How To Value Insurance Shares

General Insurers

Let’s start with the easy part.  General insurance, such as home and car insurance, is mainly short-term business.  Broadly, the insurer collects a premium and for the following twelve months is at risk of paying out.

The three factors which most influence profitability are the relationship between premiums earned and claims paid out, operating expenses, and the investment returns from the premiums received in advance.  These factors can be represented by simple performance ratios.

General Insurance Metrics

The ratio of claims paid out to premiums earned is called the claims ratio.  The ratio of expenses to premiums earned is called the expenses ratio.  The two added together is called the combined ratio, which is the total of claims paid plus operating expenses, divided by premium income.

If the combined ratio is below 100% then the insurer is earning in premiums more than it is paying out in claims and costs, and so is making an operating profit.  But it can still be profitable if the combined ratio is over 100%, as investment income makes a further contribution to the bottom line.

For valuation, the P/E ratio and dividend yield are good measures in this sector.

Financial strength can be judged by net asset value per share compared to the share price.

But this is a highly regulated sector in which regulators establish minimum capital as a buffer against unexpectedly large claims.  Currently European insurers must comply with the minimum capital set down by the Insurance Group Directive (IGD) so the ratio of actual capital to minimum IGD capital is a better measure of financial strength.

Reinsurers can be valued in the same way as general insurers.

Life Assurers

Why is life assurance more complicated?  The main reason is that life assurance business is very long term.

Premiums on a life policy may be paid up-front or on a regular basis, but in any case the level is set at the outset.  There is then a long period over which the profit on that policy is earned, with the risk of payout depending on many — and changing — actuarial variables.  Also, policy holders are entitled to some of the investment returns.

Accountants vs Actuaries

Grappling with how to allocate that profit, and assess the risk of paying out, fascinates actuaries and confounds accountants.  The International Accounting Standards Board is consulting on a new exposure draft, with its chairman Sir David Tweedie commenting that current practice results in “financial information that is impenetrable to all but the most expert of users.”

The bottom line is that there are two bottom lines.  Life assurance companies produce two sets of accounts: IFRS accounts which follow the accountants’ rules and so comply with legislation; and embedded value accounts which the actuaries believe present a more accurate picture.

The European Embedded Value (EEV) approach is standardised by the European forum of Insurance CFOs.  Market Consistent Embedded Value (MCEV) is a refinement of the traditional approach, but is consistent with EEV.  Insurers might report on an EEV or MCEV basis, as well as IFRS.

If this all sounds rather academic, let’s look at the 2009 results for Legal and General.  Its IFRS profit before tax from continuing operations was £1,074m whilst the same item on the EEV basis was £552m, roughly half.  Profit attributable to shareholders (the E in the P/E ratio) was £863m on an IFRS basis, but only £516m on the EEV basis.

Life Assurers Metrics

So when looking at P/E ratios, it is vital to compare like with like.  Typically P/E ratios are quoted on the IFRS basis, but remember the actuaries think EEV is better.  As with general insurers, dividend yield is the other main value ratio.

The Embedded value itself is the net asset value of the company (i.e. its accumulated past profits), plus the future profits of business already written but not yet earned (the Value of in-force Business).

It equals the total equity in the embedded value balance sheet, and is a measure of value (similar to price/book value) as well as financial strength.  Legal and General’s figure was £6.7bn, close to its market cap, whilst IFRS NAV was only £4.2bn.

Like general insurers, life assurers report how their capital compares to the regulatory IGD minimum, a key financial strength measure.

The final element is to measure the amount and profitability of new business: the equivalent of sales and profit margins in a retail business.

  • The Present Value of New Business Premiums (PVNBP) is the sales figure under the EEV regime.  It is the total of new single premiums plus the present value of new regular premiums.
  • Annual Premium Equivalent (APE) measures a similar concept, but does so by converting single premiums into regular annual equivalents.
  • New Business Margin is the profit arising from new business as a percentage of either the above two measures.  So it measures the profit margin on new business.

Insurance is definitely one of the toughest industries to analyse. Perhaps it’s no surprise that many investors prefer to steer clear of the sector altogether. 


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