Valuing an insurance company is complex by nature because they are prepared according to accounting and actuarial principles
varying from one country to another. Further, profit generated in one year does not warrant any similar repetition in future which makes the task more difficult. However, every insurance company attempts to tie itself to solvency and their nature of products that are sold in long term makes insurance business unique. The insurance companies have developed own tools that help them to understand their financial performance. These tools do not hold a long term vision of the profitability, rather relies on short term financial results. One approach of valuing is known as “Embedded Value” which values the current in-force value without any regard to its capacity to generate new business. As per this calculation, minimum value of the company is taken into consideration which is again can be adjusted by adding future new sales to arrive at the appraisal value of the company. The embedded value is defined as the total value of in-force business and the value of the free capital.
The core business of an insurance company is to collect premiums from its customers (insured) and the total fund collected is invested under different investment instruments. They insure risks for a fee, which is called premium. The pooled fund accumulated through premium from many insured are preserved for some losses or payments against risks covered that may occur in future. Beyond the main insurance business, the insurance companies also run and manage different types of investment portfolios for investors.
Thus, the insurance companies collect huge fund which is preserved for future contingency and that leaves a bunch of temporary free cash which is known as “float’ and which is eventually one’s money preserved for or goes to others. The cost of float is determined by examining the growth of floats over time and the cost the company incurred to generate the float. Investment income is the return on investment from its float depending upon the company’s aggressiveness on investment decision. Some analysts use ‘Dividend Discount Model’ to value an insurance company. The method measures the stock by the worth of its discounted sum of all of its future dividend payments. In other words, value of a stock is based on the net present value of the future dividends.
The insurance profit can be summed up as:
Premium earned + investment income – losses from claims– returns paid under different investment plans – operating expenses.
Methods of Valuation of Insurance Companies
Different methods can be used to value insurance companies. They are:
- Price to Book Value (P/B)
- Return on Equity (ROE)
- Price to Tangible Book Value
- Other Comprehensive Income (OCI)
- Combined Ratio
- Discounted cash flow (DCF)
Price to Book Value is a basic valuation measure that calculates the firm’s stock market price with its book value. The calculation of book value is simply the “Shareholders Equity”.
“Return on Equity” measures the income level the insurance company is making as a percentage of book value on shareholder’s equity. The higher is the better.
“Price to Tangible Book Value” takes out the value of every intangible asset such as Goodwill, etc to reveal the more accurate measure of the real assets.
“Other Comprehensive Income” method shows the implications of investment portfolio on profits. Such incomes are found in the Balance Sheet and Financial statements. This measure gives finer results because it indicates investment gains, book value or changes in equity.
The “Combined Ratio” is considered more specific for insurance industry because it measures the incurred losses and expenses as a percentage of earned premiums. If the incurred losses are more than the premium, or more than 100%, it indicates the company is losing money. If the rate is below 100%, it suggests an operating profit.
Discounted cash flow (DCF) is another method of valuing in insurance company which has less frequent use because determining the exact cash flow is difficult to measure.