Valuing Insurance Organizations

Valuing Insurance Organizations

Over the years I have been called on quite frequently to estimate the value of insurance organizations.

Insurance companies need to be valued most often, but agencies, third-party administrators, managing general underwriters, and marketing organizations can be valued using the same basic principles.  I am generally asked to estimate the economic value of the organization, rather than the market value.  The economic value is generally equal to the financial statement equity value plus the present value of future earnings under a chosen set of assumptions.  Economic value calculations are often used to evaluate the offers received, which make up the market value of the organization.

The first step is to adjust the financial statement equity value.  Some items on a normal balance sheet are not valued at their current market value.  Goodwill, for example, generally needs to be eliminated because its value will be reflected in the present value of future earnings.  Real estate and fixed assets might need to be adjusted to their current market value.  Finally, intangible assets, like computer software, may need to be written off because their value will be reflected in projected future earnings.

The next step is to project future earnings from policies that have already been sold.  Once sold, an insurance contract may extend for months or years.  Earnings from these policies will flow through to the organization with little additional effort required.  The present value of these earnings is a major part of the economic value for most insurance organizations.  Projecting those earnings, however, is not trivial.  We generally use past experience to project future cash flows from premiums, claims, commissions, and expenses.

The third step is to project future earnings from new business.  This is the most subjective calculation required.  An organization may have an establish sales force and a proven marketing plan such that future sales can be projected with a high level of certainly.  On the other hand, projections of future sales are often highly speculative.  Additionally, we must decide how many years of new sales to include in the calculation.  At what point do the new sales cease to be a result of existing structures and become a result of future efforts?

Finally, all of these projected cash flows need to be discounted back to the present.  What discount rate should be used?  Certainly the time value of money needs to be considered, but risk-free interest rates are very low these days.  The risk element is highly subjective.  I generally use 15% as a benchmark rate for discounting future contingent cash flows from a commercial business.  However, if a business is operating in a highly uncertain environment, or has special restrictions on its ownership, a much higher rate might be appropriate.  This is a matter for the buyer and seller to decide, and it plays a large role in defining the ultimate value of the organization.

How could I help you right now?

Ask the Actuary

Leave a Reply

Your email address will not be published.