Minicases

M13.1 Valuing the Operations and the Investments of a Property and

Casualty Insurer: Chubb Corporation
This case shows how to value a property casualty insurer (and, by extension, insurers in
general). Most of the analysis that students will have done to this point will have involved
industrial and merchandising firms. Financial firms including insurers require a different
treatment for they make money from financial assets; that is, their operating assets involve
assets and liabilities that look like financial items to another firm. Insurers have a particular
feature that needs to be captured. The case shows how the financial statement reformulation is
done for an insurer in a way that follows its business model and identifies value added from the
business model.
The case also shows how the accounting for financial assets and liabilities at (fair) market
value can short cut the valuation process. The students should be impressed in how far one can
go in challenging the market price with the appropriate analysis of financial statements, without
the full pro forma analysis of later chapters. The reformulation is the key.
Background
Property and casualty insurers had a difficult time in the late 1990s and early 2000s,
typically reporting operating losses on underwriting. They covered those losses, often barely,
with investment income on the assets in which the float from underwriting was invested. Chubb
was no exception, as the combined loss and expense ratios for 2001 and 2002, given in the case,
demonstrate. The combined ratios for 1998-2000 were also close to or over 100, though previous
years were a little better..

NET PREMIUMS

COMBINED

(IN MILLIONS)

LOSS AND

YEAR

WRITTEN

1994

EARNED

3,951.2

$ 3,776.3

1995

4,306.0

1996

LOSS

EXPENSE

EXPENSE

RATIOS

RATIOS

RATIOS

67.0%

32.5%

99.5 %

4,147.2

64.7

32.1

96.8

4,773.8

4,569.3

66.2

32.1

98.3

1997

5,448.0

5,157.4

64.5

32.4

96.9

1998

5,503.5

5,303.8

66.3

33.5

99.8

1999

70.3

32.5

102.8

2000

67.5

32.9

100.3

As you see in the case, ratios improved substantially after 2003.

Understand the Business Model
If students have worked Minicase M9.2 in Chapter 9, they will understand how an insurer
operates and how the financial statements are reformulated in a way that highlights its business
model.
A property-casualty insurer underwrites losses by collecting cash from insurance
premiums and paying out cash for loss claims. There is a timing difference between cash in and
cash out the float and the insurer plays the float by investing it elsewhere. Effectively the
policyholders provide cash that is invested in investment assets. In the reformulated balance
sheet, the float is represented by negative net operating assets. So the reformulated balance sheet
depicts the two aspects of the business the negative net operating assets in underwriting and the
positive investment in securities (which is also part of operations). Accordingly, the reformulated
balance sheet takes the following form:

- Net operating assets in underwriting operations

+ Net operating assets in investments

= Total net operating assets
- Financing debt
= Common equity
NOA in investments is positive, but NOA in underwriting is negative: The negative NOA in
underwriting is the source of financing for the investment, along with common equity and any
financing debt. The investment assets also serve as reserves against claims in the underwriting
business and the type of investments are constrained by regulation to make sure the
Warren Buffet and Berkshire Hathaway follow this model. They see themselves as being
good as assessing and pricing risk, so good at generating value in the insurance business. But
they also see themselves as good (fundamental) investors in equities. The insurance business
adds value and at the same time provides the cash to invest in other businesses.
The Balance Sheet Reformulation
(next page)
(The original financial statements are at the end of the case solution for Minicase 9.2 if they are
needed as handouts or presentation material.)

Chubb Corp. Reformulated Balance Sheet, December 31, 2006-2007

Underwriting operations
Operating assets:
Cash
Premiums receivable
Reinsurance recoverable on unpaid claims
Prepaid reinsurance premiums
Deferred policy acquisition costs
Deferred income tax
Goodwill
Other assets

2007

2006

49
2,227
2,307
392
1,556
442
467
1,366

38
2,314
2,594
354
1,480
591
467
1,715

8,806

9,553

Operating liabilities:
Unpaid claims and loss expenses
Unearned premiums
Accrued expenses and other liabilities

22,623
6,599
2,090

Net operating assets- underwriting

31,312

22,293
6,546
2,385

(22,506)

31,224
(21,671)

Investment operations:
Short-term investments
Fixed maturity investment-held to maturity
Fixed maturity investment-available for sale
Equity investments
Other invested asets
Accrued investment income
Total net operating assets

1,839
33,871
2,320
2,051
440

40,521

2,254
135
31,831
1,957
1,516
411

38,104

18,015

16,433

3,460

2,466

Common shareholders' equity

14,555

13,967

As reported
Dividends payable

14,455
110
14,565

13,863
104
13,967

Long-term debt

Notes:

1. Dividends payable has been reclassified as shareholders equity.

2. Other invested assets ($2,051 in 2007) are investments in private equity limited
partnerships are carried in the balance sheet as Chubbs share in the partnership based on
valuation provided by the private equity manager. Changes in these valuations are
recorded as part of realized investment gains and losses in the income statement.
The negative NOA in underwriting activities represents the float. The investment assets, though
they look like financial assets, are operating assets because a firm cannot run a risk underwriting
business without the reserves in the assets. Indeed, insurers typically make their money from
investing the float in these assets. The separation identifies two aspects of the business, one
where value is created (or lost) through underwriting and one where value is created (or lost) in
investment operations.

The Reformulated Income Statement

Rather than reporting other comprehensive income within the equity statement, Chubb reports a
separate comprehensive income statement (below the income statement in Exhibit 9.16). The
reformulated statement combines the two statements and separates the two types of operations.
Corresponding to the reformulated balance sheet, the reformulated income statement separates
income from underwriting activities from income from investment activities.

Reformulated Income Statement, 2007

Underwriting operations:
Premiums earned

11,946

Claims and expenses:

Insurance losses
Amortization of deferred policy acquisition costs
Other operating costs

6,299
3,092
444

Operating income before tax-underwriting

2,111

Corporate and other expenses

Operating income before tax, underwriting and other
Income tax reported
Tax on investment income
Core operating income after tax - underwriting
Currency translation gain, after tax
Additional pension cost
Operating income after tax, underwriting and other

9,835

300
1,811
1,130
663

125
(17)

(467)
1,344

108
1,452

Investment operations:
Before-tax revenues:
Investment income-taxable2
Realized investment gains
Other revenue
Investment expenses
Income before tax
Tax (at 35%)
Income after tax
Investment income-tax exempt
Unrealized investment gain after tax
Comprehensive income

(1738-232)

1,506
374
49
1,929
35
1,894
663
1,231
232
134

1,597
3,049

Notes:
1. Currency translation gains are identified with underwriting in other countries. These
gains are reported after tax in the comprehensive income statement.

2. Realized investment gains include gains and losses from revaluations of interests in
private equity partnerships. See note to the reformulated balance sheet.
3. Taxable investment income is total investment income minus tax-exempt income of
$232 million. The $232 million of tax-exempt income is added after tax is assessed.

Note also the following:

1. Placing the income statement on a comprehensive basis gives a more complete picture. The
net income is misleading because it omits unrealized gains and losses from available-for-sale
securities. A firm can cherry pick realized gains by selling the securities in its portfolio that
have appreciated. Comprehensive income includes the income from (available-for-sale)
securities that have dropped in value, so one gets the results for the whole investment
portfolio. For Chubb in 2007, unrealized gains (not losses) are reported, so there is no
indication of cherry picking (at least on a net basis).
2. Taxes are allocated between the investment operations and the underwriting (and other)
operation. The tax rate of 35% is applied only to taxable investment income (not the tax
exempt income).
3. Notice that the combined loss and expense ratio (9,835/11,946 = 82.3%) is approximately
that reported by Chubb for 2007 (82.9%). Notice that the ratios insurance companies report
do not include taxes in expenses.
Question A
The calculation of ReOI for underwriting:
Core ReOI from underwriting = Core income (0.09 NOA in underwriting)
= 1,344 (0.09 -22,089)
= 3,332

Core underwriting income (that excludes currency translation gains and pension adjustments)
is used because we want that income that projects to the future, purged of these transitory
items. Average NOA over the year is used.
Understand why residual income from core operations is greater than core income. The
ReOI has two components, core income and a positive amount for the charge against the
NOA: $1,344 + 1,988 = 3,332. The first component is, of course the income from
underwriting, the excess of premium revenue over expenses. The second component
represents the income from investing the float. The ReOI measure appropriately captures all
aspects of value added in the insurance business: you can make money from underwriting
(premiums greater than losses) but you also get a float to invest and that adds further value.
Note, for the subsequent analysis, that growth in ReOI is determined by increasing
underwriting income or by growing the float. There is a tension, for one can increase income
by raising premiums, but this results in less business so reduces the float. One can go for a
higher float by reducing premiums and making less income. This trade-off is at the heart of
managing an insurance operation.
The required return used is the 9% for the underwriting operations, not the expected return
on investments. Although the float is invested in the investment, it is at risk in the
operationsand the risk of losing the float. The risk in the investment assets is lower than
that for underwriting the investments are predominately relatively safe fixed income assets,
as required by required by insurance regulations.

Challenging the Market Price of $54 per Share: Negotiating with Mr. Market
The value of the equity has three components:

Value of investments
+Value of underwriting operations
- Value of financing debt
= Value of equity

We can proceed with any valuation in two ways (as Chapter 13 has instructed):
1. If the balance sheet reports the value, use the balance sheet number. Expected residual
earnings must be zero, so there is no need for forecasting.
2. If the balance sheet does not report the value, forecast future residual earning to add value
to the book value
That is, value is the book value plus the present value of expected residual earnings from balance
sheet items not at market value.
Approach (1) saves a lot of work: the accountant has the balance sheet correct, so there is
no need to add value. For Chubb, all of the investments are market to market in 2007, so we can
read the value of the investment operation from the balance sheet. (There are no held-to-maturity
investments in 2007. If there are, you can mark them to market with market values obtained from
the investments footnote).
Balance sheet value of investments

$40,521 million

(At this point it might help to review the accounting for securities; see Accounting Clinics III and
V). There is an issue here regarding the $2,051 million carrying value for other invested assets.
These are investments in private equity limited partnerships and are carried in the balance sheet
as Chubbs share in the partnership based on valuation provided by the private equity manager.
These valuations could be fair value, but not so if the manager has investments in side pockets
awaiting more solid information about valuation. There are other reservations about using
balance sheet fair values (or market values) as an indication of value. We come back to this at
the end of the case discussion.

We can also take the book value of the financing debt as its market value (unless there is
evidence of deterioration of credit quality since its issue). So, the value of the equity is:
Value of investments
+Value of underwriting operations
- Value of financing debt
= Value of equity

$40,521
?
( 3,460)
?__

The market value of the equity = $54 374.65 million shares

= $20,231 million
(Shares outstanding is issued shares minus treasury shares; there are no treasury shares)
So, we can calculate the markets implied valuation of the underwriting operations:
Value of investments
+Value of underwriting operations
- Value of financing debt
= Value of equity

$40,521
(16,830)
( 3,460)
$20,231

The value of the underwriting operations is (a negative) -$16,830 million. It is must be

negative so as to avoid double counting: the float is invested in the investments. Or seeing it
another way, the firms owes more to claimants than it has in assets for the underwriting
operation. Dont be fooled in thinking the firm must be a BUY because the market is valuing
the insurance business negatively (or is valuing the firm less than the value of the investment
securities): The two parts of the business work together insurance companies must have
reserves.
If we are satisfied with the balance sheet values for the investments and debt, we need
consider only the value of the underwriting operations. Challenging the market value for the
underwriting business is equivalent to challenging the equity price of $54 per share. Is $16,830 too high or too low?

To make the challenge, one could develop forecasts and compare the value implied by
those forecasts with the market price. We dont have information for that here (and it is
difficult for an insurance company). So we take two approaches. First we work with the
current information in the financial statements and test the market price with feasible
scenarios about how the future will involve from the present. Second, we employ reverse
engineering. These are our tools in negotiating with Mr. Market, as Benjamin Graham
would say.
Scenario: What value is implied if current ReOI were to continue into the future at the same
level of $3,332 million?
Value (underwriting) = 22,506

3,332
0.09

= $14,516 million
This is considerably higher than the -$16,830 implied by the market price, so we have leaned
something about Mr. Markets beliefs: The market must see ReOI as being much lower in the
future. 2007 looks like an exceptionally good year. Indeed, the comparison of combined loss
ratios over time indicate this.
Lets play with other scenarios. Remember that ReOI is driven by underwriting profit and
loss and growth in NOA (a more negative NOA; a higher float).
Scenario: Suppose that one expected zero core income from underwriting in the future and no
growth in the float:
Core ReOI from underwriting (2008) = Core income (0.09 NOA in underwriting)
= 0.0 (0.09 -22,506)
= 2,026
and
Value (underwriting) = 22,506

2,026
0.09

= -5 million
This is still higher than the markets valuation, so the market must expect underwriting losses in
the future or a decrease in the float. Is a forecast of underwriting losses reasonable? They
answers is yes.
The year, 2007 was an exceptional year for Chubb, with a combined loass and expense
ration of 82.9%. Very often, insurance companies report losses on underwriting. This makes
sense: A negative asset should have a negative return. Insurance companies are competing for
the business of getting a float. To get this free money they beat down the price of insurance
policies to the extent that they incur losses. Putting it from the policyholders point of view: If
we are going to give you a float, we will charge you for it in lower premiums. The outcome of a
competitive situation between insurance companies must typically be losses: in (competitive)
equilibrium, a negative asset must have negative income.
Rather than working with our own scenarios, lets now turn to reverse engineering to
discover Mr. Markets scenarios.
Scenario: What would be the ReOI, earned as a perpetuity, that would justify a value of -$16,830
for the underwriting business? With book value of NOA of -$22,506 at the end of 2007,
Value (underwriting) = -16,830 = -22,506 +

?
0.09

? = 511
If NOA were to continue at their level at the end of 2007, the income from underwriting that
would yield this ReOI would be
ReOI = 511 = ? (0.09 -22,506)
? = -$1,515
(an annual after-tax loss of $1,515 million).

The $511 in ReOI could be driven by both the size of the expected float and the loss earned
on the float. A constant ReOI of $511 million is just one scenario for justifying a valuation of
$54 per share.
Scenario. Insurance companies have good years and bad years. One might thus run a scenario
based on the average income/loss experience.
Chubbs average combined loss and expense ratio from 2001-2007 is 95.7%, from the
numbers in the case. (Including the ratios from 1994 to 2000 gives an average of 97.5% over
14 years, a little higher.) This number averages out the ups and downs of the business. Apply
this to 2007 premiums to get a normalized operating income:
Premium revenue
Insurance losses and expenses @ 95.7%
Underwriting income before tax
Tax (at 35%)
Operating income

11,946
11,432
514
180
334

If the same income were forecasted for 2008, ReOI for 2008 would be:
ReOI2008 = 334 + (0.09 -22,506) = 2,360
Plug this is into the valuation formula and reverse engineer the growth rate:
Value (underwriting) = -16,830 = 20,506

2,360
1.09 g

The solution for g is less than 1.0 (its 0.674, or a negative growth rate of 32.6%). That is, the
market sees the future prospects as lower than that from current premiums and historical
combined loss and expense ratios. Again, this could be due to lower expected operating
income (higher loss and/or expense ratios that the average here) or an expected decline in the
float.

We have not got a firm conclusion, but we have a handle. If, for example, we see the firm
as having a combined loss and expense ratio of 95.7% on average in the future and expect
some growth in the float (on even a small decline in the float) we would conclude that Chubb
is a BUY at $54. Take it from there.
One can now run other scenarios to test the market price against what is seen as reasonable
prospects. These would always involve three drivers:
1. Premiums
2. Loss and expense ratios
3. The size of the float (the negative NOA)

If, after running scenarios, you think the stock is underpriced (for example), take just one
more step before committing to trade. Ask: is there something the market is seeing that I dont
see? Are there new insurance exposures Has the risk of insurance position changed? Is the firm
getting into derivates.insuring debt with credit default swaps, for example?
Question B
1. Investment income (in the income statement) does not feature at all. Once one has the value
in the balance sheet, the income statement information becomes useless.
2. Not used, for the reason in 1. Further, these are pure transitory as these investments cannot
be sold again in the future and indeed may reflect cherry picking.
3. Not used; pure transitory fluctuations in market prices do not predict the future.
4. Important: used directly in the valuation. We make use of mark-to-market accounting.
5. These are part of the investment portfolio marked to market on the balance sheet.
6. Important. The NOA for investments gives their valuation. The NOA for underwriting is
the starting point for the valuation of the underwriting activities.

7. Tax is allocated to al parts of the income statement. It is important to get the income from
underwriting on an after-tax basis.
Question C
We used a comprehensive income statement! See the notes under the reformulated income
statement above.

Question D: Some Accounting Considerations

One always questions the quality of the accounting used in valuation. Two issues arise here.
1. The quality of the mark-to-market accounting.
We have used the mark-to-market numbers directly to value the investments. Are these
market values from liquid markets, or is estimated fair value accounting introducing
biases? Look at footnotes and see what proportion of values are Level 1, 2, or 3 under FASB
Statement No. 157.
Note that, even if these are sound market prices, we will have severe reservations if the
prices are from a bubble market or a depressed market (and thus not intrinsic values) -- the
equity investments, in particular. Note that Chubb held mortgage-backed securities with a
fair value of $4,750 million as part of its investment portfolio at the end of 2007. These
securities dropped significantly in value after the housing bubble burst (and trading them
became very difficult).
We also had a question as to whether the carrying value of the private equity investments
were their intrinsic value.
2. The quality of the unpaid claims reserve.

This is an estimate that can be biased. Check the footnote on the estimation of the liability.
Insurance companies give a good explanation for their calculations, with checks against the
historical record.