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Valuing the Intangibles: A Case Study

This case study explores the valuation of an insurance division in a management buyout deal, focusing on the intangible factors that impact its value. It discusses the challenges faced by the buyer and the seller and the factors that increase or reduce the value of the deal.

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Valuing the Intangibles: A Case Study

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  1. Valuing the Intangibles:A Case Study 2000 CAS Seminar on Valuation of Insurance Operations April 10, 2000

  2. Capital Z Commercial • A $1.85 billion private investment partnership founded in August 1998, headquartered in New York with offices in London, San Francisco, and Hong Kong. • Focused on investing in the insurance, financial services, healthcare and e-finance industries. • To date have invested (or committed to invest) $1.1 billion in 23 transactions, including 14 e-finance investments. • Typical “old economy” investment $30 - $250 million. • Typical “new economy” investment $20 - $30 million. • Atypical LP base.

  3. WHATEVER WE PAID - WHATEVER THE ACTUARIES SAID = VALUE OF INTANGIBLES (1) How to Value Intangibles: A Simple Formula (1) Based on highly scientific, actuarial survey of three Cap Z professionals

  4. Landscape of the Deal • Financially troubled insurance holding company (“Seller”) is seeking to sell one of three divisions (“Target”) in order to pay-down debt and refocus on its core business. • Capital Z is approached as a potential capital partner in completing a management buyout of the division, however, based upon initial meetings, determines that it is unwilling to proceed with the management team proposed by the seller. • Soon after, Capital Z is introduced to a small publicly traded company (“Buyer”) interested in acquiring the Target, but without the financial wherewithal to do so. • And thus, we all embarked upon an 18 month journey to complete the longest deal in history.

  5. Overview of Buyer • Publicly traded life and accident and health insurance holding company. • $150 million of direct premium, 145,000 policyholders, $139 million of premium in force. • Primarily focused in the senior market, with products including Medicare supplement, LTC, senior life and annuities. • Distributes product primarily in Florida, Texas and New York through large independent brokerages. • Highly efficient, low cost back office, processing significant internal and external client business. Capacity to absorb a substantial amount of business at a competitive incremental cost.

  6. Overview of Target • Comprised of six life and A&H insurance subsidiaries. • Products include fixed benefit disability income, hospital indemnity, term and whole life. • Distributes business to self-employed or blue collar households through a career agency distribution system with over 100 sales offices located in rural and suburban areas of the U.S. and Canada. • $170 million of direct premium, 300,000 policyholders, $326 million of premium in force. • Extremely high cost back office, poor historical financial performance and recent reserve adequacy issues.

  7. Actuarial Valuation - Target • Target was carried on the Seller’s GAAP financial statements at $470 million; during the initial meeting, Capital Z was provided with an in-house actuarial valuation supporting the GAAP valuation. • Upon review by outside actuarial consultants, this valuation was scrapped by Buyer and Capital Z and an entirely new valuation was undertaken. • This valuation incorporated actual run-rate expenses, actual (and industry consistent) loss ratios and expected production; further it incorporated reserve deficiencies uncovered during due diligence of approximately $40 million. • This analysis resulted in an after-tax actuarial valuation of the Target of $191 million.

  8. Pricing the Deal - Target • With a starting price of $191 million, at a discount rate of 15%, Capital Z and the Buyer then had to consider the intangibles in the deal. Intangibles Increasing Value • Unique career agency distribution force focused on an underserved market. • Products demonstrated stable risk characteristics, generally not subject to inflation or the rising cost of healthcare. • Target’s existing customer base represents a large, untapped market to seller Buyer’s senior market products. • Potential for significant consolidation expense savings, if executed properly by Buyer.

  9. Pricing the Deal - Target Intangibles Reducing Value • Discomfort with actuarial projection due to lack of integrity in company-prepared report and fact that final valuation was done “outside” of company. • Risk of adverse reserve development; company had poor track record on reserving and was continuing to review several reserve categories. • Extremely bloated expense structure designed for growth that had not materialized. • Demoralized employee base, due to on-going financial problems of holding company. • Corporate culture non-sales oriented; general failure to recognize agents as the true customers of the company.

  10. Pricing the Deal - Target Intangibles Reducing Value (continued) • Agency force had been repeatedly disappointed by holding company management in meeting commitments; further, prolonged sale process resulted in little or no new premium growth; significant relationship repair work required by Buyer. • Total lack of credibility with regulators and ratings agencies, due to consistent failure to meet financial and operational goals. • Tremendous amount of pressure on Seller from stock market, regulators, rating agencies and lenders to complete sale of Target. • Given potential bankruptcy of Seller, highly unlikely that there will be any ability to collect on violations of reps, warranties or indemnifications.

  11. Pricing the Deal - Target • The negotiated purchase price was $175 million, comprised of $137 million of cash and a $39 million Seller note, with offset rights against the note in the event of adverse reserve development. • Thus, the sum of the value of the “positive” and the “negative” intangibles resulted in a net reduction to the purchase price of $16-36 million (depending on ones’ view of the valuation of the note).

  12. Actuarial Valuation - Buyer • As part of the deal, Capital Z purchased $81 million of common stock of the Buyer, resulting in fully diluted ownership in excess of 50%. • Given the magnitude of the investment, Capital Z completed a full due diligence evaluation of the company, as well as a valuation process similar to the valuation of the Target. • Buyer’s management team prepared the initial actuarial valuation, utilizing actual company loss ratio experience, expected production and actual run rate expenses. • After some tweaking by Capital Z’s outside actuaries, the analysis resulted in an after-tax actuarial valuation for Buyer of $44.8 million or $2.92 per share.

  13. Pricing the Deal - Buyer • With a starting price of $44.8 million, at a discount rate of 15%, Capital Z then had to consider the intangibles in the deal. Intangibles Increasing Value • Excellent management team with significant experience in consolidating acquisitions (albeit small ones) and other purchased blocks of business. • Attractive senior market demographics, likely resulting in above- market growth. • Buyer has marketed and underwritten products similar or identical to Target’s products and has existing relationships with one of Target’s major producers.

  14. Pricing the Deal - Buyer Intangibles Increasing Value (continued) • Opportunity to cross sell Buyer’s senior market products into the Target’s existing customer base. • Equally important, ability to quickly develop and file products to be sold by Target agents. • “Cost conscious, agent focused culture”. • Potential for significant consolidation expense savings out of Target and experience at achieving such savings. • Good relationships with ratings agencies and regulators. • Publicly traded company, allowing better access to capital.

  15. Pricing the Deal - Buyer Intangibles Decreasing Value • Target has approximately $325 million of A&H premium in force, vs. $139 million for Buyer and employs 350 people vs. 240 for Buyer; therefore, successful integration is a significant risk of deal. • Publicly traded company, requiring Buyer to integrate and turn around Target in a public forum. • Completing the acquisition required significant financial leverage, increasing the overall risk to the deal and the company.

  16. Pricing the Deal - Buyer • Clearly, the intangibles in this case called for a premium to the actuarial valuation; however, how much? • In this instance, Capital Z considered the intangible values as well as the public stock price and the overall insurance M&A pricing environment and agreed to pay $3.15 per share. • Represented a 17% premium to the current market price and a 7.8% premium to the actuarial valuation. • Intangibles were implicitly valued at $4 million or 8% of the purchase price.

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