- 1 Insurance Overview & Primer
- 2 Insurance Income Statement
- 3 Investment Income and The Float
- 4 The Berkshire Hathaway Model – Warren Buffett and the Float
- 5 Insurance Company Valuation – Price/Book, Price/Earnings
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 Berkshire Hathaway Model – Warren Buffett and the Float
There is a popular concept in finance – OPM or Other People’s Money. Making returns off of the capital of other people or entities is a scalable exercise and is a reason why financiers can make so much money.
For most firms, the simplest example is leverage through debt. If a company purchases a stock with all cash and it goes up by 10%, they make 10% on their money. If a company purchases double the stock with 50% purchased via debt with after-tax interest of 3%, they make 17%. Leverage juices returns. If a bank uses its deposits to lend out for a higher interest rate, they make a margin on their loan.
Using the insurance float as an investment vehicle is unique in the way that while debt has negative carry (the borrower has to pay interest), float to some extent has positive carry. This is because the expected value of claims should be less than the total float received provided that the insurer has underwriting discipline. Unlike bank deposits or life insurance policies with surrender options, the insurer does not need to factor in bank runs or withdrawals.
Additionally, the insurer gets a boost from the nature of investment versus the claims – investment returns are immediate, while depending on the nature of the policy, claims may be paid out much later whereby the original float collected may have earned multiples on its capital.
Auto insurance and homeowner policies are short-dated – usually policies are for a year and claims are paid out on average around 6 months in. Conversely, for long-tailed liabilities such as medical malpractice or product warranties, a policy may be valid for decades. The longer dated the policies, the larger the float. It should be of no surprise that this is a business line that Berkshire specializes in.
As such, when float is invested, all income belongs to the insurer – that is common and preferred dividends, interest income and capital gains. As with any other financial product, insurance makes money from holding risk. Of course, checks and balances are in place by regulators to make sure that insurers can fulfill their duties to the benefactors of insurance policy – otherwise no one would purchase insurance.
This strategy only works if an insurer can consistently turn an underwriting profit. However, when it is applied correctly, it is an extremely effective investment vehicle, as evidenced by Berkshire’s incredible growth relative to the broader stock market.
Insurance Company Valuation – Price/Book, Price/Earnings
As with banks, insurers are difficult to value due to their complexity and the assumptions inherent in the business. Actuarial science is anything but a science and these guestimates change all of the time – nor is predicting mortality or morbidity rates really in the realm of understanding for Wall Street analysts.
Nonetheless, insurers are broadly valued using the same multiples as banks – Price/Book Value, Price/Tangible Book Value, and Price/Earnings, although the underlying drivers of those metrics may vary greatly.
All of these multiples are a function of future prospects – a rapidly growing insurer with good visibility to next year’s profits will trade at a higher P/B or P/E.
Analysts will look at growth in premiums written, in particular direct premiums written (DPW) as a function of higher market penetration and organic growth. Keep in mind that as a society becomes more prosperous, the demand for insurance grows. As such, markets such as China may see their insurers trade at strong multiples all things equal.1 However, this will be weighted against prudent underwriting rather than taking an underwriting loss for the purpose of more premiums.
Analysts will look at the combined ratio year-over-year as well as trends behind the combined ratio in the loss and expense ratios. Although these will be compared to peers, analysts have to be aware of different product mixes and selling channels. As such, if a comparable sells mostly auto while the company being analyzed sells commercial property insurance, these cannot be readily compared. Likewise, if one insurer sells primarily through direct channels whereas their peer heavily relies on brokers, valuation metrics may be clouded.
What is always useful, however, is comparing the insurer’s combined ratio against its own last year to see if operations have become more efficient. This needs to be adjusted for irregular changes in profit for a normalized figure – for instance, the insurer could have been unlucky and hit with large catastrophe losses all at once.
Return on equity is a key driver for valuation. Over a short period of time, this can fluctuate, but over the longer term performance of the company this metric does not lie. Insurers with lower ROEs are associated with poor underwriting discipline or less than adequate returns on investment.
Interest Rates and Insurers
As premiums are less interest rate sensitive while the returns on the investments that insurers are allowed to hold (bonds) tend to go up as interest rates rise, insurers usually see share price gains alongside banks when government benchmark rates rise.
For example, the float goes up by $100 while the Federal Reserve hikes interest rates from 2% to 3%. Assuming the credit spread stays the same at 2%, the insurer now makes 5% on its new bond purchases instead of 4%. This is positive for net income.
Of course, when this happens, insurers with poor underwriting discipline may cut policy premiums in order to try to generate more float.
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.
Insurance Mergers & Acquisitions
As alluded to, the insurance industry is fragmented and a regular candidate for consolidation due to the scalability of the business. Combining the premiums of two companies while cutting administrative expenses drives down the expense ratio, which in turn drives down the combined ratio and boosts overall profitability.
When industry wide return on equity is low, consolidation makes the most sense as costs are cut and the new companies that arise from the ashes of the acquired will have more pricing power.
However, two other catalysts regularly contribute to boosting M&A volumes for FIG investment bankers.
The first is the exit or entry of foreign parent corporations. For instance, global insurance giants such as AXA, XL Catlin, Travelers, Aviva and Manulife will constantly look for new markets to find superior returns for their shareholders. When they enter new markets, it is commonly better to buy than to build – that is starting their own insurance business from scratch.
The purchase of a local player immediately introduces know how and allows for an operation to begin scaling with. Should Ping An Insurance want to have an expansive Southeast Asia business, there will likely be a swath of acquisitions.
Conversely, when global insurers want to rationalize their portfolios for a variety of reasons, they may look to shop their assets in countries that are non-core. This could be because they are overleveraged and have run into poor performance at home and need to shore up their balance sheet. This could also be because the insurance market in a foreign country has been tough to crack for them and they have been unprofitable and are so looking to salvage their investment.
Less common today is demutualization. Certain insurers are operated as competitive businesses but do not have shareholders. Rather, they are co-operatives that are collectively “owned” by the policyholders of the insurance. When they choose to turn into a publicly listed company with equityholders, the policyholders will convert to shareholders in a process called demutualization.
When investment bankers look at multiples relevant for insurers, they will commonly look at precedent transaction Price/Book and accretion to book value per share (BVPS).
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%|
1Albeit not right now on average due to the proliferation of debt-fueled Ponzi schemes run by once-protected connected elites masquerading as financial institutions are now being supressed with liquidity drying up – sending short term interest rates to 36% in forced develeragings. Examples include Anbang Insurance
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