Insurance Companies Valued By Net Tangible Assets

Insurance companies derive income mainly from two sources: 1) income derived from policy sales -- insurance policy and annuity sales -- and 2) income derived from their investment portfolios. The insurance business has been described by Warren Buffett (who knows the insurance business extremely well) in his legendary annual reports as follows (here paraphrased): an insurer collects funds from policy holders, invests those funds, and then over time pays claims to policy holders from its received funds. And, as usually over time competition drives the sum of payments for claims to equal or exceed the total amount of funds received from policy payments (ie the "Combined Ratio" tends to trend towards 100), the rate of return on the funds is a key driver of the overall earnings for an insurance company.

The Significance of a Large Investment Portfolio to Market Capitalization for Insurance Companies:

The larger the investment portfolio compared to the market capitalization of the insurer may mean that the insurer is undervalued, with caveats (caveats are discussed below). That is, an intelligent investor would like to see a large sum of tangible assets and net assets (assets-liabilities) on the balance sheet compared to the market value of the firm for a possible value investment.

Note that on the balance sheet of insurance companies, most of the tangible assets of an insurance company will be the insurer's investment portfolio, while on the liabilities side, the main liabilities will be estimated future claims by policy holders and debt. Valuation of the asset side is relatively straightforward -- as most of the investment portfolio is invested in bonds, which are written at cost or at market value. The liability side of the insurance company is the larger source of uncertainty, as the estimate of future liabilities is the assessment of the insurer's actuary and may be different depending on low probability events ("acts of God") and possible miscalculations by the actuary. But note that generally the larger the firm, the better the law of averages works for the valuation of the liabilities side. For example, more confidence can generally be placed on AIG's future expected policy claims (liabilities) vs a sub-$50M asset insurance company.

Caveats -- mentioned above -- concerning this measure of the assets to market value of the insurance firm include:
A. Whether the insurer is gaining market share, (that is, an insurance company with a declining market share may not be an attractive investment even if it has a large and profitable investment portfolio)
B. has a quality credit rating --lower rated insurers should sell at a lower multiple than higher rated insurers
C. has estimated its future policy claims appropriately, (the investor does not want to see too many "surprises" in policy claims)
D. has written appropriate policies -- is pricing risk appropriately.

Analysis of the Largest Insurance Companies Worldwide:

An analysis of the largest publicly held insurers (including life and P&C and excluding reinsurance only)-- shows that there is a large discrepancy between the largest insurers in terms of price to tangible assets, but less of a discrepancy in price to tangible book value, as shown in the following chart (companies listed from lowest to highest price/tangible assets):

Ticker; Company;P/E (Hist/Proj); Tangible Assets ($US); Price/Book Value; Market Cap/Assets; Market Capitalization
ING; ING; 9.6/9.3; $1.58Tr; 2.08x; 6.2%; $96.8Bn
AZ, Allianz; 9.6/9.0; $1.46Tr; 2.28x; 6.5%; $94.5Bn
MET; Metlife; 8.6/11.5; $527.5Bn; 1.76x; 9.6%; $50.8Bn
PRU ; Prudential; 14.9/12.7; $454.3Bn; 2.03x; 10.5%; $47.9Bn
AIG; AIG; 12.6/10.4; $869.8Bn; 2.02x; 21.5%; $187Bn
ACE; Ace Ltd; 8.2/8.6; $65.0Bn; 1.65x; 31.3%; $20.4Bn
CB ; Chubb Corp; 10.0/9.0; $50.2Bn; 1.65x; 44.0%; $22.1Bn
LFC; China Life; 10.2/22.4; $69.4Bn; 2.56x; 51.0%; $35.4Bn

Discussion of the Largest Insurance Companies' Asset Values:

A few figures are striking from the above chart. First, the total assets of the German based Allianz and the Netherlands-based ING are huge -- larger than AIG in the United States (AIG is the largest insurer in the US) by a significant margin -- Allianz holds tangible assets of $US1.46 Trillion at current Euro/Dollar exchange rates compared to AIG's $US869.8Bn in tangible assets. In other words, Allianz holds 68% more tangible assets than AIG, and ING holds a similar number of assets as Allianz.

Discussion of the Significance of the Higher Asset Values at AZ and ING vs AIG:

The first observation concerning the higher asset numbers is that AZ and ING are much more levered (hold more liabilities to equity) than AIG -- AZ is levered at 21.8x assets to equity, ING is levered at 29.0x assets to equity, while AIG is levered at a much lower 8.6x assets to equity. In other words, if AIG was levered at the same level as ING (29.0x), AIG would hold an incredible $2.9 Trillion of assets. Note also that AIG's net equity value (assets minus liabilities) is approximately $100Bn compared to $70.2Bn for Allianz; AIG on this measure can be considered a larger company.

However it would not be straightforward for AIG in the above example to add a very large sum of tangible assets. Note that these are the two ways in which insurance companies gain assets, by selling either 1. insurance policies and/or 2. annuities (it is generally not the case that an insurance company will borrow money from the bond market or banks only to invest in bonds). In order for AIG to gain the number of assets of either Allianz or ING, AIG would have to either 1) underwrite a sum total of 70% more insurance policies than AIG currently has on its books and fund these policies from debt, and/or 2) sell a very large number of annuities. It would likely be very difficult to gain an incredible $700M of new policies for any firm, at an acceptable risk/pricing profile.

It follows that, the high value of tangible assets reflects that both AZ and ING are huge firms, which dominate their respective country's insurance markets and the EU. Further, one could say that the tangible assets that both AZ and ING are most likely "quality" -- meaning assets in which the companies can derive increased earnings from investment earnings -- although the high leverage places more importance on the soundness of the company's respective underwriting policies and liability and interest rate management policies.

Do the Higher Asset Values of AZ and ING Mean that they are Undervalued?

It is argued here that both AZ and ING are somewhat undervalued, compared to the large insurance universe. The price/tangible book value of AZ and ING are equivalent to AIG at approximately 2x, but the assets are as mentioned above higher, leading to higher earnings leverage with more variability. The S&P credit rating of AZ and ING are AA- and AA respectively, compared to AIG's AAA rating -- so all insurers have very strong ratings, although it is possible AZ is in line for a credit upgrade with a few more quarters of strong profitability. The European economies are improving currently (mid-2007) with reforms instituted.

Lower Differences in Price/Tangible Book Value in the Large Insurance Universe:

The second salient feature of the above is that the differences in the price/tangible book value is less dramatic than the price/asset values. Possibly an interpretation of this is that the market will give limited credit to a higher risk profile -- more asset leverage. Further, all the large insurers listed above have many analysts following them, so the likelihood of hidden value between the firms is less.