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Valuing Insurance Companies

June 20, 2011

I got asked by several members in both messages and comments about some key factors to value insurance companies when I posted the deep value analysis on PartnerRe (http://www.gurufocus.com/news/136777/partner-re-pre--a-conservative-stock-in-reinsurance-industry). So I hope this article will give us quick ideas about insurance companies in general.

First we should understand what insurance is. Insurance is actually the business of selling promises. Insurers often pool funds from many insured entities to pay for the losses that some may incur. The insured entities are therefore protected from risk for a fee, which is called a premium, with the rate of premium dependent on the frequency and severity of the event occurring. Insurers receive premiums upfront and pay claims later. The collect-now, pay-later business model leaves the insurers a bunch of temporary free cash, which is called “float,” that will eventually go to others. Insurers will go out and invest the float for the between period.

From that, we can see there are two sources of income coming to the insurers: the underwriting income and the investment income. For underwriting income, if it is positive, it means insurers got paid to hold the insured’s money. If the underwriting income is negative, then the ratio of underwriting loss to the amount of float is the cost of generating the floats. An insurance business is considered to be profitable over time if its cost of float is less than the market rate for money. If the cost of its float is higher than that, then the business has negative value.

In order to value insurance companies, there are three main important things to consider:

The safety of its risk exposure

For this, we answer the question: “If big hits come along, can the equity be large enough to absorb all the risks?” Normally we look at the amount of business the company writes compared to its tangible book value, along with its price in the market. Tangible book value represents roughly the liquidation value of the insurance companies. If we can buy in the company with less than its tangible book value (liquidation value), it somehow indicates the safety and undervalued level.

The cost of floats

As discussed above, we should examine the growth of floats over time and the cost the company incurred to generate the float. If the cost of float is higher than the market rate for money, the business has negative value. The calculation of the float is quite relative, by adjusting unpaid losses, funds held under reinsurance, unearned premium reserves and then deducting prepaid acquisition costs, prepaid taxes and deferred charges for reinsurance.

Investment income

The investment income is the return on investment of its float, indicating the ability of the company to allocate capital. Some insurance companies go very conservative, and some go very aggressive. It should be measured by two important yardsticks: the return on investment and the sustainability of those returns.

Valuing the insurance companies

Different methods can be used to value insurance companies, and those methods should be used flexibly as valuation is the relative operation. In the analysis of PRE, I have used the Dividend Discount Model. For PRE, as we can see in my research for value analysis on demand, they have good tangible equity, and the cost of float is below zero. But they are very conservative on its investment strategy (majority is fixed income instruments). That is why the best for shareholders is to pay out the dividends so that they can invest somewhere else to gain better returns. For a consistent dividend paying corporation like that, dividend discount valuation method is one reasonable method to estimate its value.

For Berkshire Hathaway insurance arm, Warren Buffett retains all the earnings for investment, to earn around more than 20% per year for the last 40 some years. If he paid out the dividend, after paying some taxes on dividends, the shareholders must use that cash to invest somewhere else, with the high probability that they cannot generate a return like Buffett has done. So the best thing for shareholders is to retain all the earnings, allowing Buffett to reinvest to achieve high sustainable return.

Any companies which do not have a history of paying dividends should be valued in different ways, either by relative valuation — comparing Price to Book Value with its competitors — or by comparables M&A, when there are some recent transactions of M&A in the insurance industries.

Another way, we can estimate the value of tangible equity the companies have in their books. Then we add the amount of the float, and we estimate the cost of generating those floats along with the return the company would get from investing those floats over the period of time in the future.

Certainly, any valuation is going along with different assumptions. And whenever we change a variable in our assumptions, the results will be very different. As long as we invest in the safe companies, we can sleep well at night. As the famous saying goes “Watch the downside, and the upside will take care of itself."

Happy investing!

About the author:

Money manager in global equities, especially in U.S. and Vietnam markets. CFA level 3 candidate. Lecturer for Stalla - CFA course in Vietnam.

Visit Anh HOANG's Website

Rating: 4.7/5 (69 votes)


Adib Motiwala
Adib Motiwala - 6 years ago    Report SPAM
thanks Anh!
Amaterass - 6 years ago    Report SPAM
I understand the dividend discount model. I just wonder if this method is good only when net income is equal to dividend, in another word, when dividend payout ratio is 100%.

Like you mentioned, Insurance companies have 2 sections: underwriting and investment. It is fun. I might have some.


Hoang Quoc Anh
Hoang Quoc Anh - 6 years ago    Report SPAM
@ Amaterass: When talking about the any business, if the payout is 100%, it means the business should be very great, requiring no further capital expenditure to keep its current competitive advantage and further growth. There seems to have no as wonderful business as that. If any business keeps paying 100% dividends out of earnings, it is certainly cutting into his body and the business will be deteriorated.

If talking 'bout financing theory, they stated that growth (g) = ROE x b. While ROE is return on equity, and b is the retained earnings (amount that doesn't paid out as dividends).

Dividend Discount Model is most appropriate for 1) firms has the dividend history, 2) the div is consistent over time and 3) it is the perspective of minority shareholders.

Roke6362 - 6 years ago    Report SPAM
Insurance companies are in the business of assuming the risk of individuals/businesses for a fee. I have been in the insurance business for 27 years, and I have tried to keep my valuations simpler (for the simpler mind: mine!)

I look at the following items:

Tangible book value

Combines ratio

Dividend payout & yield

Investment portfolio

Private market value

When are you buying in relation to the sector cycle

I believe TBV for the p&c industry is a buy at under [.90] TBV. The average high TBV at the top of the hard market is approx. [1.5] TBV.

The farther below 100% the combined ratio is (and the more consistently), the better managed the carrier.

Dividend payout and yield should be less than 50% and higher than 3%.

Investment portfolio should be mostly in bonds (in most cases). However, the duration should now be less than 5 years. This is to avoid risks of inflation, and ability to pay claims.

Private market value of an insurance carrier (p&c) is approximately 12 times normalized earnings.

Obviously, buying at the bottom of a "soft" insurance cycle is the best time. This is when underwriting results are low, loss reserve redundancies from past cycles are depleted, and investment income cannot make up for the lack of underwriting discipline.

In my opinion, now is the time to be buying this sector. TBV is at the historical low-end of the cycle, and investment income is down. My company (inflation-adjusted) is generating premiums at the same level as in 1998. This can't last forever.

Essentially, we are at the same place in this cycle as we were in 1999-2000. Premiums started to increase slightly due to underwriting deterioration. However, all h*ll broke loose after 9/11/2001.

A good barometer of this industry's cycle is www.marketscout.com. It will show the average increase/decrease in premium on a regional, national, and industry basis. You'll see that rates started to increase gradually in 2000, and spike for three years in 2002-2005. It then started to tail off.

Once you have reviewed this site, then go to a few insurance carriers, and look at how the earnings, TBV, and revenues, and share price begin to trend in a similar direction/fashion.

I think you'll get an appreciation of our industry cycle, and where it is at the present.

Good discussion.
Adib Motiwala
Adib Motiwala - 6 years ago    Report SPAM
Thanks Roke for that insight
Hoang Quoc Anh
Hoang Quoc Anh - 6 years ago    Report SPAM
Thanks Roke.

Yes for the cycle, if any big disaster hits, there would be some players left the game, reducing the supply for insurance services. That leads to the increase in the rate. That's when the insurance companies should write a lot of businesses.

Peter Lynch has written about investing in insurance companies, the investor of the begining cycle will enjoy double benefits: 1 is the increase in the rate of the insurance and 2. it will takes sometime for the rate to flow down to the bottom line, and when it does, another upside for the stock.

For the dividend payout and the investment portfolio, as long as it go through the filter of retain to invest for shares holder at the high return on equity and sustainable, it will be okay. Investing in bonds considered quite conservative.

I might do some research on one insurance company in next month. This company has enjoyed the great past performance over the stock market for quite a long time.

for your link, what segment can i get in to see the general trend of insurance rate?

Thanks again.

Roke6362 - 6 years ago    Report SPAM
At the top right of the web page, there is a barometer (in red) that shows the latest month and its corresponding renewal rating.

Click on the barometer and scroll to the bottom of the page. The page will show you 10-years of historical data.
Hoang Quoc Anh
Hoang Quoc Anh - 6 years ago    Report SPAM
Thanks. got it for now
Unlimited2 premium member - 6 years ago

Ken what do you think of UVE. I like these guys.
Charlie_CA - 6 years ago    Report SPAM

What Roke wrote is really good, and as a worker in the insurance industry, I would also add: if you do not have a deep understanding of insurance or the company, stay away from companies that write in long-tail lines (ex: construction defect, Workers' Compensation, etc), and stay close to short tail-lines (auto, property - non-cat prefered).

Luishernadez premium member - 6 years ago

What´s your opinion on The Travelers Companies (TRV)?

How about Torchmark (TMK)?

And finally, how about Markel (MKL)?

Hoang Quoc Anh
Hoang Quoc Anh - 6 years ago    Report SPAM
@Charlie_CA: Thanks for your input. Actually it's all depends on the discipline to write business that makes sense of the insurance managers. The long-tail is exposed to a lot of huge risks, so per policy needs to be taken into serious consideration before writing it. Bufffett had mentioned about the discipline of writing the business, you can refer to it here: http://www.gurufocus.com/news/137122/buffetts-letter-to-shareholders-highlights-1979

Berkshire has both short tail and long tail business, and one of the major floats come through long tail business. As long as it makes sense, you gonna be okay.

@ Unlimited2 and Luishernadez: _On the quick look MKL seems to be quite decent,, need to have some time to dig deeper in those businesses to give you the fair idea on those business along its valuation comparing with the current price in the market. Please request on the value analysis on demand and i'll dig deep on those.


Duncan - 6 years ago    Report SPAM
Roke, it would be great if you could comment on TRV. They have bought back a ton of stock over the last 5 years. Would do you think of the entry point right here? Thank you!
McFlipp - 6 years ago    Report SPAM
Any thoughts on Fairfax Financial? They're trading at about 1,1x book, have an excellent track record and are writing about a third of what they would like given their amount of capital (but don't because of the low prices in the current soft market).
Roke6362 - 6 years ago    Report SPAM
Which stock would buy, and why? I own STFC, I am also long CINF, and ORI. I own these stocks because I know the companies and do business with them. I can't stand TRV. I believe they're a bunch of pompass east coasters who think the world is flat and the cliff is somewhere just west of Philly. Please forgive my harshness. I also think TRV may be more fully valued. Thanks for the discussion.

10-Year Combined Ratio:98%105.10%99%
After-Tax Operating Margin:12%7.20%7%
Revenue Growth:178%< 0144%
Normalized Earnings: $ 2,887 $ 443 $ 90
Dividend Yield:2.89%2.60%3.71%
Dividend Growth Rate:198%>1000%439%
Payout Ratio:24.20%< 50%39.00%
Average P/E: 9 X Earn.Mixed 11 X Earn.
WACC: 11 X Earn.10.20% 9 X Earn.
Tangible Book Value:49.29 $ 201.66 $ 21.44
Debt-To-Tangible Equity:3036.00%14%
Private Market Value: $ 82.68 $ 153.00 $ 26.40
Shares Outstanding:419MM35MM 40MM
Intrinsic Value: $ 79.24 $ 150.00 $ 25
Estimated Margin of Safety:29%0.00%27%
Davidchulak premium member - 6 years ago

This industry has certainly taken a hit. Several have had their margins decimated over the last several years. I notice that STFC and others are making a slight comeback in that area over the last 3 years. Any comments?
Luishernadez premium member - 6 years ago
TRV´s average FCF over the last 4 years is $3.927,25 Million. Therefore FCF/Price is 15,96% which is pretty attractive.

The Long term investments is $72,391 Million. If we multiply this by 5% (which is an adecuate rate of return) we get $3.619,55. This would be an estimate of the Earnings Power if we assume that the long term combined ratio is 100% (which means that the cost of float is $0). Therefore Earnings Power/Price is 14,70%, which is also pretty attractive.

Book value per share has grown by around 12% in the last 5 years.

Thay went through the crisis without breaking a sweat (without any problems).

They have used $13.566 Million in the last 4 years (including last quarter) to repurchase 1/3 of the shares outstanding. Almost all the FCF ends up in share repurchases and dividends.

I guess I have lo learn about management a little more and about the predictability of the earnings into the future.

Any opinion is highly welcomed.

Duncan - 6 years ago    Report SPAM
i figure that if they keep on buying the stock at the same rate, i will wind up as the only shareholder in 7+ years. :)
Hoang Quoc Anh
Hoang Quoc Anh - 6 years ago    Report SPAM
@David: Yes, insurance is the commodity business, so when any big event hits, it hits the margins of the majority of insurers. At that time there would be reduced supply of writing insurance, pushing up the insurance rate. But for some years of no big event, no loss at all, the supply is increasing, pulling down the rate.

After few disasters for the last 03 years, of course the insurance business will come back. The stock in general will benefit double, first due to the rise in rates, and it takes months before earnings start to show improvements, then that leads to the increase in earnings.

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