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The Actuary The magazine of the Institute & Faculty of Actuaries
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Insurance: Float-based valuations

What is an insurer’s float?
For a general insurer the major components of its float are reserves for unpaid losses, unearned premiums and other liabilities to policyholders less premiums and reinsurance receivable and deferred acquisition costs. Usually, it is possible to work out the float from balance sheet information but sometimes estimates are necessary.

Float-based valuations of some insurance companies
General insurance companies often trade at share prices around net asset value. Given the competitive nature of the industry, this is not surprising. High returns on capital are rare because barriers to entry are low and competition is often based on price.

Nevertheless, a few insurers do have reasonable prospects of superior returns. Their higher profitability should justify valuation at a premium to asset value. How high should this premium be? Float-based methods provide a quick way of measuring value.

The float concept is lucidly explained in the annual reports of Berkshire Hathaway. The net insurance liabilities in the accounts, known as the float, are similar to a loan that has a cost related to underwriting losses. Consider a simplified insurer, with a balance sheet comprising an investment portfolio of £3 billion balanced by net insurance liabilities of £2 billion (its float) and shareholders’ equity of £1 billion. It breaks even on pure underwriting each year and is not growing. Returns to shareholders will therefore be the returns on the investment portfolio. If the investment return is the market return then the shares will be worth three times the asset value. The multiple should be even bigger if this insurer can increase its float, make an underwriting profit or achieve a superior investment return. If it can do all three for a long time then the sky is the limit for valuation, a fact familiar to long-term Berkshire Hathaway shareholders.

There are two ways to do a quick and dirty float-based valuation of an insurer that is expected roughly to break even on underwriting. We can add back the float to shareholders’ equity. Alternatively, we can deduct return-bearing liabilities (such as corporate debt) from investment assets and cash. The raw valuation can then be adjusted to allow for other factors.

Table 1 shows some rough calculations for two insurers at the end of 2010. Their float-based valuations turn out to be around twice their respective market capitalisation and more than twice their respective net tangible assets.

Amlin and Hiscox have grown their balance sheets and enjoyed a negative cost of float on average over the last five years. So a valuation based on underwriting breakeven and no growth might be conservative, making the shares look at least 50% undervalued. On the other hand, market conditions or competitive advantages could deteriorate, resulting in future underwriting losses or float shrinkage or both. Furthermore, a significant discount could be applied to the investment portfolios to allow for potential return shortfalls, future taxation and lack of investor access to capital. So it might be far-fetched to say the shares are half-price fair value. No investment recommendation is being made here. However, float-based methods can help to focus the valuation appraisal on the longer-term prospects for underwriting and investment.

A few insurance companies do achieve market capitalisations close to equity plus float. The well-regarded US automobile insurer, The Progressive Corporation, is growing and aims for a 96% combined ratio. It currently trades at over twice asset value and at roughly equity plus float.

Perhaps more intriguing is the huge discount to equity plus float of Munich Re. Adding back the roughly €40 billion float in its general insurance and reinsurance operations to its equity (including equity in its large life and health businesses, which is conservatively calculated) gives a total of over €60 billion. This is about three times its market capitalisation of €22 billion. Taxation of investment returns and a deteriorating reinsurance market no doubt account for much of the gap. However, it is conceivable that the shares might be undervalued. Berkshire’s significant shareholding in Munich Re, the high dividend yield and the company’s continual repurchasing of its own shares might support that view.

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Andrew Maclaren is a private investor, self-employed actuary and a trustee of the AQA pension scheme