A Comprehensive Guide to Insurance Company Valuation
In the article, we will discuss how to accurately perform insurance company valuations and also show you an example of the same.
Insurance company valuation can be complicated as it requires specialized knowledge and techniques. You must understand how an insurance company may appear similar to investment and holding companies but have very different liabilities and liquidity requirements.
To help you do so, we will explore the insurance business model through key financial figures and metrics. Then, we will explore why difficulties in estimating future cash flows can render the discounted cash flow (DCF) method and other similar methods insufficient.
Later in the article, we will discuss how to accurately perform insurance company valuations and also show you an example of the same. Read on to know more!
Key figures and metrics for insurance company valuation
In this section, we will go over some key financial figures and metrics that can help us with insurance company valuation. This will help you build intuition about which valuation methods can be useful for insurance company valuation.
Other comprehensive income (OCI)
Other comprehensive income (OCI) is a financial statement item that displays unrealized revenues, expenses, gains, and losses. Insurance companies hold large investment portfolios and their value can change depending on market conditions. These companies must also ensure a healthy level of liquidity to process any claims.
This is why most insurance companies will disclose OCI through a separate and detailed statement. By studying OCI statements, you can gain a clear understanding of a company’s financial health and how efficiently it manages its investment portfolio.
Price-to-book (P/B) ratio
Due to liquidity requirements, insurance companies mainly invest in assets such as stocks of publicly listed companies and bonds, for which there is an active market. This makes it possible to accurately calculate the book value which is simply the total liabilities subtracted from total assets.
On the other hand, making income projections is difficult because of difficulties in predicting investment , premium growth, and claims. Thus, insights from asset-based valuation multiples such as price-to-book (P/B) ratios are more reliable than income multiples.
Combined ratio
The combined ratio is calculated as incurred losses and operating expenses divided by premiums earned, and it is expressed as a percentage. You can assess how accurately an insurance company prices its premiums and ensures profits for shareholders by studying the combined ratio.
The longer a company has been in business, the more accurate the insights from such analysis tend to be.
Return on average equity (ROAE)
At insurance companies, the shareholder’s equity can vary quite a bit due to how active the market for their assets can be. Hence, instead of looking at the return on equity (ROE) to measure profitability, we must look at the return on average equity (ROAE) where we divide the returns by the average shareholder’s equity from the start and the end of the period.
Why are traditional methods not sufficient for insurance company valuation?
A company collects premiums that must cover the cost of paying out the insured parties. In many cases like life insurance, the payouts come years after the first premium is collected.
Insurance companies may also offer low premiums that will not cover the cost of payouts to beat out competition. Such companies must build a liquid but high-performing investment portfolio.
Because of such a business model, it is difficult to predict the cash flows of a company which makes it impossible to get accurate valuations via the discounted cash flow method.
How to value an insurance company?
For insurance company valuation, we must use a combination of the income and market approaches since the company’s value depends mainly on its investment portfolio and the net income generated.
As part of the income approach, it would be better to use the discounted net income (DNI) method instead of the discounted cash flows (DCF) method because of the difficulties in estimating cash flows and the importance of depreciation and amortization given the asset-heavy nature of companies.
When we take the market approach, we must acknowledge that high-performing stocks will attract a premium. So, an insurance company with a high return on average equity (ROAE) will have a high price-to-book value (P/B) ratio. So, the first step in the market approach would be to calculate the ROAE for the subject company.
Then, you will need to find companies with similar ROAEs to calculate the market P/B ratio. This market P/B ratio can be applied to the subject company’s shareholder’s equity to find their valuation.
Once the valuations from both methods have been calculated, you will need to take a weighted average to determine the insurance company’s valuation. The shorter the company’s financial history, the less weight should be assigned to the income approach.
Insurance company valuation example
In this example, we will value CrestPoint Life, an American life insurance company, following these steps:
Income approach
Last year, CrestPoint Life had an annual premium of $10 million and an investment portfolio of $80 million. The assets in this investment portfolio were worth $76 million at the start of the year. It plans to introduce a new product that will bring in another $2 million in annual income from premiums.
We will make the following assumptions:
- Expected growth rate of premiums from existing products = 15%
- Expected growth rate of premiums from new product = 30%
- Annual income from investment = 15%
- Combined ratio = 94%
- Required return, i.e. the discounting factor = 15%
- The entirety of the investment portfolio has to be paid out equally over 5 years as insurance claims
- Total debt of $10 million with a weighted average interest rate of 12%
Now, let us look at annual premium income projections.
| Year | Premium from existing products (in millions) | Expected premiums from new products (in millions) | Total premiums (in millions) |
|---|---|---|---|
| 1 | $11.50 | $2 | $13.50 |
| 2 | $13.23 | $2.60 | $15.83 |
| 3 | $15.21 | $3.38 | $18.59 |
| 4 | $17.49 | $4.39 | $21.88 |
| 5 | $20.11 | $5.71 | $25.83 |
CrestPoint Life has a combined ratio of 94%. So, it makes profits of 6% on the premiums it collects. Based on this, let us calculate their underwriting profits.
| Year | Total premiums (in millions) | Expenses (in millions) | Underwriting profits (in millions) |
|---|---|---|---|
| 1 | $13.50 | $12.69 | $0.81 |
| 2 | $15.83 | $14.88 | $0.95 |
| 3 | $18.59 | $17.47 | $1.12 |
| 4 | $21.88 | $20.57 | $1.31 |
| 5 | $25.83 | $24.28 | $1.55 |
CrestPoint Life’s investment portfolio has to be paid out as claims equally over 5 years and it earns an investment of 15% on the remaining investment portfolio. Based on this, we must calculate the investment income.
| Year | Claims paid out (in millions) | Size of investment portfolio (in millions) | Investment income (in millions) |
|---|---|---|---|
| 1 | $16 | $64 | $9.60 |
| 2 | $16 | $48 | $7.20 |
| 3 | $16 | $32 | $4.80 |
| 4 | $16 | $16 | $2.40 |
| 5 | $16 | $0 | $0.00 |
Now, all we need to do is sum the investment income and the underwriting profits. Then, we need to subtract the interest expenses. The result will be CrestPoint Life’s total projections that must be discounted.
| Year | Underwriting profits (in millions) | Investment income (in millions) | Interest expense (in millions) | Total income (in millions) | Discounted income (in millions) |
|---|---|---|---|---|---|
| 1 | $0.81 | $9.60 | $1.20 | $9.21 | $8.01 |
| 2 | $0.95 | $7.20 | $1.20 | $6.95 | $5.25 |
| 3 | $1.12 | $4.80 | $1.20 | $4.72 | $3.10 |
| 4 | $1.31 | $2.40 | $1.20 | $2.51 | $1.44 |
| 5 | $1.55 | $0.00 | $1.20 | $0.35 | $0.17 |
As per this approach, CrestPoint Life’s valuation will be the total discounted income. In this case, the total discounted income is approximately $17.97 million.
Market approach
At the beginning of last year, CrestPoint Life had an investment portfolio worth $76 million. Since they earned 15% on this portfolio, their investment was $11.4 million. We already know that their premiums were $10 million. So, CrestPoint Life’s total was $21.4 million.
Based on this information, let us calculate Crest Point Life’s return on average equity (ROAE).
ROAE = Returns ÷ Average shareholder’s equity
= $21.4 million ÷ {[(Investment portfolio at the start of the year – Total debt) + (Investment portfolio at the end of the year – Total debt)]/2}
= $21.4 million ÷ {[($80 million – $10 million) + ($76 million – $10 million)]/2}
= $21.4 million ÷ $68 million
= 31.47%
After some research, we found out that the following insurance companies had ROAEs in the range of 30% to 35%.
| Insurance Company | Book value (in millions) | Market capitalization (in millions) |
|---|---|---|
| Summit Assurance | $65 | $97.50 |
| MarkGuard Life | $80 | $136 |
| LibertyPath | $90 | $144 |
| EverGuard Life | $70 | $105 |
| Heritage Life | $95 | $180.50 |
| BlueHorizon Life | $100 | $170 |
| PinnacleGuard | $75 | $120 |
| Total | $575 | $953 |
So, the market P/B ratio = Market capitalization of the market ÷ Market book value
= $953 million ÷ $575 million
= 1.66
Now, we just need to apply this ratio to CrestPoint Life’s book value to find their valuation.
CrestPoint Life’s valuation = (Book value = Assets – liabilities) × Market P/B ratio
= ($80 million – $10 million) × 1.66
= $116.2 million
Final valuation
CrestPoint Life had a financial history of 1 year. So, we will assign a weight of 20% to the income approach valuation and the rest to their market approach valuation.
| Approach | Weight | Valuation (in millions) | Weighted valuation (in millions) |
|---|---|---|---|
| Market | 80% | $116.20 | $92.96 |
| Income | 20% | $17.97 | $3.59 |
| Total | 100% | Total weighted valuation | $96.55 |
So, CrestPoint Life’s valuation is $96.55 million.
Eqvista – Where Complex Valuations Meet Clear Solutions
Insurance company valuation presents unique challenges due to their unique business models. To build some context about their business models, we looked at a brief overview of key financial metrics and figures like other comprehensive income and the price-to-book value ratio. We also discussed the difficulties in estimating the cash flows of an insurance company.
To overcome the shortcomings of traditional valuation methods like the discounted cash flow (DCF) method, we must use a combination of income and market approaches.
The process involves careful analysis of premium income projections, investment returns, and market comparisons. As demonstrated in the CrestPoint Life example, a weighted average of income and market approaches yields a comprehensive valuation.
If you need expert guidance for your insurance company valuation, consider relying on Eqvista’s seasoned professionals. We have delivered accurate and insightful valuation reports for various unique business models. Contact us to know more!
Interested in issuing & managing shares?
If you want to start issuing and managing shares, Try out our Eqvista App, it is free and all online!