Valuing Insurance Companies: Part 2

Valuing Insurance Companies: Part 2
By Emil Lee September 28, 2007

In the first part of this article, we talked about some of the qualitative criteria investors should use to evaluate insurance companies. Now let's get down to some of the quantitative aspects of insurance valuation -- the hard numbers that help indicate insurers' overall health.
Tangible book valueTangible book value (TBV) is the value of an insurer's assets minus its liabilities, excluding intangibles and goodwill. This could also be a proxy for liquidation value -- an estimate of what the insurance company would be worth if the company closed its doors, paid out claims, and returned excess capital to shareholders. (Hence the term "shareholders' equity.") Obviously, you'd want to pay a lower multiple of tangible book value to increase your margin of safety, assuming you can't get shares at a discount to TBV.

The amount of floatA big part of a bank's value is its amount of core deposits, because a bank can easily earn more from a depositor's money than it pays out in interest. And that doesn't even include the myriad fees it can reap, including overdraft and service charges on those deposits.

Similarly, an insurer pockets any investment income it earns from policyholder float. So the amount of float an insurer generates plays a big role in determining its worth. To calculate float, add together loss and loss adjustment expenses with unearned premiums, then subtract premiums receivable and deferred policy acquisition costs. Using the latest quarterly figures, I calculate Income Investor recommendation Mercury General's (NYSE: MCY) float at roughly $1.5 billion, or about half the company's nearly $3 billion market cap. Meanwhile, I calculate Progressive's (NYSE: PGR) float at about $6.8 billion, or nearly half the company's $14 billion market cap. Clearly, Progressive's larger amount of float makes the company more valuable.
Cost of floatThe cost of float varies inversely with its value. The more you have to pay for it, the less it's worth. If I opened up my own bank, and offered depositors a 10% interest rate, I could probably attract deposits very quickly -- until I went broke trying to pay out that interest.
Insurers that generate low-cost float are much, much more valuable than their higher-cost peers. The best way to gauge the cost of float would be to look at a company's long-term combined ratio versus its competitors. If the insurer consistently earns combined ratios of less than 100%, that's very good. It means that the insurer earns an underwriting profit, and has a positive cost of capital. Think of it as a bank whose depositors pay the bank to hold their deposits -- and allow the bank to pocket any investment income it earns.

The two most sustainable ways to generate low-cost float are exercising underwriting discipline and maintaining low overhead and expense ratios. Progressive, and Berkshire's (NYSE: BRK-A) (NYSE: BRK-B) GEICO, particularly fit the bill in those regards. Last year, they posted 13.3% and 11.9% underwriting profit margins, respectively, compared to the auto insurance industry's average of 7%.

Float growthFloat growth, as long as it comes at a reasonable price, increases an insurer's value. For example, through organic growth and acquisitions, Berkshire increased its float from about $20 million in 1967 to $50.9 billion at the end of 2006. That represents a roughly 21%-22% annual increase, almost identical to Berkshire's share price appreciation and the annual growth in its per-share book value.

Investment incomeThe last piece of the puzzle? How profitably the insurer actually uses its float. Some insurers tend to put all their money in low-yielding investment-grade fixed-income securities. There's nothing wrong with that, but it'd be nice if insurers could earn higher risk-adjusted returns, the way Berkshire, Markel (NYSE: MKL), and White Mountains (NYSE: WTM) do. Flagstone Re (NYSE: FSR) and Greenlight Re (NYSE: GLRE) are just getting started, but they follow the same mold. I'd also advise Fools to look at Enstar Group (NYSE: ESGR).
Add these factors together -- tangible book value; the size, cost, and expected growth of the float; and the expected returns from that float -- and you should be able to estimate an insurer's true worth.

Related Foolishness:
Valuing Insurance Companies: Part 1
Don't Sell Without Reading This First
How George Soros Predicted the Mortgage Crash

NAA and Foresters Help Children’s Miracle Network Hospital

NAA Agent Melissa Rinehart receives a $20,000 pledge from a caller during the Nov. 21 Children’s Miracle Network radiothon. The event raised more than $260,000 for the Children’s Medical Center of Dayton, Ohio.

NAA and Foresters Help Children’s Miracle Network Hospital

On November 21, National Agents Alliance and Foresters helped raise more than a quarter of a million dollars for the Children’s Medical Center of Dayton, Ohio.
Organizers of the Foresters Fraternal event called it “a huge success.” Using volunteers from NAA and Foresters, the radiothon raised $262,658 for this Children’s Miracle Network Hospital.
In addition to staffing the phones during the event’s radiothon, the NAA agents also toured the children’s care facility and saw firsthand how the money will be used to meet the needs of the hospital’s young patients.

“Taking the tour made me want to do a lot more,” said Patrick Connors, one of eight NAA agents to assist with the fundraiser. “When we left, we had a new focus. Seeing that we can have an impact by giving a sliver of our time really opened my eyes. I’m so proud to be in business with National Agents Alliance and Foresters.”

Foresters and Children’s Miracle Network have a long-standing relationship based on a shared commitment to improving the health and well-being of children.

The funds raised in Dayton will be used for patient care equipment, including: a $36,000 giraffe bed in the Newborn Intensive Care Unit; a $6,000 bili-rubin monitor for the emergency room; a $113,500 total care bed for inpatients; and more than $17,000 of equipment for one of the hospital’s transport vehicles.

Dayton Children’s Hospital is a regional pediatric referral center and has nearly 250,000 visitors annually.

In addition to providing funds for the hospital, the radiothon also helped promote Foresters Strong Foundation and National Agents Alliance through co-branded marketing materials, including radio and newspaper advertisements.

In addition to Connors, the following NAA agents also participated: Alex Abuyuan, Carl Brown, Daniel Brown, Tim Byers, Cindy Byers, Doug Jackson, and Melissa Rinehart.

For more information about NAA’s community involvement, contact Kurt Ward at 336-227-3319, ext. 160 or kward@naaleads.com.