Company Valuation Under IFRS : Interpreting and Forecasting ...

Company valuation under IFRS
How can a business be profitable if it has negative margins? Because there is a
timing difference between when it receives income and when it pays out against
claims. The other side of the insurance business is its investment activity, and
when investment returns are taken into account the overall business should
(under normal circumstances) generate a profit. Not for nothing have insurance
companies been named ‘investment trusts with an expensive hobby’, though this
is unfair. The underwriting business generates cash on which the investment
business aims to earn a return.
Although we have not yet looked at the balance sheet, it is evident that the
balance sheet of an insurance company will be dominated by two items. The first
is investment assets, and the second is a provision for the payments that it is
likely to have to pay out in future against claims. Estimating the required reserves
is clearly an actuarial matter, but it is notable that in this business reserves
represent more than 100 per cent of net earned premiums. The reason for this is
that many contracts have a life of more than one year. General insurance
contracts will vary in length, and it is not surprising that reserves in the industrial
and marine and energy businesses represent a larger multiple of annual net earned
premiums. The contracts cover longer periods. Establishing the appropriate level
of reserves is clearly the most complex task for the management of an insurance
company and its actuaries.
We shall pass over the subsequent three pages of this model without comment,
since these work in exactly the fashion just described. But we need to pause at
page five, the Runoff business. This represents a long-tailed exposure to a
business that the company is discontinuing (imagine insurance against asbestosrelated
health claims as a possible example) and against which the company
believes that it will be required to place considerable reserves, despite enjoying
no operating income from the business.
4.3.2.2 Consolidated profit and loss account
Most of the profit and loss account on page six of the model represents an
aggregation of the businesses that we have already modelled. The main item
requiring explanation is the investment return. We shall look at how this is
forecast later, but at this stage will merely concentrate on the allocation of
investment income. Insurance company investments comprise two separate
sources of funds. The larger part represents the provisions that have been made
against future expected claims. The smaller part represents the equity
shareholders’ interests. Unlike an industrial company, or even a bank, for an
insurance company equity does not finance the operations of the business. For an
industrial company, we finance invested capital with debt and equity. With a bank
we finance the assets with capital and deposits. But with an insurance company
the act of underwriting generates cash. The equity does not, in that sense, finance
anything, other than at the start of the company’s life, when it is required to fund
the acquisition cost of the first new business. Once the company is mature, equity
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