Investors To Insurers: Diversify At Your Own Peril
In studying what drives shareholder value in the insurance industry, our research has convinced us that key business fundamentals have consistently shaped insurance company valuations, even in the midst of change and turmoil.
We have also found that specializing in a few businesses–and doing them well–has become important as market cycles shorten, the levels of expertise required have risen, and products and prices have become commoditized.
Theoretically, the advantages of strategic focus are clear. Resources, both capital and human, are scarce. Fundamentally, most organizations do only a small number of things extremely well. Also, scale is critical in each business a company operates in, and operating efficiency is critical to succeed in each business.
Our latest research effort explored the impact of specialization on market valuation. We examined the market performance of 69 U.S.-based, publicly traded companies over a five-year period ending in early 2002 in relation to various indicators of scale and specialization. The sample set covered a full spectrum of company types, ranging from pure-play life and property-casualty companies to multiline companies with a life or p-c emphasis.
Our analysis utilized various regression models to see whether capital markets systematically distinguish multiline from single-line companies. We modeled three variables for each company: the size of their life, annuity and health business; the size of their p-c business; and a concentration index variable based on the relative sizes of their life-health and p-c business lines. These variables were based on three different measures from company statutory filings, including net admitted assets, net premiums and reserves.
The key element of the analysis was the "concentration index," which measured the level of concentration in either life-health or p-c lines. Our analysis ran regressions that set these independent variables against the market capitalization of the company. The regressions were designed such that if the market showed a preference for specialized (or concentrated) companies, the regression coefficient of the concentration index would be non-zero and positive.
The results of the research are clear: there was overwhelming evidence that the capital markets reward companies that exhibit higher degrees of concentration in one of the two main industry segments–either the p-c sector, or the life, annuity and health lines.
Conversely, the markets penalize companies for diversification across those two broad businesses. Across every one of the various permutations of our regression model, the estimated coefficient on the concentration index indicated that investors view company specialization across the two lines positively.
Financial models of this type are considered robust if they explain a significant portion of the market capitalization across the universe of companies studied, and if the same model can explain variations in market cap over many years and varying market conditions. The model we developed easily met these criteria.
The results of this study not only reinforced the theory, but also provided a quantitative measure of the value of specialization. To illustrate just how much investors prefer business concentration, we can consider a specific example company. The example company is a large multiline insurer with a high concentration toward life, annuity and health products. The company has net admitted assets of $170 billion, of which only about 3 percent (roughly $5 billion) consists of p-c assets.
To illustrate the premium that the market places on concentration level, we can compare the impact on market capitalization of a change in p-c net admitted assets based on the results of two models: one in which we include the concentration index and the other in which we ignore it.
When we assume a full discarding of the p-c business (with all other characteristics held constant and ignoring proceeds received from any divestiture), without the concentration index our analysis suggests a fall in the company's market capitalization of $4.4 billion.
However, when the concentration index is included in the analysis, the expected dive in market capitalization would be only $413 million.
While the market will always be looking at a company as a whole, the estimated impact, in which the concentration index is taken into consideration, supports the intuitive conclusion that there will be little market reaction to the elimination of a small and non-core business. Further, this example does not take into account the value creation potential of an investment in the life-health lines using the proceeds from the sale of the p-c business.
We also saw an increasing trend in the importance of the concentration index over the five years analyzed. We interpret this trend as an indication that the capital markets have gravitated toward valuing specialized companies more favorably. Indeed, the past five years have witnessed the significant deconstruction of conglomerates in the U.S. insurance industry as companies have sought to become more concentrated.
Our analysis shows that the market approves this trend, and we expect to observe further mergers-and-acquisitions and divestiture activities aimed at achieving greater specialization. We may also begin to see the same trend for the non-U.S. conglomerates.
Executives should take note of this clear message from investors. For the multiline companies, the lowered asset base and reduced earnings associated with the divestiture of an entire line should be tempered by understanding the valuation premium that can be gained from achieving greater concentration.
Yes, market capitalization will likely fall in response to the elimination of a major business line. But equally likely, the capitalization will not plunge by as much as may be indicated on a pro forma basis, which does not take into account investor preferences for company specialization.
Similarly, recognition of the "concentration premium" should be factored into M&A considerations. Acquisitions of multiline targets may provide unrecognized value-creation potential because of the possibility of subsequently divesting acquiree's certain business lines and increasing the overall concentration level of the acquirer.
Investors have long resisted companies that have undertaken diversification on their behalf. Instead, investors like to reserve for themselves the prerogatives of diversification in keeping with their own risk and wealth profiles.
We have long hypothesized that in the financial services sector, specialized companies are more highly valued than diversified companies. With this analysis, we believe that we have provided a comprehensive look at this issue for the insurance sector.
Pete Porrino is global and Americas director of Insurance Industry Services for Ernst & Young in New York. Daniel Kahn is a senior manager in Ernst & Young's Strategic Finance and Valuation Services practice in Washington, D.C.
Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, July 21, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.
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