8.

VALUATION OF A LIFE INSURANCE COMPANY

8.1 INTRODUCTION

Valuation of an insurance company, and a Life Insurance Company for that matter, may provide
useful information, and give confidence to any potential investor into that company. Additionally,
any such investor would require the trust that the company’s actuaries have made sound and
reasonable assumptions about the company’s premium income and future claims.

8.2 VALUATION

A couple of measures can be used to value insurance companies, and they happen to be common
to financial companies in general.

These are Price to Book (PB) and Return on Equity (ROE). PB is a primary valuation measure that
relates the insurance company’s stock price to its book value, either on a total company value or a
per-share amount.

In accounting, the book value is the value of an asset according to its balance sheet account
balance. The value is based on the original cost of the asset, less any depreciation. Traditionally, a
company’s book value is its total assets minus intangible assets and liabilities. However, in
practice, depending on the source of the calculation, book value may invariably include goodwill,
intangible assets, or both. When intangible assets and goodwill are explicitly excluded, the
measure is often specified to be ‘tangible book value’.

An asset’s initial book value is its actual cash value or its acquisition cost. Cash assets are recorded
or ‘booked’ at actual cash value. Assets such as buildings, land and equipment are valued based
on their acquisition cost, which includes the actual cash cost of the asset plus certain costs tied to
the purchase of the asset, such as agent’s fees.

Monthly or annual depreciation, amortization and depletion are used to reduce the book value of
assets over time as they are ‘consumed’ or used up in the process of obtaining revenue.

Book value, which is simply shareholders’ equity, is a proxy for a company’s value should it cease
to exist and be completely liquidated.

Price to tangible book value takes away goodwill and other intangible assets to give an investor a
more accurate gauge on the net assets left over, should the company fold up.

For an insurance company, the 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 company is generating as a shareholders’ equity, or
book value. The higher the ROE, the better.

As with any valuation exercise, there is as much art as science in getting reasonable value estimate.
Historical numbers may be easily calculated and measured, but valuation is about making a
reasonable estimate of what the future holds.

8.3 PUBLIC & PRIVATE FIRMS

The most obvious difference between privately-owned companies and publicly-traded companies
is that, public companies have sold at least a portion of themselves during an initial public offering.
This gives outside shareholders, an opportunity to purchase an ownership (or equity) stake in the
company in the form of a stock or shares. Private companies on the other hand, have decided not
to access public markets for financing, and therefore ownership in their businesses remains in the
hands of a select few shareholders.

The biggest advantage of going public is the ability to tap the public financial markets for capital,
by issuing public shares or corporate bonds. Having access to such capital can allow public
companies to raise funds to take on new projects or expand the business. The main disadvantage
of being a publicly-traded company is that the Securities & Exchange Commission (SEC) requires
such companies to file numerous filings, such as quarterly earnings reports, etc.

Private companies are not bound by such stringent regulations, allowing them to conduct business
without having to worry so much about SEC policy and public shareholder perception. This is the
primary reason why private companies choose to remain private than enter the public domain.

Although private companies are not typically accessible to an investor, instances do arise where
private companies will seek to raise capital, and ownership opportunities present themselves. For
instance, many private companies will offer employees stock as compensation, or make shares
available for purchase. Additionally, private companies may seek capital from private equity
investments and venture capital. In such a case, those making an investment in a private company
must be able to make a reasonable estimate of the value of the company, in order to make an
educated and well-researched investment.

The simplest method of estimating the value of a private company is to use Comparable Company
Analysis (CCA). To use this approach, one must look to the public markets for companies which
most closely resemble the private (or target) companies, and base valuation estimates on the values
at which publicly-traded peers are traded. To do this, one requires at least some pertinent financial
information of the private company.

While no two companies are the same, similarly sized competitors with comparable marketshare
will be valued closely on most occasions.
8.4 EMBEDDED VALUE

The Embedded Value (EV) is a construct which allows insurance companies to be valued. Thus
the EV of a life insurance company, is the present value of future profits plus adjusted net asset
value.

EV measures the value of the insurer by adding today’s value of the existing business (i.e. future
profits) to the market value of net assets (i.e. accumulated past profits).

It is a conservative measure of the insurer’s value in the sense that it only considers future profits
from existing policies and so ignores the possibility that the insurer may sell new policies in future.
It also excludes goodwill. As a result, the insurer is worth more than its EV.

Embedded Value is calculated as follows:

EV = PVFP + ANAV

Where EV = Embedded Value

PVFP = Present value of future profits

ANA = Adjusted Net Asset Value