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.

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produce a core set of principles for equity analysis; collect and synthesize best thinking and best practices;

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These studies are intended to provide readers with a comprehensive review of the pertinent accounting

conventions, academic literature, and approaches to security analysis.

This paper does not necessarily reflect the views of the center¡¯s advisory board or the center¡¯s sponsors.

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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