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Estimated total equity value Market value ol equity

Estimated total equity value Market value ol equity

Percent difierence between market and estimated value

Value-Based Management at Insurance Companies

This section summarizes some of the insights that a shareholder value perspective and DCF valuation approach have brought to insurance companies. Separating Asset Management from Insurance Operations

Insurance companies are organized most often by product line. A property and casualty company may have a worker's compensation division, an auto insurance division, a homeowner's division, and so forth. Each will have its own profit and loss statement and balance sheet and will handle its own asset management. In this sense, the organization seems logical because it is customer facing, by type of coverage. But a further breakdown may help.

There are really two kinds of business within each of these divisions: insuring risks and investing the cash from premiums until claims are paid. Insurance companies have traditionally not separated value creation into these two parts. Yet, with advanced portfolio performance techniques it is possible to determine whether the investment management side of the business is creating or destroying value. When companies have consolidated these investment activities under one chief investment officer with clear accountability, they have often been able to increase their portfolio return by 10 to 50 basis points without changing the level of risk.

To consolidate investment management activities, the company needs some way of providing the various lines of business with a fair return on their investment portfolio. Companies can do this by paying a market return based on a fixed income portfolio matched to the duration of their reserves. In this way, the product line managers can focus on the insurance aspects of their business and the asset manager can focus on the investment management side of the business.

Tax and Earnings Management

Insurance companies bolster income by realizing capital gains when the results from the rest of their business have turned down. But the maneuver may reduce the value of the company because the effect of realizing capital gains is to pull the company's cash outflows for tax into the present.

The opposite situation—the realization of capital losses—is also worth discussing. In early 1982, one of the authors met with the chief investment officer of a major West Coast insurance company. The executive's company had roughly $50 million in unrealized capital losses in its bond portfolio because interest rates had risen dramatically in the past year. He also said that the company had about $50 million in realized capital gains elsewhere in its business. An immediate reaction was to suggest a tax offset by taking the losses on the bond portfolio to shelter the taxes on the gains. The executive rejected the idea "because our profits would be lower if we realize the capital losses." And, he continued, "our share price depends on our profitability." We protested, asking whether he would change his mind if we produced evidence that the marketplace values companies on cash flows, not profits. "That's irrelevant because our CEO believes that the market follows earnings," he replied. And that was more or less the end of the conversation. Even today beliefs have not changed much. But don't forget the lesson of Chapter 5: The empirical evidence heavily supports the conclusion that stock prices depend on cash flows, not earnings.

Using Value Driver Analysis to Change Strategies

A large property and casualty company studied three value drivers: combined ratio, pricing policy, and potential divestiture of selected business units. The total value impact was estimated at $798 million. Exhibit 22.14 shows Company X's combined ratio relative to its peers during a three-year period.

The company decided that it would try to achieve performance in the first quartile of its peer group, meaning a 7 percent combined ratio

Exhibit 22.14 Company X Combined Ratio Relative to Peer Group

Sonríe; Best's Insiirante Reports,

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