How Investment Bankers Value Insurance Companies Valuation of Insurance Operations April 10 Casualty Actuarial Society

In Todays Market Casualty Actuarial Society

Two Approaches Market Approach Fundamental Approach Traditional Approach Non-traditional Approach Casualty Actuarial Society

Market Approach Research Analyst Buy-side Analyst Investor Community Casualty Actuarial Society

Market Approach Valuations for property casualty insurance companies have declined significantly during the past year The decline in the property casualty sector is the result of deterioration in the industry fundamentals that drive value Casualty Actuarial Society

Market Approach Volatility of the industrys results has declined over the last twenty years 0.0x 0.5x 1.0x 1.5x 2.0x 2.5x 3.0x 3.5x 4.0x Standard Deviation Volatility of Property & Casualty Earnings Casualty Actuarial Society

Which operating factors drive stock market values? Profitability, as measured by return on equity Profit margin Operating leverage Earnings consistency Standard deviation of change in earnings Reserve development In other words, the market rewards risk adjusted returns on capital Casualty Actuarial Society

Value Drivers Return on Equity Earnings Consistency Earnings Growth Price/Book Baldwin & Lyons, Inc.0.79x W.R. Berkley Corporation0.65 Capitol Transamerica Corp.1.00 HCC Insurance Holdings, Inc.1.31 Markel Corporation1.74 Medical Assurance, Inc.1.40 NYMAGIC, Inc.0.52 Penn-America Group, Inc.0.78 Philadelphia Cons. Holding Co.1.13 RLI Corp.0.93 Casualty Actuarial Society

Value Drivers Casualty Actuarial Society

Value Drivers Casualty Actuarial Society

Value Drivers Casualty Actuarial Society

Who Cares about the Actuaries Casualty Actuarial Society

Frontier Chart Casualty Actuarial Society

Meadowbrook Chart Casualty Actuarial Society

Consolidation and the Need for Economies of Scale Opportunities for convergence Need for multiple distribution channels Need for broader line of products Need to achieve greater efficiencies Need to minimize rating pressures Need for improved access to capital Casualty Actuarial Society

Increased Consumer Awareness Consumers more informed through internet More product choices and distribution methods increase awareness Privacy issues becoming more significant Consumers becoming informed about structural alternatives (such as demutualization) Casualty Actuarial Society

Margin Erosion Commodity products (e.g. term insurance, auto) New entrants Widespread consumer information Competitive pressures – increasing loss ratios High cost distribution systems Casualty Actuarial Society

Rating Pressures and Capital Requirements Eroding profits or growth rates put pressure on ratings Low rates of return on equity Some companies have high loss ratios – reserves need strengthening Casualty Actuarial Society

Fundamental Analysis We traditionally base our valuation of insurance companies on four valuation methodologies: Analysis of public market comparables Private and public market M&A transactions Discounted cash flow analysis Additional areas of value that must be developed with potential buyers Casualty Actuarial Society

Comparable Company Analysis We focus our multiple analysis on Price/Earnings and Price/Book multiples. In analyzing these multiples, we consider the following factors: Core earnings power of the Company Earnings growth compared to the comparable companies Relationship between price to book value and return on equity Casualty Actuarial Society

M&A Transactions Analysis Additionally, we analyze recent private and public market transactions for companies within comparable sectors We look closely at the specific characteristics of each transaction in order to find the most comparable multiples Casualty Actuarial Society

Multiple Analysis Casualty Actuarial Society

Discounted Cash Flow Analysis A discounted cash flow approach offers a good proxy for value due to the following: Multiple analyses may be too weighted to the historical performance, which in some cases is limited Discounted cash flow approach captures both growth and operating profitability Casualty Actuarial Society

Discounted Cash Flow Analysis The discounted cash flow analysis captures the value of both the value of the existing balance sheet and the value of new business. Casualty Actuarial Society

Discounted Cash Flow Analysis In valuing the existing balance sheet, we focus on the following components: The existing surplus (pro forma for any reserve strengthening or other adjustments) The value of the runoff of the reserves (actuarially determined payout pattern) Any value/equity in the unearned premium reserve (value of deferred acquisition cost) Casualty Actuarial Society

Discounted Cash Flow Analysis In valuing the new business, we focus on the following factors: The premium growth potential The potential to introduce new products The projected combined ratio for the business The expected payout of the future reserves and associated investment income Casualty Actuarial Society

Valuation Summary Casualty Actuarial Society

Non-traditional Approach Due to the uncertainty of the quality of the Company's earnings, We value some of the Companies based on an analysis of the various components of the company Casualty Actuarial Society

Non-traditional Approach - Example The Company stock has not recovered since its 2 nd Quarter earnings announcement Casualty Actuarial Society

Non-traditional Approach As a starting point we attempt to determine the tangible book value of the company: Eliminated the goodwill from previous transactions Estimated the current adequacy of loss reserves Casualty Actuarial Society

Non-traditional Approach We add to the current book value an estimate of the value of the premium using two approaches: Value based on projected cash flows from the in-force book of business Estimated cost to purchase a book of business of that size Casualty Actuarial Society

Non-traditional Approach We also attempt to assess the value of the runoff of the loss reserves by estimating the payout of the liabilities and the associated investment income earned on the runoff. Casualty Actuarial Society

Non-traditional Approach The final component of value that we included was the value of any non-risk bearing segments Value of service businesses are sometimes incorporated in the book value of the company Estimated value from future earnings on the business or estimated sale value of the business Casualty Actuarial Society

Non-traditional Approach Casualty Actuarial Society

Non-traditional Approach Casualty Actuarial Society

Non-traditional Approach The value of new business was projected out over 30 years. The underwriting performance assumptions were as follows: Base Case: 118% combined ratio, decreasing to 117% in 2002 Loss ratio of 95% Expense ratio of 23% Casualty Actuarial Society

Non-traditional Approach Case 2: 115.7% combined ratio, decreasing to 114.7% in 2002 Loss ratio of 95%, decreasing to 94% in 2002 Expense ratio of 20.7% Casualty Actuarial Society

Non-traditional Approach Gross written premium is projected to decrease 20% in 2000, increase at an annual rate of 5% from 2001 to 2004, slow to a growth rate of 2.5% from 2005 to 2009, and then grow at a rate of 1% for each year thereafter A valuation range was obtained by applying discount rates to both scenarios Casualty Actuarial Society

Non-traditional Approach Casualty Actuarial Society

Non-traditional Approach An estimated valuation range was generated by selecting a discount rate of 7-10% and calculating the implied NPV. Casualty Actuarial Society

Non-traditional Approach A valuation range was selected by applying current multiples of public companies and multiples from M&A transactions to the projected results of the company Casualty Actuarial Society

Conclusion Why are you doing the valuation? For whom are you doing the valuation? What changes may occur at the target or the investment? Everybody has an opinion, thats what makes a market Casualty Actuarial Society