how investment bankers value insurance companies valuation of insurance operations april 10 casualty...

How Investment Bankers Value Insurance Companies

Valuation of Insurance Operations

April 10

Casualty Actuarial Society

In Today’s Market


Two Approaches Market Approach Fundamental Approach

Traditional Approach Non-traditional Approach


Market Approach Research Analyst Buy-side Analyst Investor Community


Market Approach Valuations for property casualty insurance

companies have declined significantly during the past year

The decline in the property casualty sector is the result of deterioration in the industry fundamentals that drive value

Historical Relative Performance

50%

60%

70%

80%

90%

100%

110%

120%

03/31/1999 05/31/1999 07/31/1999 09/30/1999 11/30/1999 01/31/2000 03/31/2000

Per

cent

age

of B

ase

Pri

ce

S&P 500 S&P P&C


Market Approach Volatility of the industry’s results has declined

over the last twenty years

0.0x0.5x1.0x1.5x

2.0x

2.5x3.0x

3.5x4.0x

Standard Deviation

1942-46

1947-51

1952-56

1957-61

1962-66

1967-71

1972-76

1977-81

1982-86

1987-91

1992-96

Volatility of Property & Casualty Earnings


Which operating factors drive stock market values? Profitability, as measured by return on

equity Profit margin Operating leverage

Earnings consistency Standard deviation of change in earnings Reserve development

In other words, the market rewards risk adjusted returns on capital


Value Drivers

Return on Equity

Earnings Consistency

Earnings Growth

Price/BookBaldwin & Lyons, Inc. 0.79xW.R. Berkley Corporation 0.65Capitol Transamerica Corp. 1.00HCC Insurance Holdings, Inc.

1.31

Markel Corporation 1.74Medical Assurance, Inc. 1.40NYMAGIC, Inc. 0.52Penn-America Group, Inc. 0.78Philadelphia Cons. Holding Co.

1.13

RLI Corp. 0.93

Company Market Cap

($ in millions)

1999 ROE

Baldwin & Lyons, Inc. $226.1 6.5% W.R. Berkley Corporation 384.3 -5.5 Capitol Transamerica Corp. 133.1 12.1 HCC Insurance Holdings 610.5 15.9 Markel Corporation 667.6 9.9 Medical Assurance, Inc. 456.3 14.4 NYMAGIC, Inc. 121.1 7.1 Penn-American Group, Inc. 63.0 2.3 Philadelphia Cons. Holding Co. 181.8 10.4 RLI Corp. 272.9 10.6


Value Drivers

MAI

HCC

MKL

CATA

RLIPNG

PHLY

NYM

BWINB

R2 = 0.3554

0.00

0.25

0.50

0.75

1.00

1.25

1.50

1.75

2.00

2.0% 5.0% 8.0% 11.0% 14.0% 17.0%

ROE

Pri

ce/B

ook

(x)


Value Drivers

CurrentP/E 1996-1998 1996-1999 1996-1998 1996-1999 1996-1998 1996-1999

Baldwin & Lyons, Inc. 12.7 x 8.3% 5.6% -11.7% -5.0% 3.7% 3.4%W.R. Berkley Corporation NM 14.1% 13.0% -22.8% N/A 7.1% -2.8%Capitol Transamerica Corporation 8.3 7.0% 2.3% 2.9% -3.1% 9.5% 4.0%HCC Insurance Holdings, Inc. 13.4 -9.7% -6.9% 37.0% -13.3% 16.5% 11.4%Markel Corporation 16.6 4.1% 12.5% 10.8% -4.5% 25.2% 11.7%Medical Assurance, Inc. 10.0 16.3% 16.3% 23.4% 14.5% 16.2% 12.3%NYMAGIC, Inc. 8.0 -11.5% -16.7% -9.5% -10.1% 12.5% 8.6%Penn-America Group, Inc. 37.3 13.8% 7.4% 12.7% -33.7% 59.1% 33.2%Philadelphia Consolidated Holding Corp. 12.0 30.5% 31.8% 22.4% 12.1% 26.1% 21.8%RLI Corp. 9.0 4.4% 14.3% 4.8% 7.0% 17.5% 13.2%

Mean 14.1 x 7.7% 8.0% 7.0% -4.0% 19.3% 11.7%Median 12.0 7.7% 9.9% 7.8% -4.5% 16.3% 11.6%

Premium Growth Rate Net Income Growth Rate BV/Share Growth Rate


Value Drivers

YE 1996 YE 1997 YE 1998 YE 1999 % Change P/EP/E P/E P/E P/E 1998-1999

Baldwin & Lyons, Inc. 12.4 x 13.8 x 20.3 x 16.0 x -21.0%W.R. Berkley Corporation 13.4 14.5 19.4 N/M N/MCapitol Transamerica Corporation 12.7 15.8 10.9 6.8 -37.4%HCC Insurance Holdings, Inc. 27.6 19.9 11.8 25.9 118.7%Markel Corporation 10.8 17.5 17.8 21.5 21.0%Medical Assurance, Inc. 10.1 15.5 16.5 10.3 -37.2%NYMAGIC, Inc. 8.4 10.3 10.9 7.8 -28.2%Penn-America Group, Inc. 15.6 17.5 10.1 32.3 220.7%Philadelphia Consolidated Holding Corp. 12.4 15.7 16.9 11.6 -31.3%RLI Corp. 11.7 15.0 12.5 11.0 -12.0%

Mean 13.5 15.5 14.7 15.9 21.5%Median 12.4 15.6 14.5 11.6 -21.0%


Who Cares about the Actuaries


Frontier Chart

Frontier Stock History

$0

$5

$10

$15

$20

$25

$30

$35

$40

01/02/1997 07/02/1997 01/02/1998 07/02/1998 01/02/1999 07/02/1999 01/02/2000

Reserve Adjustmentof $40 Million




Meadowbrook Chart

Meadowbrook Stock History

$0

$5

$10

$15

$20

$25

$30

$35

$40

01/02/1997 07/02/1997 01/02/1998 07/02/1998 01/02/1999 07/02/1999 01/02/2000


Reserve Adjustmentof $2.7 Million

Reserve Adjustmentof $7.3 Million


Consolidation and the Need for Economies of Scale

Opportunities for convergence Need for multiple distribution channels Need for broader line of products Need to achieve greater efficiencies Need to minimize rating pressures Need for improved access to capital


Increased Consumer Awareness Consumers more informed through

internet More product choices and distribution

methods increase awareness Privacy issues becoming more

significant Consumers becoming informed about

structural alternatives (such as demutualization)


Margin Erosion Commodity products (e.g. term

insurance, auto) New entrants Widespread consumer information Competitive pressures – increasing

loss ratios High cost distribution systems


Rating Pressures and Capital Requirements Eroding profits or growth rates put

pressure on ratings Low rates of return on equity Some companies have high loss

ratios – reserves need strengthening


Fundamental Analysis We traditionally base our valuation

of insurance companies on four valuation methodologies: Analysis of public market comparables Private and public market M&A

transactions Discounted cash flow analysis Additional areas of value that must be

developed with potential buyers


Comparable Company Analysis We focus our multiple analysis on

Price/Earnings and Price/Book multiples. In analyzing these multiples, we consider the following factors: Core earnings power of the Company Earnings growth compared to the

comparable companies Relationship between price to book

value and return on equity


M&A Transactions Analysis Additionally, we analyze recent

private and public market transactions for companies within comparable sectors

We look closely at the specific characteristics of each transaction in order to find the most comparable multiples


Multiple AnalysisMultiple Valuation

(Dollars in thousands) Selected MultiplesLow High

Net Income ValuationAdjusted 1999 Net Income $1,935 $1,935Selected Multiple (1) 12.0 x 14.0 x

Implied Value $23,224 $27,095

Projected 2000 Net Income $1,766 $1,766Selected Multiple (1) 10.0 x 12.0 x


Book Value ValuationCurrent Book Value $16,274 $16,274Selected Multiple (1) 1.00 x 1.25 x


Required Book Value (4) $7,233 $7,233Selected Multiple (1) 1.25 x 1.50 x

Implied Value 9,041 10,849

Excess Book Value 9,041 9,041Selected Multiple 1.00 x 1.00 x

Implied Value 9,041 9,041

Total Implied Value $18,082 $19,890Casualty Actuarial Society

Discounted Cash Flow Analysis A discounted cash flow approach

offers a good proxy for value due to the following: Multiple analyses may be too weighted

to the historical performance, which in some cases is limited

Discounted cash flow approach captures both growth and operating profitability


Discounted Cash Flow Analysis The discounted cash flow analysis

captures the value of both the value of the existing balance sheet and the value of new business.


Discounted Cash Flow Analysis In valuing the existing balance sheet,

we focus on the following components: The existing surplus (pro forma for any

reserve strengthening or other adjustments)

The value of the runoff of the reserves (actuarially determined payout pattern)

Any value/equity in the unearned premium reserve (value of deferred acquisition cost)


Discounted Cash Flow Analysis In valuing the new business, we focus

on the following factors: The premium growth potential The potential to introduce new products The projected combined ratio for the

business The expected payout of the future

reserves and associated investment income


Valuation Summary


DCF Valuation

Discount 1.75 x 11.0 xRate Book Value Net Income Average

13.0% $44,886 $45,832 $45,359

14.0% 42,957 43,862 43,40915.0% 41,126 41,992 41,559

16.0% 39,388 40,218 39,803

17.0% 37,738 38,533 38,135

Low HighSelected Valuation Range $40,000 $45,000

Terminal Multiples

Non-traditional Approach Due to the uncertainty of the

quality of the Company's earnings, We value some of the Companies based on an analysis of the various components of the company


Non-traditional Approach - Example The Company stock has not

recovered since its 2nd Quarter earnings announcement

One-Year Stock Price History

$10.00

$20.00

$30.00

$40.00

$50.00

$60.00

03/31/1999 05/31/1999 07/31/1999 09/30/1999 11/30/1999 01/31/2000 03/31/2000

Sh

are

Pri

ce

50% drop after second quarter earnings showed significant reserve redundancies were used to manufacture earnings.


Non-traditional Approach As a starting point we attempt to

determine the tangible book value of the company: Eliminated the goodwill from previous

transactions Estimated the current adequacy of

loss reserves


Non-traditional Approach We add to the current book value

an estimate of the value of the premium using two approaches: Value based on projected cash flows

from the in-force book of business Estimated cost to purchase a book of

business of that size


Non-traditional Approach We also attempt to assess the

value of the runoff of the loss reserves by estimating the payout of the liabilities and the associated investment income earned on the runoff.


Non-traditional Approach The final component of value that we

included was the value of any non-risk bearing segments

Value of service businesses are sometimes incorporated in the book value of the company

Estimated value from future earnings on the business or estimated sale value of the business


Non-traditional Approach


9/30/99 Book Value $166,826Goodwill (76,604)

Tangible Book Value $90,222

Low HighOther AdjustmentsTangible Book Value 90,222 90,222Reserve Adjustment (26,000) (13,000)

Adjusted Book Value 64,222 77,222

Low HighValuation SummaryAdjusted Book Value $64,222 $77,222Estimated Value of Premium 27,000 37,000Estimated Value of Reserve Run-off 25,000 27,000Estimated Value of TPA & Service Segment 35,000 40,000Transaction Costs (2,500) (1,500)

Total Valuation $148,722 $179,722

Value per Share $15.33 $18.53

Current Price $18.13 $18.13Premium to Current Price -15.4% 2.2%


Paid Losses as a % of Initial Reserves

0%

10%

20%

30%

40%

50%

60%

70%

80%

1 2 3 4 5 6 7 8 9 10

Accident Year

Prior

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998


Non-traditional Approach The value of new business was

projected out over 30 years. The underwriting performance assumptions were as follows: Base Case:

118% combined ratio, decreasing to 117% in 2002

Loss ratio of 95% Expense ratio of 23%


Non-traditional Approach Case 2:

115.7% combined ratio, decreasing to 114.7% in 2002

Loss ratio of 95%, decreasing to 94% in 2002

Expense ratio of 20.7%


Non-traditional Approach Gross written premium is projected to

decrease 20% in 2000, increase at an annual rate of 5% from 2001 to 2004, slow to a growth rate of 2.5% from 2005 to 2009, and then grow at a rate of 1% for each year thereafter

A valuation range was obtained by applying discount rates to both scenarios



DCF Valuation - New Business($ in thousands)

DiscountRate Base Case Case 2

10% $42,758 $52,07011% 36,890 44,90212% 32,003 38,94313% 27,909 33,95914% 24,460 29,76715% 21,539 26,219

High $37,000Low 27,000

Selected Valuation Range


Non-traditional Approach An estimated valuation range was generated by

selecting a discount rate of 7-10% and calculating the implied NPV.

High $27,000Low 25,000

Selected Valuation Range


(Dollars in thousands)Year

1 2 3 4 5 6 7 8 9 10

Assumed Payout Pattern 30.0% 22.5% 15.0% 10.0% 5.0% 5.0% 5.0% 2.5% 2.5% 2.5%

Loss Reserves OutstandingBeginning of Year $266,012 $186,209 $126,356 $86,454 $59,853 $46,552 $33,252 $19,951 $13,301 $6,650Loss Reserves Paid (79,804) (59,853) (39,902) (26,601) (13,301) (13,301) (13,301) (6,650) (6,650) (6,650)

End of Year 186,209 126,356 86,454 59,853 46,552 33,252 19,951 13,301 6,650 0

Average Reserves O/S 226,111 156,282 106,405 73,153 53,202 39,902 26,601 16,626 9,975 3,325Net Investment Yield 7.0% 7.0% 7.0% 7.0% 7.0% 7.0% 7.0% 7.0% 7.0% 7.0%

Net Investment Income 15,828 10,940 7,448 5,121 3,724 2,793 1,862 1,164 698 233

Net Investment Income 15,828 10,940 7,448 5,121 3,724 2,793 1,862 1,164 698 233Assumed Tax Rate 35.0% 35.0% 35.0% 35.0% 35.0% 35.0% 35.0% 35.0% 35.0% 35.0%

After-Tax Income $10,288 $7,111 $4,841 $3,328 $2,421 $1,816 $1,210 $756 $454 $151

NPV CalculationImplied

Discount Rate Value

6.0% $27,4577.0% 26,7718.0% 26,1169.0% 25,491

10.0% 24,89311.0% 24,322

Non-traditional Approach A valuation range was selected by applying current

multiples of public companies and multiples from M&A transactions to the projected results of the company


($ in thousands)Selected MultiplesLow High

1999 Projected Revenue $31,128 $31,128Selected Multiple (1) 1.00 x 1.25 x


1999 Projected Net Income $3,174 $3,174Selected Multiple (1) 11.00 x 13.00 x


Selected Value $35,000 $40,000

Notes:(1) Based on the public market trading multiples for selected comparable companies.

Conclusion Why are you doing the valuation? For whom are you doing the

valuation? What changes may occur at the

target or the investment? Everybody has an opinion, that’s

what makes a market


how investment bankers value insurance companies valuation of insurance operations april 10 casualty...

Documents

property casualty sector

discounted cash flow

market approach volatility

fundamental analysis

market approach valuations

value of new business

comparable company analysis

ma transactions analysis