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So far we have seen the application of the conventional valuation technique which uses Discounted Cash flow technique. Via this technique we used the following two variables to get the value of the business.
1. Base Free Cash flow: This is calculated by subtracting Capital expenditures from Cash flow from operations.
The Fair value of the business = {(Base Free cash flow) x (Multiple)} + {Net tangible book value that is not employed in the operations} Please Click here to learn more about basics of Discounted cash flow analysis. Even though the end purpose of an Insurance business is same as any other business, which is to have more dough at the end of the life of the business as compared to when the business was started. But unlike other businesses an Insurance business does not have any substantial Capital Expenditures, thus it becomes tricky to figure what is the real FREE CASH FLOW. Let us start with a simple example and try to understand the basics of this business.
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EXAMPLE: Jerry lives in New York City and sees an opportunity for Boat insurance business amongst a niche area focused on retirees who rarely use their boats and keep it merely as a prized property. He approaches the state insurance department to apply for a license. He is first referred to the following document from NAIC that gives the basic capital requirements for starting any insurance company in each state. For New York the capital requirements is provided via the following link Through the above link one can see that the basic capital requirement for Liability – Personal injury and Liability – Physical damage are $150k and $750k respectively. Plus let us assume that he needs $100k as an initial working capital. Thus altogether Jerry needs $1 million as a startup capital. Thus he invests $1million and starts his company called “Blue creek Boat insurance” . Following are the figures from its first year’s operations:
Total Premiums earned : $10 million.
Thus the net cash generated by the business = ($10million - $8 million - $1 million - $500,000 + $700,000) x 0.65 For Year-2 and Year-3 the business grows by 10% each year. Year-4 and Year-5 it drops by 20%. By end of fifth year, Jerry winds down his business because the business is no longer lucrative as more competitors are able to tap in this niche market. Assuming a discount rate of 10%. The Discounted Cash flow for next 5 years is shown as follows.
We can see that the net discounted cash flow of the business for the five years is $3.26 million.
SO WHAT IS THE FAIR VALUE OF THE BUSINESS?
The fair value = (Initial book value of the business) + (Discounted free cash flow generated in the lifetime of the business) = $1 million + $3.26 million = $4.26 million.
WE CAN STATE THE FAIR VALUE IN TERMS OF BOOK VALUE = $1 million x 4.26 = $4.26 million. In this case we can say that the book value multiple for the company is 4.26
The above example is the most simplistic insurance operation that one can think of. In real world one might not find such a simple business, but it does showcase the
fundamentals of the business that one needs to analyze in order to value the business. We will now dig deeper into these fundamentals.
1. Total claims paid: In our example we took a simple figure and plugged in our valuation model. But in the real world insurance business the final claims paid and the
ones shown in the financial statements can vary a lot. It’s because a Claim cycle can be lengthy, thus the actuarial department of the Insurance company has to make assumptions
in order to report Claims expenses and also has to create a liability called Claims Reserves that shows the total amount the company feels it finally has to pay out on Claims
that have occurred but not settled yet.
EXAMPLE: Let us say that a boat accident happens on Sep-1-2012 and the Insured files a claim of $62,000 as bodily injury. The Claim adjuster feels that the actual amount to
be paid is $20,000. Thus the Insured files a lawsuit and the matter goes to court. In the mean while the company needs to report its Financials on Dec-31-2012 and hence reports
$20,000 based on its estimate and puts that $20,000 amount as Claims reserves. The lawsuit lasts 1 year and the court orders the Insurance Company to pay $37,000 to the Insured.
The company now has to make an adjustment of $17,000 in its reserves before paying off the Claim to the Insured. Thus the Financials for Dec-31-2013 will now report that additional
$17,000 as Claims expense.
This is the trickiest part of valuing any insurance business because the analyst has to weigh in what is the final adjustments that will be made to
the Claims reserves before they are settled. If the Insurance Company is conservative then the adjustment can be very minor. But if the Insurance Company has a
history of making large adjustments to its reserves then one needs to apply a higher adjustment factor to loss reserves while valuing the business.
2. Investment income: An insurance company earns Investment income by purchasing bonds , stocks or other financial assets like Mortgage backed securities.
In the above example we did not delve much as to how Jerry generated $700,000 investment income. We just assumed that he invested in a safe asset that guaranteed the principal
and generated the investment income via interest payment. But in real scenarios this could be pretty complicated. AIG was a classic example where even though the underlying insurance business was strong , but the business had to be bailed out because the business was involved with toxic assets like credit default swaps and Mortgage backed securities, which at the time of purchase were assumed to be safe and generating a healthy income , but later on these investments turned out to be almost worthless and had to be written off thereby causing un-precedent losses to its shareholders.
Thus while valuing an Insurance business one needs to carefully analyze all the investments that the business is holding and validate if they are fairly carried in its books.
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