Actuaries in Acquisitions CAS Limited Attendance Seminar on

Actuaries in Acquisitions CAS Limited Attendance Seminar on Valuation St. Louis, Missouri April 10 -11, 2000

Acquisition process Phase I: Internal Phase II: External Phase III: Legal Phase IV: Operational Identification Fit Analysis Value Merger Effects Iterative Due Diligence Negotiate & Close Integrate

Actuarial involvement in the process Actuaries could, perhaps should, be involved in every major step of the acquisition process. 4 Critical areas: Valuation m Due diligence m 4 Important areas: Merger consequences m Proactive identification m Deal structure m

Valuation 4 Sturgis lists five forms of valuation: m Market m Book m “Comparative” m “Dilution” m Economic 4 Miccolis defines economic value as: {Stat. Net Worth + Reserve Adjustments + Non-admitted assets + Special Liabilities - Excess of Book over Market of Bonds} + {NPV(Future Earnings) - Cost of Capital}

Valuation (continued) The valuation is the sum of : 4 The “true value” of the balance sheet (old business) 4 The “true value” of the current and future business on an “as is” basis Market Value 4 Marginal value to the buyer of intended use Economic Value 4 Are there other sources of value? m Option value m Intangibles Price

Valuation - critical assumptions Balance Sheet 4 Reserves Future Earnings 4 Revenue (premium) 4 Loss experience 4 Expenses Adequacy m Run-off pattern m Capitalization m Taxes m Expected expense savings m Integration costs m 4 Assets 4 Cash flows 4 Capitalization 4 Taxes Yields m Market values m Cost of Capital 4 Target ROE 4 WACC

Valuation (continued) 4 Separate the economics of the target in question from the financing of the deal 4 Our business is stochastic by nature; valuations should be expressed in ranges based on simulations, scenarios, or both

Merger consequences analysis 4 Pro forma income statements and balance sheets of the buyer and the target, appropriately reflecting the deal structure -- before & after 4 Key considerations Reflect the transaction financing m Constraints m Restructuring the balance sheet m Is there a diminished value to the buyer? m

Merger consequences example Financing EPS Effect on: ROE RBC All Cash +0. 50 +1. 5% -225 to 20% All Debt +0. 60 +2. 0% - 20 to 45% All Stock -0. 15 +1. 5% - 20 to 15% “Optimal” Combination +0. 25 +0. 0% - 20 to 25% Pooling +0. 35 +1. 5% - 20 to 15% D/C

Common reasons for failure The causes for “failed” acquisitions are equally split between pre-acquisition and post-acquisition. 4 Pre-acquisition causes can be summarized simply as “paid too much” Inadequate financial analysis m Deal not based on the value of cash flows m Lack of understanding of the company m Over optimistic market assessment m All balance sheet and future income related Actuaries can -- and should -- be the principal form of protection for pre-acquisition causes of failure