Analysis and Valuation of Insurance Companies

Analysis and Valuation of Insurance Companies

Industry Study Number Two

Center for Excellence in Accounting and Security Analysis

Columbia Business School established the Center for Excellence in Accounting and Security Analysis (CEASA) in 2003 under the direction of Professors Trevor Harris and Stephen Penman. The center aims to be a leading voice for independent, practical solutions for financial reporting and security analysis, promoting financial reporting that reflects economic reality, and encouraging investment practices that communicate sound valuations. CEASA's mission is to develop workable solutions to issues in financial reporting and accounting policy; produce a core set of principles for equity analysis; collect and synthesize best thinking and best practices; disseminate ideas to regulators, analysts, investors, accountants, and management; and promote sound research on relevant issues. Drawing on the wisdom of leading experts in academia, industry, and government, the center produces sound research and identifies best practices on relevant issues. CEASA's guiding criterion is to serve the public interest by supporting the integrity of financial reporting and the efficiency of capital markets. Located in a leading university with a mandate for independent research, CEASA is positioned to spearhead a discussion of issues, with an emphasis on sound conceptual thinking and without obstacles of constituency positions. More information and access to current research is available on CEASA's website at . CEASA is supported by its generous sponsors--General Electric, IBM, and Morgan Stanley--and gratefully acknowledges the support of these organizations and their recognition of the need for excellence in accounting and security analysis.

Industry Study Comment

These studies are intended to provide readers with a comprehensive review of the pertinent accounting conventions, academic literature, and approaches to security analysis.

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Center for Excellence in Accounting and Security Analysis

ANALYSIS AND VALUATION OF INSURANCE COMPANIES

Doron Nissim; Ernst & Young Professor of Accounting and Finance, Columbia Business School

Center for Excellence in Accounting & Security Analysis

November 2010

Table of Contents

Overview ....................................................................................................................................................................... 2 1. Business ....................................................................................................................................................................3

1.1 Activities and Organization ................................................................................................................................3 1.2 Products and Services.......................................................................................................................................20 1.3 Distribution Channels.......................................................................................................................................25 1.4 Competition.......................................................................................................................................................28 1.5 Regulation.........................................................................................................................................................30 1.6 Taxation ............................................................................................................................................................40 1.7 Risks and Risk Management .............................................................................................................................44 2. Financial Reporting and Line-Item Analysis ......................................................................................................68 2.1 Common-Size Financial Statements..................................................................................................................71 2.2 Insurance Reserves and Related Expenses .......................................................................................................76 2.3 Revenue and Related Accruals..........................................................................................................................95 2.4 Deferred Policy Acquisition Costs and Related Expenses ................................................................................97 2.5 Reinsurance ....................................................................................................................................................100 2.6 Investment Assets ............................................................................................................................................103 2.7 Separate Accounts...........................................................................................................................................110 2.8 Debt.................................................................................................................................................................111 2.9 Derivatives ......................................................................................................................................................115 3. Valuation ..............................................................................................................................................................120 3.1 What Drives Value? ........................................................................................................................................120 3.2 Profitability.....................................................................................................................................................123 3.3 Accounting Quality .........................................................................................................................................131 3.4 Growth ............................................................................................................................................................134 3.5 Cost of Equity Capital.....................................................................................................................................138 3.6 Macro, Industry-Wide, and Line-Specific Drivers ..........................................................................................143 3.7 Valuation Models............................................................................................................................................145 Conclusion ................................................................................................................................................................162 References ................................................................................................................................................................163 Acknowledgments ....................................................................................................................................................178

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Overview

During 2008 and 2009, the insurance industry experienced unprecedented volatility. The large swings in insurers' market valuations, and the significant role that financial reporting played in the uncertainty surrounding insurance companies during that period, highlight the importance of understanding insurers' financial information and its implications for the risk and value of insurance companies. To facilitate an informed use of insurers' financial reports, this manuscript reviews the accounting practices of insurance companies, discusses the financial analysis and valuation of insurers, summarizes relevant insights from academic research, and provides related empirical evidence.

The paper contains three sections. The first section describes the insurance business, including activities and organization of insurance companies, products and services, distribution channels, competition, regulation, taxation, and risks and risk management. The second section discusses how insurance activities are reflected in financial reports. Specifically, for each key line item from insurers' financial statements, the study provides evidence on the economic significance of the item, reviews the related US accounting principles, discusses earnings quality issues, describes analyses and red flags that inform on the item's quality, reviews selected research findings, and describes the primary differences between International Financial Reporting Standards (IFRS) and US GAAP.

Building on the discussion and analyses in the previous two sections, the third section addresses the valuation of insurance companies. The section starts by discussing the primary drivers of insurers' intrinsic value, including profitability, growth prospects and cost of equity capital, as well as accounting quality indicators that inform on the reliability of the measured drivers. It then describes relative and fundamental valuation models that translate those fundamentals into value estimates. Finally, in the context of fundamental valuation models, the study presents a template for forecasting the key financial statement line items of insurance companies.

This document is rather long and its efficient use, therefore, requires an understanding of the structure and content of the different sections. The first two sections of the document are mostly descriptive, while the final section is primarily prescriptive. All three sections discuss academic papers, often with significant details. To increase the usefulness of the literature review, the papers are discussed in separate categories by main focus. However, many of the studies provide evidence relevant to multiple categories. The subsections containing detailed discussions of academic research usually follow a summary of the main findings and can generally be skipped without loss of continuity.

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1. Business

This section describes the business of insurance. It is divided into seven subsections: the primary activities and organization of insurance companies (subsection 1.1), the products and services offered by insurance companies (1.2), distribution channels (1.3), competition (1.4), regulation (1.5), taxation (1.6), and risks and risk management (1.7).

1.1 Activities and Organization

Insurance provides economic protection from identified risks occurring or discovered within a specified period. Insurance is a unique product in that the ultimate cost is often unknown until long after the coverage period, while the revenue--premium payments by policyholders--are received before or during the coverage period.

Insurance contracts are classified as either property and casualty (PC) or life and health (LH) policies:

PC insurance ? contracts providing protection against (a) damage to or loss of property caused by various perils, such as fire, damage or theft, (b) legal liability resulting from injuries to other persons or damage to their property, (c) losses resulting from various sources of business interruption, or (d) losses due to accident or illness.

LH insurance ? contracts that pay off in lump sums or annuities upon the insured's death, disability, or retirement.

Some insurance policies, primarily health-related policies, have both PC and LH characteristics and can therefore be classified as either PC or LH.

Most insurance companies specialize in either PC or LH insurance, but some have significant operations in both segments. In addition, while many insurers underwrite reinsurance policies (insurance sold to insurers), some focus on reinsurance as their core activity. Insurers increasingly offer products and services that involve little or no insurance protection, such as investment products and fee-based services. The industry also includes companies that provide insurance brokerage services (sourcing of insurance contracts on behalf of customers). Reflecting this variation in activities, the Global Industry Classification (GIC) system classifies insurance companies as follows:

Life and Health Insurers (40301020) ? Companies providing primarily life, disability, indemnity or supplemental health insurance. This category excludes managed health care companies, which are included in the Health Care sector. Examples include MetLife Inc. (MET), Prudential Financial (PRU), AFLAC Inc. (AFL), Lincoln National Corp. (LNC), Unum Group (UNM), and Torchmark Corp. (TMK).

Property and Casualty Insurers (40301040) ? Companies providing primarily property and casualty insurance. Examples include Berkshire Hathaway Inc. (BRK-A&B), Allstate Corp. (ALL), The Travelers Companies Inc. (TRV), Ace Limited (ACE), The Chubb Corporation (CB), Progressive Corp. (PGR), and CNA Financial Corp. (CNA).

Multi-line Insurers (40301030) ? Companies with diversified interests in life, health, property and casualty insurance. Examples include American International Group Inc. (AIG), Hartford Financial Services Group Inc. (HIG), and Assurant Inc. (AIZ).

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Reinsurers (40301050) ? Companies providing primarily reinsurance. Examples include Reinsurance Group of America Inc. (RGA), Everest Re Group Ltd. (RE), PartnerRe Ltd. (PRE), Arch Capital Group Ltd. (ACGL), Transatlantic Holdings Inc. (TRH), and ReinsuranceRe Holdings Ltd. (RNR).

Insurance Brokers (40301010) ? Companies providing insurance and reinsurance brokerage services. Examples include AON Corporation (AON), Marsh & Mclennan (MMC), Willis (WSH), Arthur J Gallagher & Co. (AJG), and Brown & Brown Inc. (BRO).

The primary purpose of the insurance business is the spreading of risks. Because the risks associated with different policies are not perfectly correlated, the total risk of a portfolio of policies is smaller than the sum of the policies' risks. Thus, insurance functions as a mechanism to diversify PC and LH risks, similar to the role of mutual funds in diversifying investment risks. In fact, because insurers accumulate substantial funds in conducting their business, they also diversify investment risks for their stakeholders by investing in diversified portfolios.

The activities of insurance companies include underwriting insurance policies (including determining the acceptability of risks, the coverage terms, and the premium), billing and collecting premiums, and investigating and settling claims made under policies. Other activities include investing the accumulated funds and managing the portfolio. Investing activities are particularly important for LH insurers; for many LH insurers, the spread between the return on investments and the interest cost of insurance liabilities is the primary source of income.1 Investment income is also significant for PC insurers. PC insurers accumulate substantial funds due to the time gap between the receipt of premiums and payment of claims, and they invest and manage these funds to generate investment income. This income contributes to earnings and so affects the pricing of insurance policies.

The time gap between the receipt of premiums and payment of claims, which creates the so-called float, consists of four components. The first is the time interval between the receipt of premium and the occurrence of insured events. In most cases this component is relatively small, because the duration of PC policies is usually short, six-months to a year. This component of the float is reflected in the financial statements in the balance of the unearned premium liability. The other three components, which vary in importance across PC lines, relate to the gap between the occurrence of insured events and the subsequent payments. Some insured losses are discovered many years after the event (e.g., exposure to asbestos), and in many cases the claim settlement process extends over several years (e.g., medical malpractice litigation). Also, in some cases insurance payments are made over extended periods of time (e.g., workers' compensation). These three components of the float are reflected in the financial statements in the balance of the reserve for losses and loss adjustment expenses, which insurers are required to accrue when insured events occur. Accordingly, the analysis of the float often focuses on unearned premium (first source of float) and, primarily, the loss reserve (other three sources of float).

PC contracts involve greater uncertainty than LH contracts because both the frequency and magnitude of PC claims are more volatile than LH claims. PC losses are highly sensitive to catastrophic events such as hurricanes, earthquakes and terrorism acts, events which typically

1 As discussed in Section 2, the primary liabilities of LH insurers are the liability for future policyholder benefits and policyholder account balances. Interest cost is accrued on both liabilities, although for future policyholder benefits it is included in the benefits expense.

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have limited effect on LH claims. In addition, the required payment for PC insurance claims depends on the insured's loss (subject to limits), while for LH insurance it is often the face value of the policy.

Because PC reserves involve greater uncertainty than LH liabilities, PC insurers hold larger equity cushions and generally invest in less risky assets compared to LH insurers. They also reinsure significant portions of their exposure, issue insurance-linked securities, and arrange contingent capital facilities. In addition, because the timing of PC claim payments is less predictable and generally nearer than that of LH benefit payments, PC insurers invest in more liquid and shorter maturity (and therefore less interest rate sensitive) assets, particularly securities. In contrast, LH insurers often invest significant amounts in long term mortgages and risky securities.

Some insurers obtain thrift or banking charters and use the charters to cross-sell related products to insurance clients. LH insurers often use thrift or banking charters to provide trust services which complement life insurance and retirement and estate planning activities. For example, life insurance policies can be used to fund trusts, retirement funds may be direct deposited into checking accounts, and certificates of deposit may be incorporated into asset diversification plans for retirement or estate planning purposes. PC insurers use thrift or banking charters for retail activities such as home mortgages and auto loans, which complement the auto and homeowner lines of insurance offered.

Insurance companies are also classified based on their form of ownership, where the primary forms are stock and mutual companies. Mutual insurers, which are owned by their participating policyholders, can issue debentures and similar financial instruments but not common stock. Stock companies are owned by stockholders and can issue debentures, common stock and a wide variety of related financial instruments. Most insurers are stock companies. Examples of mutual insurers include NY Life, Massachusetts Mutual Life, and State Farm (PC). A relatively new, hybrid form of ownership involves a mutual company converting into a mutual holding company with a subsidiary stock company that can issue stock to the public. This form of ownership is allowed in only some states and is uncommon. Two examples are Liberty Mutual Holding Company (PC) and Pacific Mutual Holding Company (LH).

Academic Research on Activities and Organization

Numerous studies investigate various aspects of insurers' operating, investing, and financing activities. Another prolific area of research explores differences across organizational structures, primarily stock versus mutual companies. Studies have also looked at issues relevant to the insurance industry overall, including the value of and demand for insurance, the problems of adverse selection and moral hazard in insurance, and the underwriting cycle (PC insurance). I discuss these studies in separate categories by main focus. However, many of the studies provide evidence relevant to multiple categories.

Efficiency and Profitability

This area of research concerns the success of insurance companies in conducting their operating activities, primarily in terms of efficiency and profitability. Studies examining efficiency consider several dimensions, including cost efficiency, technical efficiency, allocative efficiency, and revenue efficiency. Cost efficiency measures the insurer's success in minimizing costs by

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