Relative Valuation of U.S. Insurance Companies

Abstract

This study examines the accuracy of relative valuation methods in the U.S. insurance industry, using price as a proxy for intrinsic value. The approaches differ in terms of the fundamentals used, the adjustments made to the fundamentals, the use of conditioning variables, and the selection of comparables. The primary findings are as follows: Unlike for non-financial firms, book value multiples perform relatively well in valuing insurance companies and are not dominated by earnings multiples. In fact, over the last decade book value multiples have performed significantly better than earnings multiples. That is, estimated values calculated as the product of book value and the average price-to-book ratio of comparable insurers are generally closer to price than are similarly-calculated earnings-based value estimates; Inconsistent with the practice of many insurance analysts, excluding Accumulated Other Comprehensive Income (AOCI) from book value worsens rather than improves valuation accuracy; As expected, using income before special items instead of reported income improves valuation accuracy, but, surprisingly, excluding realized investment gains and losses does not. An exception to this latter result occurred during the financial crisis, likely due to an increase in “gains trading” activities; Conditioning the price-to-book ratio on ROE significantly improves the valuation accuracy of book value multiples. In contrast, incorporating proxies for growth, earnings quality and risk does not consistently improve out-of-sample predictions, although these determinants of the price-to-book ratio generally have the expected effects and are significant; Limiting peers to the same sub-industry (as opposed to all insurance companies) improves valuation accuracy; Adjusting with respect to potentially dilutive shares improves earnings-based valuations but not book value-based valuations; As expected, valuations based on analysts’ earnings forecasts outperform those based on reported earnings or book value. However, the gap between the valuation performance of forecasted EPS and the conditional price-to-book approach was relatively small during the last decade.

Keywords: insurance, valuation, accounting

JEL Classification: G22, G12, M41, G30