrealized investment gains in the insurance portfolio and changes in equity, or book value, that are important to measure.
A number of valuation metrics are more specific to the insurance industry. The Combined Ratio measures incurred losses and expenses as a percentage of earned premiums. A ratio above 100% means the insurance firm is losing money on its insurance operations. Below 100% suggests an operating profit.
One investment banking report advocated a focus on premium growth potential, the potential to introduce new products, the projected combined ratio for the business, and the expected payout of future reserves and associated investment income in regard to the new business an insurance firm is generating (because of the difference in timing between premiums and future claims). Therefore, the liquidation scenario and emphasis on book value is most valuable. Also, comparable approaches that compare a firm to its peers (such as ROE levels and trends) and buyout transactions are useful in valuing an insurer.
Discounted cash flow (DCF) can be used to value an insurance firm, but it is less valuable because cash flow is more difficult to gauge. This is due to the influence the investment portfolio, and resulting cash flows on the cash flow statement, which make it harder to gauge the cash being generated from the insurance operations. Another complication mentioned above is that these flows require many years to generate.
A Valuation Example
Below is an example to give a clearer picture of the above valuation discussion. Life insurer MetLife (NYSE:MET) is one of the largest in the industry. It is the largest U.S.-based insurer based on total assets, and its market capitalizationlevel as of August 2013 was right at $53 billion, which was only exceeded by China Life Insurance Co. (NYSE:LFC) at $71 billion. Prudential plc (of the U.K.) is another large player with market caps just below $50 billion.
MetLife’s ROE has only averaged around 5% over the last five years but suffered during the financial crisis. This was below the industry average of 8% during this period, but MetLife’s ratio is projected to reach 10.2% for the current calendar year, and the company has goals to increase it closer to 15% over the next several years. China Life’s projected ROE is nearly 13%, and Prudential’s is 13.9%. MetLife is currently trading at a P/B of 0.9, which is below the industry average of 1.3. China Life’s P/B is 1.8, and Prudential’s is 3.1.
Based on the above, MetLife looks like a reasonable bet. Its ROE is returning to double digits and is above the industry average. Its P/B is also below 1, which is generally a good entry point for investors based on historical P/B trends. China Life and Prudential have higher ROEs, but P/B is also much higher. This is where it becomes important to dig deeper into each firm’ financial statements. OCI is important in investigating the investment portfolios, and analyzing growth trends will be needed to decide if paying a higher P/B multiple is warranted. If these firms outgrow the industry, they could be worth paying a premium.
The Bottom Line
As with any valuation exercise, there is as much art as science in getting to a reasonable value estimate. Historical numbers are easy to calculate and measure, but valuation is about making a reasonable estimate of what the future holds. In the insurance space, accurate predictions of metrics such as ROE are important, and paying a low P/B can help put the odds in investors’ favor.
The above data was taken from a different source to analyze the different level of some insurance companies. From the analysis, we have been able to come out with everything on Learn How To Value An Insurance Company. Kindly share this article with your friends on social media below.
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