Companies are required to place a value on all their investments, but it is not so easy to value something in run-off Bryan Joseph outlines some of the solutions.
The latest version of the rules set out under International Accounting Standards requires companies to produce a realistic valuation of their investments.
Investments that are listed on a recognised stock exchange are simple to value and indeed there exists a liquid market for them in the majority of cases. What happens, however, if your asset consists of a re/insurance company where the business is in run-off? How do you place a realistic value on an entity where there are limited markets and within which the outcome is very uncertain?
These are questions that are exercising the minds of the directors and shareholders of re/insurance companies and their auditors, and for which there is no straightforward answer. So what methods should be applied by management seeking to place a value on their run-off insurance business?
Book value assessment
The most basic valuation can be developed by considering the book value of the re/insurer. The vast majority of insurance entities are held within the accounts of their parent companies at book value or net asset value.
This value has the advantage of being simple to calculate and easy to explain to audiences. The user is reliant on the integrity and accuracy of the insurance companies' report and accounts and as these have generally been audited they do provide a basis of fact. We would note, however, that companies rarely change hands on the basis of their book value and in the case of run-off insurers, they are often sold at a discount to book value.
Present value of future distributions
Another valuation method that can be used is to value the entity as the present value of the future profits available from the company. Under this method of assessment, the valuation is conducted by assessing the future dividend stream that is likely to be available as the portfolio is run off to extinction. This approach places the run-off entity on a similar basis to the evaluation of other investments. It is, however, quite complex to undertake for a number of reasons which include:
- Insurance companies, as regulated entities, often have to seek permission from their regulators in order to make dividend payments. This permission is unlikely to be forthcoming if the company's solvency is impaired or the regulator is concerned about the nature and quantum of the liabilities on the companies' books.
- It is difficult to establish what should be the basis of the discount for future distributions; ie, what interest rate should be used and what amounts should be included in the cash flows to be discounted.
Regulators have a responsibility to the policyholders and not to the shareholders of an insurance company. They are therefore concerned with making sure that there are sufficient assets available to pay the future insurance liabilities of the company and not to meet shareholders' requirements for a return on or of their investment. As a consequence, forecasting a future dividend stream is neither simple nor straightforward.
In the UK, the regulator is on record as stating that a run-off company will be allowed to distribute any amounts over a valuation of the liabilities that can be described as 'worst plausible'.
Worst plausible is not a defined regulatory or actuarial term, however a consensus opinion has developed that an assessment of the insurance and expense liabilities of the company that approximates to a level of certainty in excess of 95% on an undiscounted basis can be described as a worst plausible assessment. It is then customary to discount the worst plausible liabilities using the risk free rate for bonds of appropriate duration that will match the mean term of the liabilities to establish the free assets and thus the assets that are available for distribution.
This type of approach is complicated but is becoming increasingly possible and consistent with the management of run-off business in the UK. The UK regulators require run-off companies to produce business plans that include financial plans. These plans include the calculation of forecasts of the company's liabilities on both a best estimate basis and on a worst plausible basis. These forecasts can be used as the basis of the calculations described, if a UK company is being evaluated.
Actuaries are often involved in these calculations as they have the models available to establish the liabilities on both the best estimate basis and also on an approximate worst plausible basis. It then remains to the investor or assessor to identify an appropriate discount rate for the purposes of the valuation.
Investors are familiar with this concept and indeed there is a considerable body of financial theory which discusses the choice of a discount rate for different types of investor. Suffice it to state that the holder of the business should evaluate the insurance company as though it were another investment project and if the cost of holding the insurance company is exceeded by the utility achieved by freeing up the locked in capital and deploying it elsewhere then the investor should dispose of the business.
The precise market value of a company can only be established when the business is bought or sold. This presents some difficulty as whilst there are now ready markets for businesses in run-off, establishing the value of the business to a potential purchaser is a more difficult process.
The vendor should always consider a number of issues when considering the value of the business for sale. These include:
- The business is always worth less than the vendor thinks. An existing portfolio of business may be benefiting from a number of aspects of being part of a larger group of companies. When this business is separated from its parent and has to operate on its own.
- The majority of investors purchasing run-off portfolio are looking for private equity type levels of return on their capital employed.
- The quantum of the provisions that are necessary for a run-off company that is being sold is greater than that of a company being retained within a group as the buyers are seeking to achieve an adequate return on their investment.
So how should an investor calculate the value of a company from its perspective?
To assess this value the investor needs to take a detailed look at the company's balance sheet. The investor has to:
- Consider the case estimates of the company. The valuation needs to understand how the case estimates of the company have been established, the source of major disputes and how well the claims have been controlled in the past.
- Adjust liabilities so that they are placed on a realistic best estimate basis. Companies establish their reserves on a wide variety of bases and there is a significant amount of judgment in the establishment of case reserves and IBNR (Incurred But Not Reported). In a number of instances, companies implicitly discount their provisions by simply funding reserve increases on a rolling basis rather than on a comprehensive one. The investor or its actuaries will assess the reserves and ensure that they are raised to the standard of a reasonable best estimate.
- Evaluate any additional amounts that are needed to raise the best estimate reserves to the reserves that are suitable for a sale. In my experience, the majority of companies change hands with reserves that are set at an implied 75% to 85% level of certainty on an undiscounted basis.
- Assess the reinsurance asset. Reinsurance provisions are, for many old London Market portfolios, one of the largest assets of the company.
As a consequence, they require detailed scrutiny. The assessor should obtain or create a reinsurance structure diagram, that identifies the key elements of the programme, its security, any disputes, the current processes for handling reinsurance submissions and where the big outwards asset lies. The analysis should also identify the provisions made by the company in respect of its reinsurance programme and the basis for those provisions.
- Consider the principal to principal position of the company. The target company as has been customary for many insurance entities is likely to maintain its records on an agent or broker basis and not on a customer basis. This position is not satisfactory as the assessor needs to know and understand who the company's debtors and creditors are and therefore be able to make rational decisions on how cash flow should be managed.
The valuation should at the minimum identify the liabilities of the largest customers of the company.
- Consider the personnel employed by the company. Insurance is a people business and it is important that the quality and suitability of staff forms part of any evaluation. The cost of any redundancy programme or to buy-out any staff benefits should also be evaluated as a charge against the assets.
- Other assets. The assets held by the company need to be assessed against the ability to convert them into cash. Cash or cash equivalent assets have the lowest volatility and there is therefore a charge that must be made against any assets that are more volatile.
The above considerations plus some of the softer issues will lead to a number of financial adjustments that determine the value of the insurance company under consideration. This value should be compared with the present value of the future distributions that would be expected from the insurance companies at the investors' required rate of return.
We have discussed how to value an insurance company using a number of different mechanisms. It only then remains to identify where actuaries fit into this process. Actuaries are and have been engaged in the financial modelling of insurance reserves. They do have a role to play in establishing the level of reserves, the speed of the run-off and the amounts required to raise reserve levels to varying degrees of certainty. In combination with a wider team of business professionals they can assist in answering the question, "How much is that portfolio worth?"
- Bryan Joseph is managing principal at Karoni Insurance Services Ltd.