Analysis and Valuation of Insurance Companies

Abstract

During 2008 and 2009, the insurance industry experienced unprecedented volatility. The large swings in insurers’ market valuations, and the significant role that financial reporting played in the uncertainty surrounding insurance companies during that period, highlight the importance of understanding insurers’ financial information and its implications for the risk and value of insurance companies. To facilitate an informed use of insurers’ financial reports, this manuscript reviews the accounting practices of insurance companies, discusses the financial analysis and valuation of insurers, summarizes relevant insights from academic research, and provides related empirical evidence. The paper contains three sections. The first section describes the insurance business, including activities and organization of insurance companies, products and services, distribution channels, competition, regulation, taxation, and risks and risk management. The second section discusses how insurance activities are reflected in financial reports. Specifically, for each key line item from insurers’ financial statements, the study provides evidence on the economic significance of the item, reviews the related US accounting principles, discusses earnings quality issues, describes analyses and red flags that inform on the item’s quality, reviews selected research findings, and describes the primary differences between International Financial Reporting Standards (IFRS) and US GAAP. Building on the discussion and analyses in the previous two sections, the third section addresses the valuation of insurance companies. The section starts by discussing the primary drivers of insurers’ intrinsic value, including profitability, growth prospects and cost of equity capital, as well as accounting quality indicators that inform on the reliability of the measured drivers. It then describes relative and fundamental valuation models that translate those fundamentals into value estimates. Finally, in the context of fundamental valuation models, the study presents a template for forecasting the key financial statement line items of insurance companies.