A:

Insurance companies could be an attractive addition to an investment portfolio, offering a good balance of capital appreciation and dividends. Similar to other financial services firms, valuing insurance companies poses difficulties to analysts due to small capital expenditures and depreciation that have little effect on insurers' profitability.

Additionally, insurance companies do not have standard working capital accounts such as inventories and accounts receivable and payable, making relative valuation multiples based on capital useless. For these reasons, analysts focus on equity multiples, one of which is the price-to-earnings (P/E) ratio. In January 2018, the average trailing 12 months P/E ratio for general insurance companies with positive earnings was approximately 22.2.

How to Calculate the P/E Ratio

The P/E ratio is calculated as current market price divided by earnings per share (EPS). There are different variations of this ratio depending on which EPS are used in the denominator. The forward P/E ratio is calculated based on expected EPS in the next 12 months. The trailing-12-month (TTM) P/E ratio is based on earnings for the most recent four quarters. The P/E ratio for insurance companies depends on the expected earnings growth, risk, payout and profitability of the insurer.

The insurance industry is divided into several categories including property and casualty, surety and title, accident, health, and life insurance. Each type of business commands its own P/E ratio since there are differences in risk profile and expected earnings growth.

The average P/E ratio should be used with caution since large outliers can greatly influence it by the average. Analysts ordinarily supplement the average P/E ratio with the median P/E ratio. The large difference that may occur between the average and median is due to a few companies having very large P/E ratios that skew the average statistic.

(For related reading, see "How Does the Insurance Sector Work?")

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