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Exhibit 22.13 Estimated Equity Value of TransAmerica
Cash flow Economic profit PV factor PV of CF PV of EP
1999 1,437 121 0.9141 1,313 110
2000 451 228 0.8355 377 191
2001 450 224 0.7637 3-11 171
2002 449 219 0.6981 313 153
2003 439 207 0.6381 230 132
2004 430 194 0.5832 251 113
2005 420 192 0.5331 224 97
2006 410 169 0.4873 200 82
2007 400 156 0.4454 178 69
2008 390 142 0.4071 159 5E
Continuing value 4,637 1,444 0.4071 1,888 58S
Operating value 5,527 1,765
Beginning of period equity, less unrealized capital gains 3,762
Equity value (less capital gains) 5,527 5,527
Mid year adjustment factor 1.04 1.04
Total equity 5,738 5,738
Plus: Unrealized capital gains 1,943 1,943
Less: Market value of preferred stock 0 0
Estimated total equity value Market value of equity
Percent difference 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
First quartile = 104%
I 104.2 I 105.3
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95 100 105 110!