- 1 Financial Institutions Group Overview
- 2 Financial Institutions Group – FIG Investment Banking
- 3 Insurance Overview & Primer
- 4 Related Reading for Financial Institutions
Financial Institutions Group Overview
Financials make up 20% of 25% of the market capitalization of the TSX. Financials encompass banks (commercial and investment banks), insurance, asset managers, captive finance arms, leasing companies and credit unions (in Canada, only Desjardins is a significant player, with VanCity an extremely distant second).
Globally, financial institutions coverage is large and sophisticated – however, in Canada the financial services industry is extremely concentrated across banking and insurance – with both banks and insurers also having a very strong share of wealth/asset management businesses.
Big 5 banks (RBC, TD, BNS, BMO, CIBC) dominate lending (especially mortgage lending), with Canadian Western Bank having some regional presence in the West and Desjardins (a credit union), National Bank and Laurentian having some share in the East.
Life insurance is dominated by a Big 3 in Great-West Life (controlled by Power Financial [TSE:PWF] , which is in turn controlled by the Desmarais family’s Power Corporation – although they take on a hands-off approach), Manulife [TSE:MFC] and Sun Life Financial. Property & Casualty insurance is more fragmented, with prominent Canadian domiciled names including Intact Financial [TSE:IFC] and Fairfax Financial [TSE:FFH].
A very simplified way of looking at banks and insurers is to consider them to be intermediaries or middlemen in terms of risk pooling to mitigate loss. When an entity deposits money at a bank, the deposit earns interest in a savings account. When an entity borrows money from the bank, interest must be paid on the loan. Why can the bank not be cut out of this relationship?
The amount deposited and the amount borrowed are rarely the same, nor do entities want to have the exposure to default by the borrower. Also, the timing of when the borrower wants to repay or when the lender wants to withdraw will differ. With a bank, all of these factors are pooled together – if the average borrower defaults 1% of the time, spread over thousands of borrowers the bank will still get 99% of the principal back from every loan (before considering collateral). A bank makes money by capturing the spread between what it pays its lenders (depositors) and what it collects from its borrowers.
Financial Institutions Group – FIG Investment Banking
The Financial Institutions Group is one of the largest and most prestigious groups in investment banking globally, but not in Canada. Globally, the business done is some of the most sophisticated and lucrative, as financial institutions have a very good understanding of capital, require large amounts of capital raises and will take views on capital because capital is an inherent part of their business (as opposed to a normal corporate such as an oil and gas company where the oil and gas assets are the operating assets).
In the US, financial institutions is an extremely fragmented sector and the Big 4 banks (JP Morgan Chase, Bank of America, Wells Fargo and Citi) do not bank a majority of the population. Competition is fierce and there are banking options from credit unions, regional banks, thrifts, alternative lenders, fintech (Venmo, Alipay, Lending Club) and other financials.
Given that the product is undifferentiated and have a lot of redundant costs (head office, IT), banking in the USA is always a good option for consolidation via mergers & acquisitions.
Banks will also issue large amounts of debt, equity and preferred shares, as well as hybrid instruments that have debt and equity components. These can become very esoteric, ranging from contingent capital convertibles (CoCos) to mandatory convertible preferred shares. Capital ratios are key measures for banks and as such, capital issued will have flexible measures to ensure banks are in line.
Debt is not limited to bonds, but companies such as State Street will regularly purchase shares of corporate loans and give investment banks a lot of asset-liability management business. Mortgages and other loans are frequently securitized and sold by banks to institutional investors looking for yield while freeing up capital for investment or distributions by smaller financials.
Likewise, both Life Insurance and P&C are also extremely fragmented, with giants such as MetLife or Travelers holding a far smaller market share compared to the Canadians in their home market.
Financials engage in trading on a very regular basis and in addition to hedging may use derivatives as speculative instruments. While it is extremely rare for a corporate to use exotic options such as barriers, financials will take views often if they feel that they can reasonable shave off basis points in lending.
Financial Institutions Group in Canada
In Canada, financials are extremely concentrated due to the protectionist and heavily regulated nature of the market. The Big 5 banks dominate all lending and deposits and cross-sell insurance and mutual funds. The Big 5 banks indirectly are the largest asset managers in Canada as well.
Similarly, for insurers, the Canadian Big 3 (Manulife, Sun Life, and Power Financial via Great-West Life) dominate the life insurance market while P&C continues to become more concentrated led by Intact Financial.
As such, there is almost no investment banking business from banks as the investment banking arm of any bank will handle the majority of any bond issuance or preferred share raise while naming themselves bookrunner for league table credit.
Also, Big 5 Canadian banks do not like to issue common equity as their investor base is primarily yield seeking retail investors who do not want to see any sort of dilution. The smaller banks and credit unions are far too small to offer business comparable to industries such as mining and energy, but will tend to generate some capital markets business with Big 5 banks (swaps, securitization).
The insurers offer limited capital markets business as there are only three big clients with strong internal corporate development (corporate finance) teams. Also, given their size, they often are clients of Bulge Bracket banks in New York as well. However, from time to time they require M&A advisory and also are large debt and preferred share issuers.
The pension funds such as the Canadian Pension Plan Investment Board and the Ontario Teachers Pension Plan are massive financial institutions in Canada and a huge source of capital markets trading revenue as well as DCM. However, they do not issue equity and are in good position to demand very tight pricing from the banks. Any portfolio investments in private equity or infrastructure are covered not by the Financial Institutions Group, but a Financial Sponsors or respective industry group as well as the mergers and acquisitions team.
Canadian Asset Management Industry
Canadians are less sophisticated with their approach to asset management vs retail US investors and will tend to purchase mutual funds – this market is dominated by the Big 5 banks, all who have large wealth management operations. Generally, having a chequing account with TD usually means that once assets are large enough, an individual will speak with the Financial Services Representative and purchase a TD Balanced Fund. Higher net worth customers will be given access to more personalized wealth management options (which are rarely better until they are at the ultra high net worth segment – which may be more of a function of the UHNW customer having a better understanding of investing).
Beyond the banks, lifecos (Sun Life and Manulife) sell a basket of mutual funds, usually through third-party contractors. These funds may be tied into their other insurance products including policies and annuities. Investors Group is owned indirectly by Power Financial.
A number of independent asset managers exist in Canada – including Mawer, AGF Investments, and CI Financial that serve retail clients. A large number of firms serve high net worth individuals, including Gluskin Sheff and various hedge funds operating in Canada.
Demographic changes (Millenials) have resulted in increased scrutiny of holdings and a shift towards index (S&P, TSX, NASDAQ) and sector (technology, banks) ETFs – there is less home bias for Millennial investors and a desire to know which firms have a record of alpha generation. Due to this, Blackrock, Vanguard, Invesco and Fidelity have done well and are likely to grow their footprint in Canada.
Insurance Overview & Primer
Insurance is the business of selling indemnity (security against loss) for a premium (policies). As with banks, risk pooling is a core part of the business.
Insurance is separated into life & health (Life) and property and casualty (P&C). As implied, life and health insurance indemnifies individuals from mortality (death) and morbidity (grievous or debilitating injury) risk for the term stipulated in the policy. Property & casualty indemnifies against damage or loss of property, auto and other non-life issues.
Life insurance is much more heavily regulated as the government needs to ensure that insurers fulfil their fiduciary duties to policy holders (problematic if a policyholder who supports a family dies and the insurer is insolvent due to aggressive dividend policy to shareholders). Property and casualty insurance is regulated but with more room than life.
Insurance is a large, concentrated and profitable industry in Canada. Similar to the banks and asset managers, the traditional LifeCos in Canada are also banks and asset managers – very diversified financial institutions. P&C insurers tend to stick to their own business, but some of them operate on a Berkshire Hathaway model (Warren Buffett) that includes a value investment component.
Insurance – Risk Pooling and Indemnity
The need for insurance stems from protection of loss. As a simplified example, a business agrees to sell a cargo of oil in one year’s time for $100,000. It has also contracted to purchase the oil from a producer for $40,000.
The contract stipulates that the business will only be paid if the oil is delivered. In this example, the business has a 90% chance of receiving $100,000 in 1 year’s time – 10% of the time we assume an unforeseen event such as a storm destroys the cargo mid-journey. Accordingly, his expected return is $90,000 – 90% x 100,000 + 10% x 0 = $90,000.
However, regardless of whether the cargo is delivered, the business will still owe the producer $40,000 – to ensure the business does not go bankrupt, the company needs to lock in the profit through insurance.
From the insurer’s standpoint, it knows that the expected loss is $10,000. Accordingly, if they charge a premium of $12,000, they can expect to lose $10,000 on average and still make an average profit of $2,000 per policy. Meanwhile, the business may want to purchase a policy even if it produces the oil itself, as most businesses prefer smooth cash flows (preference to lock in $88,000 of profit each time instead of an uncertain expected value of $90,000).
The process of selling policies where the insurer agrees to be the owner or bearer of risk is called underwriting.
In one single underwritten transaction, insurance is an extremely risky business. However, if an insurer underwrites thousands or millions of these policies, the actual loss will start to look like the expected loss (if it does not, it means that the risk is mispriced). On average, the insurer will make an average profit of 20% in this example, although hurdles for insurers vary from life to P&C and depending on other factors such as industry concentration and government regulation.
Insurance Income Statement
Insurance income statements have two segments – underwriting income (or loss) and investment income. Underwriting income is the profit from selling premiums less claims paid out.
Shown below is a simplified illustrative income statement for an insurer (ignoring lending and asset management business that LifeCos in Canada have as diversified financial institutions):
Revenue from Premiums
less: Premiums Ceded to Reinsurers
Net Premium Revenue
less: Gross Claims & Benefits
add: Claims Ceded to Reinsurers
less: Premium Taxes (Various jurisdictions will have special taxes on insurance premiums)
This is the operating income for an insurer. Depending on factors specific to the corporate make up of the firm such as capital structure and administrative costs, other line items will influence net income.
Insurers sell premiums that will provide coverage as stipulated in the policyholder’s agreement. Whether the insurer is insuring against life or cars, they will have teams of actuaries who will determine what the expected claims paid out are. This is based on empirical data and assumptions, but cannot be fully accurate.
It is important to know that revenue is not recognized when the premium is sold. Gross premiums sold represent a cash flow into the firm, but revenue is recognized as the life of the policy amortizes.
Life and health insurance actuaries are trying to estimate how many people die, how rates differ within higher risk groups such as smokers, what age people die at, and how many prescription drugs do people consume every year.
Property & casualty insurers look for how many car crashes there are a year, what an appropriate deductible is and at many other variables. Sometimes, a catastrophe occurs (earthquake, wildfire) that causes large scale damage in a concentrated area. Insurers must ensure they are profitable enough to eat these losses, or be adequately reinsured.
Selling insurance also comes with embedded costs. Most insurers do not sell direct (like a retail model) and will have broker channels that carry their premiums. When insurers outsource the actual sale of their premiums, they must pay commissions to the broker. On a return on capital basis, this means higher returns for insurers as they do not have to pay for the salary and rent for much of the distribution channel – however should there be a lack of better investment opportunities, this is money left on the table.
Insurance is based around risk levels – if internal risk limits are breached for a certain type of risk insured against, insurers may offload these risks to a reinsurer. Reinsurers insure insurers. On the income statement, policies that have been sold off to reinsurers will be shown as Premiums Ceded.
Theoretically, an underwriter would sell a premium at a price which exceeds the expected claims, commissions and other costs by a return margin acceptable to investors. In reality, many insurers have extremely low underwriting discipline and will sell premiums at an expected loss to get as much cash upfront as possible because they can recuperate these losses via investment income.
Investment Income and The Float
For insurers, there is a difference in timing between when premiums are collected and when claims are paid. However, the cash is received upfront and the claims are paid out at a future date. This account is called the float. During the time before claims are paid, the insurance company invests the cash into securities such as stocks and bonds to earn a return.
Returns on the float magnify return on equity. Similar to how debt can be used to enhance investment returns (if a private equity firm takes on a debt with an interest rate that is lower than the return on equity, the geared or leveraged company will offer a higher percentage return to equityholders), the float also amplifies any returns from dividends, interest coupons or asset appreciation.
However, whereas debt is costly (a company that issues debt must pay interest), there is no interest on the float – in fact if the two parts of the business (investing and underwriting income) are not segregated, an insurer could be perceived to be getting paid to invest the money and magnify returns (as policyholders pay a premium). Usually, insurers can stack the leverage with one layer of debt (which has negative carry as it pays interest) and one layer of float (which has positive carry or a premium despite being cash up front) as well as equity – as such, a 3% yield on a corporate bond may well be a 9% return on investment.
Given that insurers hold a fiduciary duty to policyholders that supersedes the business return to shareholders, there are regulations in place so that insurers cannot invest in riskier assets until assets and liabilities are matched. Generally, insurers will have to invest in high quality corporate bonds and government securities to ensure that there will not be capital loss. LifeCos have less flexibility and must purchase safer assets while P&Cs may be more liberal in investing. LifeCos have global and domestic capital ratios they must adhere to (Tier I and Tier II Capital is the same as with banks but with different metrics).
P&C insurers will sometimes look to not just capture enhanced yields on high quality bonds (leveraged coupon income) but actively manage the float by purchasing assets meant for capital appreciation (stocks, discounted bonds). Insurers that have this business model include Fairfax Financial and Berkshire Hathaway. Insurers who sell direct (Berkshire Hathaway’s GEICO) are able to lock in cost savings and be more competitive throughout the course of the underwriting cycle. This is only possible with a strong combined ratio.
The Combined Ratio for Property & Casualty Insurers
Combined Ratio = (Claims Incurred + Underwriting Expenses) / Premiums Earned
Combined Ratio = Loss Ratio + Expense Ratio
The combined ratio is an important ratio for insurers in evaluating their pricing discipline and operational efficiency. Many insurers will run the underwriting segment of their business at a loss for more premiums to boost investment returns. This competition happens until losses become too large and there is pullback.
Insurers such as Berkshire Hathaway always keep their combined ratio below 100 and will pull out of business lines that they cannot compete in on that metric.
Note: Underwriters have told us that in Canada, private auto insurance is always sold at a loss while commercial insurance is profitable – which makes sense as businesses are invested in continuing as a going concern
Remember, insurers have two revenue streams: the premiums from the clients for the service provided (indemnity of loss) and the returns from investing those premiums.
Combined Ratio is a measure of profitability of insurer in its daily underwriting activity excluding the profits from investing the premiums obtained from clients. The combined ratio is the aggregate of the loss ratio and the expense ratio, which together indicate the profitability of the underwriting segment.
As illustrated above, the combined ratio is calculated by taking the sum of incurred losses and operating expenses and dividing it by earned premiums.
A ratio below 100% indicates that the company is profitable from underwriting service whereas anything over 100% indicates that the company pays out more money in claims and expenses than it receives from premiums.
Underwriting Expenses / Premiums Earned
The first part of the equation is a ratio that speaks to the company’s operations. The ratio shows the percentage of Net Earned Premium that is paid out for acquiring and servicing the insurance payments and enables one to see how efficient the company is with costs. Price also drives volume, and lower costs can in turn allow for lower prices at a profit, which attracts more clients and a higher net income. This ratio benefits the most from consolidation in the insurance industry, as corporate eliminations are possible, including reduced office rent, infrastructure, financial reporting and research.
Claims Incurred / Premiums Earned
When customers make claims on the insurance policies, the insurer has to pay out. Although large actuarial teams are tasked with finding the appropriate expected loss for premium pricing, claim figures are volatile and deviate greatly from expectation.
Although less obvious, there are also synergies from consolidation for the loss ratio, as actuarial accuracy is based on data. Although mortality and morbidity tables are dynamic and influenced by numerous, changing factors, more data and more resources can lead to added precision.
A consistently high loss ratio usually indicates that the insurer has priced their product too cheaply and better underwriting discipline should be exercised.
The Current P&C Market
Generally, the a figure below 95% is considered to be a good indication of underwriting profit, which allows for a cash flow cushion before investing returns that are hard to predict. A low combined ratio normally indicates the disciplined insurer that commit to long-term profitability over short-term gains.
This trade-off between volume and margin is best illustrated by GEICO’s use of retail channels (selling direct), which does come at the expense of having large numbers of third party sellers (who have no start up costs for the P&C firm).
Since the insurance premium is commoditized (a contract can be structured by any P&C and regulation is in place to ensure indemnity), the consumers’ buyer power is high and they will seek the cheapest option on the market. The industry’s profits are tied to the cyclical nature of economic, environmental, social and political situations.
When times are good, even undisciplined insurers can make underwriting profit and loss ratio subsequently decreases. The combined ratio helps to distinguish between disciplined profitable insurers and undisciplined ones because the latter tend to chase short-term gains by underpricing premiums in times of low loss ratios. The disciplined insurers, despite the low loss ratio, cut back on premium growth.
Eventually, when the cycle turns and claims peak, the insurers who sold high volume, low price policies bear the brunt of the losses and experience a high combined ratio while disciplined insurers avoid large losses and maintain a low combined ratio.
The combined ratio should not be the only factor in evaluating insurer profitability, however, as it does speak to the profits made from investments in equities and bonds and is ultimately not the final return to shareholders. That said, it is informative in isolation as it is much more predictable while investment returns are subject to the vagaries of the stock and bond markets.
Combined Ratio Comparison for Major Publicly Traded Property and Casualty Insurance Companies in Canada and U.S
|Company||US||Canada||Combined Ratio 2016||Loss Ratio 2016||Expense Ratio 2016|
|Intact Financial Corp.||Yes||95.2%||64.8%||30.4%|
Related Reading for Financial Institutions