Analysis and Valuation of Insurance Companies
Analysis and Valuation of Insurance Companies
Industry Study Number Two
Center for Excellence in Accounting and 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
1
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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