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SonrĂ­e; Best's Insiirante Reports,

Potential improvement 6-7%

improvement. As shown in Exhibit 22.15, the total company value would increase by $602 million if the improvements could be made.

Next, preliminary analysis of pricing policy suggested that even at improved underwriting performance levels, Company X could maximize the value of its worker's compensation line by raising prices by 7 percent and accepting an expected 30 percent reduction in premium volume. When a similar analysis was applied across the board, aggregate premium volume was expected to decline 13 percent, but the higher prices more than offset this decline, and the total company's value was estimated to increase by $44 million.

Another example of how value drivers shape management thinking is taken from a life insurance company. Let's call it Long Life. Before experimenting with value-based management, Long Life had identified three important value drivers: expense ratio, mortality, and the new premium growth rate. The puzzle was that two of its top competitors had higher profit margins despite the fact that Long Life had superior results in the three levers that management thought were most critical. Something was missing. Through a valuation analysis, the company identified three new value drivers, namely the policy lapse rate, volume of reinsured policies, and investment yield. To everyone's surprise, the investment yield was as important as the expense ratio. Long Life's management decided to track investment yield regularly, and to study opportunities to increase it through improved cash management and portfolio optimization techniques.

Exhibit 22.15 Potential DCF Improvement from Reduction of Combined Ratio to Upper Quartile by Line

Exhibit 22.15 Potential DCF Improvement from Reduction of Combined Ratio to Upper Quartile by Line

Summary

Insurance companies are financial institutions that provide value for their shareholders (or their policyholders, if they are mutual companies) by writing insurance and investing money. We recommend valuing insurance companies by discounting free cash flow to equity at the cost of equity (we used GAAP accounting but we also demonstrated that free cash flows are the same whether one uses GAAP or statutory accounting). We demonstrated our approach by valuing TransAmerica. Finally, we illustrated some of the value drivers of insurance companies as applied in practice.

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