Most investors avoid trying to value financial firms due to their complicated nature. However, a number of straightforward valuation techniques and metrics can help them quickly decide whether digging deeper into valuation work will be worth the effort. These straightforward techniques and metrics also apply to insurance companies, though there are also a number of more specific industry valuation measures.
A Brief Introduction to Insurance
On the face of it, the concept of an insurance business is pretty straightforward. An insurance firm pools together premiums that customers pay to offset the risk of loss. This risk of loss can apply to many different areas, which explains why health, life, property and casualty (P&C) and specialty line (more unusual insurance where risks are more difficult to evaluate) insurers exist. The difficult part of being an insurer is properly estimating what future insurance claims will be and setting premiums at a level that will cover these claims, as well as leave an ample profit for shareholders.
Beyond the above core insurance operations, insurers run and manage investment portfolios. The funds for these portfolios come from reinvesting profits (such as earned premiums, where the premium is kept because no claim occurred during the policy's duration) and from premiums before they get paid out as claims. This second category is a concept known as float and is important to understand. Warren Buffett frequently explains what float is in Berkshire Hathaway’s annual shareholder letters. Back in 2000 he wrote:
"To begin with, float is money we hold but don't own. In an insurance operation, float arises because premiums are received before losses are paid, an interval that sometimes extends over many years. During that time, the insurer invests the money. This pleasant activity typically carries with it a downside: The premiums that an insurer takes in usually do not cover the losses and expenses it eventually must pay. That leaves it running an "underwriting loss", which is the cost of float. An insurance business has value if its cost of float over time is less than the cost the company would otherwise incur to obtain funds. But the business is a lemon if its cost of float is higher than market rates for money."
Buffett also touches on what makes valuing an insurance company difficult. An investor has to trust that the firm’s actuaries are making sound and reasonable assumptions that balance the premiums they take in with the future claims they will have to pay out as insurance payments. Major errors can ruin a firm, and risks can run many years out, or decades in the case of life insurance.
Insurance Valuation Insight
A couple of key metrics can be used to value insurance companies, and these metrics happen to be common to financial firms in general. These are price to book (P/B) andreturn on equity (ROE). P/B is a primary valuation measure that relates the insurance firm’s stock price to its book value, either on a total firm value or a per-share amount.Book value, which is simply shareholders’ equity, is a proxy for a firm’s value should it cease to exist and be completely liquidated. Price to tangible book value strips out goodwill and other intangible assets to give the investor a more accurate gauge on the net assets left over should the company close shop. A quick rule of thumb for insurance firms (and again, for financial stocks in general) is that they are worth buying at a P/B level of 1 and are on the pricey side at a P/B level of 2 or higher. For an insurance firm, book value is a solid measure of most of its balance sheet, which consists of bonds, stocks and other securities that can be relied on for their value given an active market for them.
ROE measures the income level an insurance firm is generating as a percentage of shareholders equity, or book value. An ROE around 10% suggests a firm is covering its cost of capital and generating an ample return for shareholders. The higher the better, and a ratio in the mid-teens is ideal for a well-run insurance firm.
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