M14.1 Valuing the Operations and the Investments of a ... · M14.1 Valuing the Operations and the...

The Value of Operations and the Evaluation of Enterprise Price-to-Book Ratios and Price-Earnings Ratios

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M14.1 Valuing the Operations and the Investments of a Property and

Casualty Insurer: Chubb Corporation

This case shows how to value a property casualty insurer. Most of the analysis that

students will have done to this point will have involved industrial and merchandising

firms. Financial firms – including insurers – require a different treatment for they make

money from “financial assets;” that is, their operating assets involve assets and liabilities

that look like financial items to another firm. Insurers have a particular feature that needs

to be captured. The case shows how the financial statement reformulation is done for an

insurer in a way that follows its business model and identifies value added from the

business model.

The case also shows how the accounting for financial assets and liabilities at (fair)

market value can short cut the valuation process. The students should be impressed in

how far one can go in challenging the market price with the appropriate analysis of

financial statements, without the full pro forma analysis of later chapters. The

reformulation is the key.

Background

Property and casualty insurers had a difficult time in the late 1990s and early 2000s,

typically reporting operating losses on underwriting. They covered those losses, often

barely, with investment income on the assets in which the float from underwriting was

invested. Chubb was no exception, as the combined loss and expense ratios for 2001

(113.4%) and 2002 (106.7%), given in the case, demonstrate. The combined ratios for

1998-2000 were also close to or over 100, though previous years were a little better…..

NET PREMIUMS COMBINED

(IN MILLIONS) LOSS AND

LOSS EXPENSE EXPENSE

YEAR WRITTEN EARNED RATIOS RATIOS RATIOS

1994 $ 3,951.2 $ 3,776.3 67.0 % 32.5 % 99.5 %

1995 4,306.0

4,147.2 64.7 32.1 96.8

1996 4,773.8

4,569.3 66.2 32.1 98.3

1997 5,448.0

5,157.4 64.5 32.4 96.9

1998 5,503.5 5,303.8 66.3 33.5 99.8

1999

70.3 32.5 102.8

2000

67.5 32.9

100.3


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As you see in the case, ratios improved substantially after 2003.

Understand the Business Model

If students have worked Minicase M10.2 in Chapter 10, they will understand how an

insurer operates and how the financial statements are reformulated in a way that

highlights its business model.

A property-casualty insurer underwrites losses by collecting cash from insurance

premiums and paying out cash for loss claims. There is a timing difference between cash

in and cash out – the float – and the insurer plays the float by investing it elsewhere.

Effectively the policyholders provide cash that is invested in investment assets. In the

reformulated balance sheet, the float is represented by negative net operating assets. So

the reformulated balance sheet depicts the two aspects of the business – the negative net

operating assets in underwriting and the positive investment in securities (which is also

part of operations). Accordingly, the reformulated balance sheet takes the following

form:

- Net operating assets in underwriting operations

+ Net operating assets in investments

= Total net operating assets

- Financing debt

= Common equity

NOA in investments is positive, but NOA in underwriting is negative: The negative NOA

in underwriting is the source of financing for the investment, along with common equity

and any financing debt. The investment assets also serve as reserves against claims in the

underwriting business. The type of investments are constrained by regulation.


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Warren Buffet and Berkshire Hathaway follow this model. They see themselves as

being good at assessing and pricing risk, so good at generating value in the insurance

business. But they also see themselves as good (fundamental) investors in equities. The

insurance business adds value and at the same time provides the cash—a float―to invest

in other businesses (which they have also done well).

The Balance Sheet Reformulation

(next page)

(The original financial statements are at the end of the case solution for Minicase 10.2 if

they are needed as handouts or presentation material.)


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Chubb Corp.

Reformulated Balance Sheet, December 31, 2010 ($ mllions) 2010 2009

Underwriting operations

Operating assets:

Cash 70 51

Premiums receivable 2,098 2,101

Reinsurance recoverable on unpaid claims 1,817 2,053

Prepaid reinsurance premiums 325 308

Deferred policy acquisition costs 1,562 1,533

Deferred income tax 98 272

Goodwill 467 467

Other assets 1,152 1,200

7,589 7,985

Operating liabilities:

Unpaid claims and loss expenses 22,718 22,839

Unearned premiums 6,189 6,153

Accrued expenses and other liabilities 1,725 30,632 1,730 30,722

Net operating assets- underwriting (23,043) (22,737)

Investment operations:

Short-term investments 1,905 1,918

Fixed maturity investment-held to maturity 19,774 19,587

Fixed maturity investment-available for sale 16,745 16,991

Equity investments 1,550 1,433

Other invested assets 2,239 2,075

Accrued investment income 447 42,660 460 42,464

Total net operating assets 19,617 19,727

Long-term debt 3,975 3,975

Common shareholders' equity 15,642 15,752

As reported 15,530 15,634

Dividends payable 112 118

15,642 15,752

Notes:


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1. Dividends payable has been reclassified as shareholders’ equity.

2. “Other invested assets” ($2,239 in 2010) are primarily investments in private

equity limited partnerships and are carried in the balance sheet as Chubb’s share

in the partnership based on valuations provided by the private equity manager.

Changes in these valuations are recorded as part of realized investment gains and

losses in the income statement.

The negative NOA in underwriting activities represents the float. The investment

assets, though they look like financial assets, are operating assets because a firm cannot

run a risk underwriting business without the reserves in the assets. Indeed, insurers

typically make their money from investing the float in these assets. The separation

identifies two aspects of the business, one where value is created (or lost) through

underwriting and one where value is created (or lost) in investment operations.

The Reformulated Income Statement

Rather than reporting other comprehensive income within the equity statement, Chubb

reports a separate comprehensive income statement (below the income statement in

Exhibit 10.16). The reformulated statement combines the two statements and separates

the two types of operations. Corresponding to the reformulated balance sheet, the

reformulated income statement separates income from underwriting activities from

income from investment activities.


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Reformulated Income Statement, Year Ended December 31, 2010

Underwriting operations:

Premiums earned 11,215

Claims and expenses:

Insurance losses 6,499

Amortization of deferred policy acquisition costs 3,067

Other operating costs 425 9,991

Operating income before tax-underwriting 1,224

Corporate and other expenses 290

Operating income before tax, underwriting and other 934

Income tax reported 814

Tax on investment income 638 (176)

Core operating income after tax - underwriting 754

Currency translation gain, after tax (18)

Postretirement benefit cost change 12 (6)

Operating income after tax, underwriting and other 752


Before-tax revenues:

Investment income-taxable2

(1665 - 241) 1,424

Realized investment gains 437

Other revenue 13

1,874

Investment expenses 50

Income before tax 1,824

Tax (at 35%) 638

Income after tax 1,186

Investment income-tax exempt 241

Unrealized investment gain after tax 69

Other-than-temporary impariments (4) 1,492

Comprehensive income 2,244


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Notes:

1. Currency translation gains are identified with underwriting in other countries.

These gains are reported after tax in the comprehensive income statement. But

they are not core income from underwriting—they do not predict future

income―nor are the pension cost changes (also in from other comprehensive

income).

2. Realized investment gains include gains and losses from revaluations of

interests in private equity partnerships. See note to the reformulated balance

sheet.

3. Taxable investment income is total investment income minus tax-exempt

income of $241 million (from footnote to the 10-K). The $241 million of tax-

exempt income is added after tax is assessed.

Note the following:

1. Placing the income statement on a comprehensive basis gives a more complete

picture. The net income is misleading because it omits unrealized gains and losses

from available-for-sale securities. A firm can “cherry pick” realized gains by selling

the securities in its portfolio that have appreciated. Comprehensive income includes

the income from (available-for-sale) securities that have dropped in value, so one gets

the results for the whole investment portfolio. For Chubb in 2010, unrealized gains

(not losses) are reported, so there is no indication of cherry picking (at least on a net

basis).

2. Taxes are allocated between the investment operations and the underwriting (and

other) operation. The tax rate of 35% is applied only to taxable investment income

(not the tax exempt income).

3. Note further, that the income from underwriting is usually quite small. Indeed, in

many years, insurance firms make losses on underwriting. Yet they add value, as we

will see.


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4. Notice that the loss and ratio (6,499/11,215 = 57.9%) is approximately that reported

by Chubb for 2010 (58.1%). The combined loss and expense ratio (9,991/11,215 =

89.1%) is also close to the ratio reported of 89.3%.

Question A

The calculation of ReOI for underwriting:

Core ReOI from underwriting = Core income – (0.06 × NOA in underwriting)

= 754 – (0.06 × -22,890)

= 2,127

This calculation requires some discussion:

First, average NOA in underwriting is used for the calculation.

Second, core underwriting income (that excludes currency translation gains and

pension adjustments) is used because we want the income that projects to the future,

purged of these transitory items.

Third, understand why residual income from core operations is greater than core

income. ReOI has two components, core income (positive here) and a positive amount

for the charge against the NOA: $754 + 1,373 = 2,127. The first component is, of

course, the income from underwriting, the excess of premium revenue over expenses.

The second component represents the income from investing the float. The ReOI

measure appropriately captures all aspects of value added in the insurance business:

you can make money from underwriting (premiums greater than losses) but you also

get a float to invest, and that adds further value.

Fourth, the 6% used for calculating the benefit of the float is not the required return

for the underwriting operations but the expected return from investing the float in


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investment assets given in the case. So the amount of $22,890 × 0.06 = $1,373 million

is the expected annual dollar return from investing the float.

Note, that we have identified the drivers of the ReOI for insurance activities and for

its growth. ReOI grows by increasing underwriting income or by growing the float.

There is a tension, for one can increase income by raising premiums, but this results in

less business so reduces the float. One can go for a higher float by reducing premiums

but making more losses (or lower income) in underwriting. This trade-off is at the

heart of managing a property-casualty insurance operation.

The 6% expected return from the making investments is different from the required

return used is the 9% for the underwriting operations. The later represents the risk of

the insurance operations…the risk making losses on underwriting and of losing the

float. The risk in the investment assets is typically lower than that for underwriting –

the investments are predominately relatively safe fixed income assets, as required by

required by insurance regulations. We will see how the 9% required return is applied

below.

Challenging the Market Price of $58 per Share: Negotiating with Mr. Market

The value of the equity has three components:

Value of investments

+Value of underwriting operations

- Value of financing debt

= Value of equity

We can proceed with any valuation in two ways (as Chapter 14 has instructed):

1. If the balance sheet reports the value, use the balance sheet number. Expected

residual earnings must be zero, so there is no need for forecasting.


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2. If the balance sheet does not report the value, forecast future residual earning to add

value to the book value

That is, value is the book value plus the present value of expected residual earnings from

balance sheet items not at market value.

Approach (1) saves a lot of work: the accountant has the balance sheet correct, so

there is no need to add value. For Chubb, most of the investments are market to market in

2010, so we can read the value of the investment operation from the balance sheet. (There

are no held-to-maturity investments in 2010. If there are, you can mark them to market

with market values obtained from the investments footnote).

Balance sheet value of investments $42,660 million

(At this point it might help to review the accounting for securities; see Accounting

Clinics III and V). There is an issue here regarding the $2,239 million carrying value for

“other invested assets.” These are investments in private equity limited partnerships and

are carried in the balance sheet as Chubb’s share in the partnership based on valuation

provided by the private equity manager. These valuations could be fair value, but not so

if the manager has investments in side pockets awaiting more solid information about

valuation. There are other reservations about using balance sheet fair values (or market

values) as an indication of value. We come back to this at the end of the case discussion.

We can also take the book value of the financing debt as its market value (unless

there is evidence of deterioration of credit quality since its issue). So, the value of the

equity is:

Value of investments $42,660

+Value of underwriting operations ?

- Value of financing debt ( 3,975)

= Value of equity ?__


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The market value of the equity = $58 × 297.273 million shares

= $17,242 million

(Shares outstanding is issued shares minus treasury shares:

Shares issued = 371,980,460

Treasury shares = 74,707,547

Share outstanding 297,272,913)

So, we can calculate the market’s implied valuation of the underwriting operations:

Price of investments $42,660

+Price of underwriting operations (21,443)

- Value of financing debt ( 3,975)

= Price of equity $17,242 million

The price that the market is placing on the underwriting operations is (a negative) -

$21,443 million. It must be negative so as to avoid double counting: the float is

invested in the investments. Or seeing it another way, the firms owes more to

claimants than it has in assets for the underwriting operation. Don’t be fooled in

thinking the firm must be a BUY because the market is valuing the insurance business

negatively (or is valuing the firm less than the value of the investment securities): The

two parts of the business work together – insurance companies must have reserves.

If we are satisfied with the balance sheet values for the investments and debt, we

need consider only the value of the underwriting operations. Challenging the market

price for the underwriting business is equivalent to challenging the equity price of $58

per share. Is -$21,443 too high or too low?

To make the challenge, one could develop forecasts and compare the value implied

by those forecasts with the market price. We don’t have information for that here (and

it is difficult for an insurance company). So we take two approaches.


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First,we work with the current information in the financial statements and test the

market price with feasible scenarios about how the future will involve from the

present.

Second, we employ reverse engineering. These are our tools in “negotiating with Mr.

Market,” as Benjamin Graham would say. They are also our tools in Chapter 7.

Scenario analysis:

What value is implied if current ReOI were to continue into the future at the same

level of $2,127million?

Value (underwriting) = 09.0

127,2043,23

= $590 million

Note that we use the ending NOA for underwriting her for that is the base for 2011

residual income. Note also that we use the required returns for the insurance operation,

9%, for that reflects its risk.

This ReOI of $593 million is considerably higher than the -$21,443 implied by the

market price, so we have learned something about Mr. Market’s beliefs: The market

must see ReOI as being considerably lower in the future. This would be the case if

2010 is an exceptionally good year. Indeed, the comparison of combined loss ratios

over time indicate this (only 89.3% for the combined loss and expense ratio in 2010).

Let’s play with other scenarios. Remember that ReOI is driven by underwriting

profit and loss and growth in NOA (a more negative NOA; a higher float).

Scenario: Suppose that one expected zero core income from underwriting in the future

and no growth in the float:

Core ReOI from underwriting (2008) = Core income – (0.06 × NOA in underwriting)


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= 0.0 – (0.06 × -22,890)

= 1,373

and

Value (underwriting) = 09.0

373,1043,23

= -7,787million

This is still higher than the market’s valuation, so the market must expect underwriting

losses in the future or a decrease in the float. Remember that this ReOI is driven by

expected underwriting income and growth in the float. As we have no growth built in,

we are saying that a valuation with no income from underwriting and no growth in the

float is higher than the market valuation. The market must be expecting underwriting

losses in the future or a decrease in the float.

Is a forecast of underwriting losses reasonable? They answers is “yes.” The year,

2010 was an exceptional year for Chubb, with a combined loss and expense ratio of

89.3%. But very often, insurance companies report losses on underwriting, as the ratios

for 1998-2002 at the beginning of the case make clear. This makes sense: A negative

asset should have a negative return. Insurance companies are competing for the business

of getting a float. To get this “free money” they beat down the price of insurance

policies to the extent that they incur losses. Putting it from the policyholders’ point of

view: If we are going to give you a float, we will charge you for it in lower premiums.

The outcome of a competitive situation between insurance companies must typically be

losses: in (competitive) equilibrium, a negative asset must have negative income. This is

indeed how operating liability leverage works: customers and supplies charge implicit

interest for using their money. See Chapter 12 and the Dell example there.


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Reverse Engineering:

Rather than working with our own scenarios, let’s now turn to reverse engineering to

discover Mr. Market’s scenarios.

Scenario: What would be the ReOI, earned as a perpetuity, that would justify a the

market price of -$21,443 for the underwriting business? With book value of NOA of -

$23,043 million at the end of 2010,

Value (underwriting) = -21,443 = -23,043 + 09.0

?

? = 144

If NOA were to continue at their level at the end of 2010, the income from

underwriting that would yield this ReOI would be

ReOI = 144 = ? – (0.06 × -23,043)

? = -$1,239 million

This is an annual after-tax loss of $1,239 million from underwriting. That seems

unreasonable, and there is no allowance for the growth in the float. This suggests that

the $58 price is low. Do you see how we are getting a handle on the problem?

Considering the ups and downs of the insurance business:

Insurance companies have good years and bad years. One might thus run a scenario

based on the average income/loss experience.

Chubb’s average combined loss and expense ratio from 2001-2010 is 93.4%, from

the numbers in the case. (Including the ratios from 1994 to 2000 gives an average of

95.8% over 17 years, a little higher.) This number averages out the ups and downs of


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the business. So it is a better indicator on the average outcome expected in the future.

Apply this to 2010 premiums to get a normalized operating income:

Premium revenue 11,215

Insurance losses and expenses @ 93.4% 10,475

Underwriting income before tax 740

Tax (at 35%) 259

Operating income 481

(Notice that this is lower than the underwriting income for 2010, a good year).

If the same income were forecasted for 2011, ReOI for 2011 would be:

ReOI2011 = 481 + (0.06 × -23,043) = 1,864

Plug this is into the valuation formula and reverse engineer the growth rate:

Value (underwriting) = -21,443 = g

09.1

864,1043,23

The solution for g is less than 1.0, that is, the market sees a negative growth rate. The

market sees the future prospects as lower than that from current premiums and

historical combined loss and expense ratios. Again, this could be due to lower

expected operating income (higher loss and/or expense ratios that the average here) or

an expected decline in the float.

We have not got a firm conclusion, but we have a handle. If, for example, we see

the firm as having a combined loss and expense ratio of 93.4% on average in the

future and expect some growth in the float (on even a small decline in the float) we

would conclude that Chubb is a BUY at $58. Isn’t the float likely to increase? Take it

from there.

One can now run other scenarios to test the market price against what is seen as

reasonable prospects. These would always involve three drivers:

1. Premiums


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2. Loss and expense ratios

3. The size of the float (the negative NOA)

One can also test to see how sensitive ones conclusions are to a higher discount rate that

9% or a lower expected return on investments that the 6% here.

If, after running scenarios, you think the stock is underpriced (for example), take just

one more step before committing to trade. Ask: is there something the market is seeing

that I don’t see? Are there new insurance exposures? Has the risk of insurance position

changed? Is the firm getting into derivates….insuring debt with credit default swaps, for

example? Are there any “tail” exposures (black swans) that I have not considered?

Postscript: Chubb’s share price stood at $70 in mid-April, 2012.

Question B

1. Investment income (in the income statement) does not feature at all. Once one has

the value in the balance sheet, the income statement information becomes useless.

2. Not used, for the reason in 1. Further, these are pure transitory as these investments

cannot be sold again in the future – and indeed may reflect cherry picking.

3. Not used; pure transitory – fluctuations in market prices do not predict the future.

4. Important: used directly in the valuation. We make use of mark-to-market

accounting.

5. These are part of the investment portfolio marked to market on the balance sheet.

6. Important. The NOA for investments gives their valuation. The NOA for

underwriting is the starting point for the valuation of the underwriting activities.

7. Tax is allocated to al parts of the income statement. It is important to get the income

from underwriting on an after-tax basis.


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Question C

We used a comprehensive income statement! This finesses the cherry picking problem.

See the notes under the reformulated income statement above.

Question D: Some Accounting Considerations

One always questions the quality of the accounting used in valuation. Two issues arise

here.

1. The quality of the mark-to-market accounting.

We have used the mark-to-market numbers directly to value the investments. Are

these market values from liquid markets, or is estimated “fair value” accounting

introducing biases? Look at footnotes and see what proportion of values are Level 1,

2, or 3 under FASB Statement No. 157.

The $2,239 million in “other invested assets” are primarily investments in private

equity limited partnerships and are carried in the balance sheet as Chubb’s share in

the partnership based on valuations provided by the private equity manager. If these

investments are not at fair value, then we do not have the appropriate value of the

investment portfolio, which of course feeds into the implied market price of the

underwriting activities. (If the private equity firm locks up until realization, this will

be the case). It is difficult to deal with this problem, but one could see how sensitive

the analysis above is to marking up the private equity investments somewhat.

Note that, even if these are sound market prices for investments, we will have

severe reservations if the prices are from a bubble market or a depressed market (and

thus not intrinsic values) -- the equity investments, in particular. In 2007, just before


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the financial crisis, Chubb held mortgage-backed securities with a fair value of

$4,750 million as part of its investment portfolio. These securities dropped

significantly in value after the housing bubble burst (and trading them became very

difficult). Commentators at the time said that there was a real estate bubble in 2007

2. The quality of the unpaid claims reserve.

This is an estimate that can be biased. Check the footnote on the estimation of the

liability. Insurance companies give a good explanation for their calculations, with checks

against the historical record.

Below are Chubb’s reformulated statements for 2007, for comparison.


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Chubb Corp. Reformulated Balance Sheet, December 31, 2006-2007 2007 2006

Underwriting operationsOperating assets:Cash 49 38 Premiums receivable 2,227 2,314 Reinsurance recoverable on unpaid claims 2,307 2,594 Prepaid reinsurance premiums 392 354 Deferred policy acquisition costs 1,556 1,480 Deferred income tax 442 591 Goodwill 467 467 Other assets 1,366 1,715

8,806 9,553 Operating liabilities:

Unpaid claims and loss expenses 22,623 22,293 Unearned premiums 6,599 6,546 Accrued expenses and other liabilities 2,090 31,312 2,385 31,224

Net operating assets- underwriting (22,506) (21,671)


Short-term investments 1,839 2,254 Fixed maturity investment-held to maturity - 135 Fixed maturity investment-available for sale 33,871 31,831 Equity investments 2,320 1,957 Other invested asets 2,051 1,516 Accrued investment income 440 40,521 411 38,104

Total net operating assets 18,015 16,433

Long-term debt 3,460 2,466

Common shareholders' equity 14,555 13,967

As reported 14,455 13,863 Dividends payable 110 104

14,565 13,967


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Reformulated Income Statement, 2007

Underwriting operations:

Premiums earned 11,946

Claims and expenses:

Insurance losses 6,299

Amortization of deferred policy acquisition costs 3,092

Other operating costs 444 9,835

Operating income before tax-underwriting 2,111

Corporate and other expenses 300

Operating income before tax, underwriting and other 1,811

Income tax reported 1,130

Tax on investment income 663 (467)

Core operating income after tax - underwriting 1,344

Currency translation gain, after tax 125

Additional pension cost (17) 108

Operating income after tax, underwriting and other 1,452


Before-tax revenues:

Investment income-taxable2

(1738-232) 1,506

Realized investment gains 374

Other revenue 49

1,929

Investment expenses 35

Income before tax 1,894

Tax (at 35%) 663

Income after tax 1,231

Investment income-tax exempt 232

Unrealized investment gain after tax 134 1,597

Comprehensive income 3,049


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Notes:

1. Currency translation gains are identified with underwriting in other countries.

These gains are reported after tax in the comprehensive income statement.

2. Realized investment gains include gains and losses from revaluations of

interests in private equity partnerships. See note to the reformulated balance

sheet.

3. Taxable investment income is total investment income minus tax-exempt

income of $232 million. The $232 million of tax-exempt income is added

after tax is assessed.

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