REAL AND ILLUSORY VALUE CREATION BY INSURANCE COMPANIES

INTRODUCTION One of the fundamental tenets of financial economics is that insurance companies, just as other financial and non-financial firms, have a very strong incentive to maximize current shareholder value. (1) This seemingly simple observation leads to a wide variety of managerial behavior. (2) In this article we will review a simple decomposition of the value of an insurance company. The decomposition illuminates the motivation for a variety of strategies that can be observed in practice. These strategies run the gamut from accounting manipulation through risk transfer schemes to positive net present value (NPV) "project" selection. We will review these in some detail below. Then we will illustrate these techniques from our experience with every major U.S. life insurer insolvency since Baldwin United in 1984. COMPONENTS OF From VALUE The market value of insurance company owners' equity is defined as the difference between the market value of assets and the market value of liabilities. For purposes of valuation, it is helpful to partition more finely the components of equity value. In this section, we will partition the value of insurance company owners' equity, or stock in the case of a stock company, into its four major components: franchise value, market value of tangible assets, present value of liabilities, and put option value (see Figure 1). The first two of these components are clearly assets. The third component is related to liability value. The put option value can be treated as part of the liability value as a contra-liability or as an asset. We will discuss each component in turn. [FIGURE 1 OMITTED] The franchise value stems from what economists call "economic quasi-rents." It is the present value of the "quasi-rents" that an insurer is expected to garner because it has scarce resources, scarce capital, charter value, licenses, a distribution network, personnel, reputation, and so forth. It includes renewal business. (3) Franchise value is dependent on firm insolvency risk. The less insolvency risk there is, the more likely the firm is to remain solvent long enough to capture all the available economic rents arising from its renewal business, its distribution network, its reputation, and so forth. (4) The market value of liabilities includes pricing of all contingencies within the insurance liabilities. In our decomposition we have elected to separate out the risk of the insurance company defaulting on its obligations. The risk of such a default is captured by the put option. Other contingencies, including such risks as interest rate contingencies, mortality contingencies, or equity market contingencies, are included in the present value of liabilities. Thus, the present value of liabilities is the present value of all promised liability cash flows discounted at Treasury rates rather than discounting at rates that would reflect the possibility of default. In the case of interest sensitive cash flows, it is the value of the Treasury security portfolio (including derivatives as needed) that fully defeases the liabilities with all non-default contingencies fully hedged. This quantity will be larger than the market value of liabilities where the promised liability cash flows are discounted at rates that reflect the risk of failure to make the promised cash flows. Merton (1974) initially observed that the value of a debt obligation could be expressed as the value of a default-risk free bond minus a put option. The put option represents the value to the issuer of the possibility of defaulting on the obligation. The same holds true for insurance liability obligations. The market value of liabilities can be expressed as the present value of liabilities minus the put option that represents the value to the issuer of potentially defaulting on the obligations. (5) The market value of tangible assets and the present value of liabilities can be netted together, producing what we will call "net tangible value. …