Study compares the accuracy of valuation methods of insurance companies

Although book value multiples tend not to be an accurate measure when valuing non-financial firms, these multiples perform relatively well when valuing insurance companies, the study shows. In fact, over the last decade, book value multiples have performed significantly better than earnings multiples. Contributing factors include the financial nature of the majority of insurance company assets and liabilities, the relatively small size of unrecognized intangibles, and the role of capital-related regulation.

Analysts often exclude Accumulated Other Comprehensive Income (AOCI) from book value, a practice that is unique to the insurance industry. This is usually seen as a way to reduce the volatility of book value and mitigate accounting distortions. However, excluding AOCI tends to worsen, rather than improve, the accuracy of valuation, the study shows. AOCI measures unrecognized economic gains and losses that increase net invested assets, and should therefore be included in book value.

In another surprising finding, the study also showed that excluding realized investment gains and losses from earnings does not improve valuation accuracy. An exception occurred during the recent financial crisis, most likely caused by an increase in "gains trading," or the selective realization of gains.

Consistent with common industry practice, the study finds that conditioning the price-to-book ratio on return on equity significantly improves the valuation accuracy of book value multiples. In contrast, incorporating proxies for growth, earnings quality and risk does not consistently improve out-of-sample predictions.

Two methodological issues relevant for the use of price multiples are the definition of industry group and the measurement of shares. The study finds that, for insurance companies, limiting peers to the same sub-industry (as opposed to using all insurance companies) improves valuation accuracy, and that adjusting with respect to potentially dilutive shares improves earnings-based valuations but not book value-based valuations.

The sample used in the study includes information from all insurance companies available in the intersection of three databases: IBES, CRSP, and COMPUSTAT. Market-related data, such as price, stock returns, shares, and adjustment factors, were extracted from CRSP and Yahoo! Finance (for recent data).

Provided by Columbia Business School