Insurance Companies
What you'll learn
- LOS 10.fDescribe key ratios and other factors to consider in analyzing an insurance company.
Insurance company revenues include premium income and income on float (i.e., income earned on premiums between their collection and the payment of claims). Property and casualty (P&C) insurers differ from life and health (L&H) insurers in terms of variability of claims and contract duration. Claims for P&C insurers tend to be lumpier as compared to relatively stable and predictable claims for L&H insurers.
Contract duration (i.e., policy period) is much higher for L&H insurers relative to that of P&C insurers. Regulatory requirements that focus on solvency of insurance companies often result in different reporting standards compared to IFRS or U.S. GAAP.
P&C Insurance Companies
Premium income is usually the highest source of income for a P&C insurer. Keys to the profitability of an insurer are prudence in underwriting, pricing of adequate premiums for bearing risk, and diversification of risk. To diversify their risks, insurers often reinsure some risks.
The policy period is often very short, with premiums received at the beginning of the period and invested during the float period. Claim events (e.g., fire, accident, etc.) are clearly defined but may take a long time to emerge.
Property insurance covers specific assets against loss due to insured events. Casualty insurance (also called liability insurance) protects against a legal liability (often to a third party) due to the occurrence of a covered event. Sometimes a policy, known as multiple peril policy, may cover both property and casualty losses occurring during a covered event.
P&C Profitability
P&C margins are cyclical. During periods of heightened competition, price cutting to obtain new business leads to slim or negative margins ( soft pricing period). This soft pricing period leads to losses and a shrinking capital base for many insurers, who either leave the industry or stop underwriting new policies.
The resulting reduction in competition leads to a healthier pricing environment ( hard pricing period), which in turn results in fatter margins. Higher margins during the hard pricing period attract new competition, perpetuating the cycle.
Major expenses for P&C insurers include claims expense and the expense of obtaining new policy business. The cost of writing new policies depends on whether the insurer uses a direct to customer model (in which case it would bear the fixed cost of staffing) or the agency model (in which case it would pay variable commissions). Soft or hard pricing is driven by the industry’s combined ratio (total insurance expenses divided by net premiums earned).
When the ratio is low (high), it is a hard (soft) market.
For a single insurer, a combined ratio in excess of 100% indicates an underwriting loss.
The combined ratio, per Statutory Accounting Practices, is the sum of the underwriting loss ratio and the expense ratio.
The underwriting loss ratio measures the relative efficiency of the company’s underwriting standards (whether the policies are priced appropriately relative to risks borne), while the expense ratio measures the efficiency of the company’s operations. The underwriting loss ratio is also called the loss and loss adjustment expense (discussed later). The expense ratio is also called the underwriting expense ratio.
Notice that the denominator in the two ratios is different. For reporting purposes, sometimes insurers use U.S. GAAP, which calls for net premium earned as the denominator for both ratios.
The loss reserve is an estimated value of unpaid claims (based on estimated losses incurred during the reporting period). Subject to management discretion in measurement, the loss reserve is a highly material amount. Insurers revise their estimate of the loss reserve as more information becomes available.
Downward revisions indicate that the company was conservative in estimating their losses in the first place. Upward revisions indicate aggressive profit booking, a warning sign for analysts.
Other Profitability Ratios
Loss and loss adjustment expense ratio measures the relative success in estimation of risks insured (lower is more successful).
Dividends to policyholders (shareholders) ratio is a liquidity measure measuring cash outflow on account of dividends relative to premium income.
Combined ratio after dividends (CRAD) measures total efficiency and is more comprehensive than the combined ratio.
Andy Miranda is evaluating three P&C insurers and has collected selected information for the latest fiscal year.
1. Calculate the loss and loss adjustment expense ratio, underwriting expense ratio, combined ratio, and CRAD to policyholders.
2. Which insurer is most profitable on a combined ratio basis?
3. Which insurer has the most efficient operations?
4. Which insurer is most profitable overall?
Solution
1. The computation of ratios is shown in the following:
2. On a combined ratio basis, ABC, Inc., has the lowest combined ratio and is most profitable.
3. ABC, Inc., has the most efficient operations as evidenced by its lowest underwriting expense ratio.
4. XYZ, Inc., is the most profitable as evidenced by the lowest CRAD.
Investment Returns
After premium income, investment return is an important source of P&C insurers’ profitability. Due to the inherent risk of the insurance business, insurers tend to invest premiums conservatively. An evaluation of a P&C insurer’s investment portfolio should look for diversification by asset class and concentration by type, maturity, industry classification, and geographic location.
The total investment return ratio is used to evaluate the performance of an insurer’s investment operations.
Instead of total investment income, computing the ratio after excluding unrealized capital gains from income provides information about the importance of unrealized gains and losses to the insurer’s total income.
Liquidity
Liquidity is an important consideration for P&C insurers as they stand ready to meet their claim obligations. One way to gauge the liquidity of the investment portfolio is to look at their fair value hierarchy reporting. As stated earlier for banks, Level 1 assets are based on readily available prices for traded securities and therefore tend to be most liquid.
Level 2 assets tend to have lower liquidity, and Level 3 assets are generally the least liquid.
Capitalization
There are no global risk based capital requirement standards for insurers. Regionally, the E.U. has adopted the Solvency II standards, while NAIC in the United States has specified minimum capital levels based on size and risk (including asset, credit, liquidity, underwriting, and other relevant risks).
L&H Insurance Companies
Similar to P&C insurers, L&H insurers derive their revenue primarily from premiums, while investment income is the secondary source. Life insurance policies can be basic term life, whereby the insurer makes payment if death occurs during the policy period. Other types of policies may include other investment products attached to pure life policies.
Health insurance policies vary globally by the type of coverage provided.
Primary considerations in analysis of L&H insurers include:
1. Revenue diversification. The proportion of income generated from premiums, investments, and fees can vary over time and among insurers. While diversification is a desirable attribute, premium income tends to be more stable over time relative to other sources.
2. Earnings characteristics. An L&H insurer’s profitability reflects a number of accounting items that require judgment and estimates. Actuarial assumptions affect the value of the future liabilities due to policyholders. Current period claim expense includes not only actual claim payments, but also interest on the estimated liability to policyholders.
L&H insurers also capitalize the cost of acquiring new and renewal policies and amortize it based on actual and estimated future profits from that business. Therefore, estimates influence the amount that is amortized in any given period. Estimates also affect the value of securities and, hence, investment returns (discussed in the next section).
Finally, mismatches between the valuation approaches for assets and liabilities can distort values when the interest rate environment changes.
Apart from standard ratios such as ROA, ROE, and EBIT margins, industry specific cost ratios include:
a. total benefits paid Ă· net premiums written and deposits. b. commissions and expenses Ă· net premiums written and deposits.
1. Investment returns. L&H insurers have a longer float period than P&C insurers, so investment returns are a key component of the insurer’s profitability. A large portion of the investment portfolio is often long term debt. Duration mismatch between the insurer’s assets and liabilities is an area of concern.
Similar to P&C insurers, the total investment income ratio (investment income divided by amount of invested assets) is often used to evaluate an L&H insurer’s investment portfolio performance. Analysts often recalculate this ratio after removing unrealized gains and losses from investment income to remove the impact of estimated fair values for some of the investment assets.
2. Liquidity. While policy surrenders can be unpredictable, the liquidity needs of L&H insurers are generally fairly predictable. Hence, keeping excess liquidity is not as much of a concern for L&H insurers compared to P&C insurers. Analysis of liquidity for an insurer includes analyzing the insurer’s investment portfolio.
Non investment grade bonds and equity real estate are typically relatively illiquid as compared to investment grade debt.
A liquidity measure used by Standard and Poor’s, for example, takes a ratio of adjusted investment assets to adjusted obligations. Assets are adjusted based on their ready convertibility into cash, while obligations are adjusted based on assumptions about withdrawals. This ratio is estimated both under normal market conditions and under stress scenarios to assess the liquidity risk for the insurer.
1. Capitalization. Similar to P&C insurers, there are no global minimum capitalization standards. Domestic regulators often do specify risk adjusted minimum capital requirements. Due to duration mismatches between assets and liabilities for L&H insurers, risk adjusted capital requirements usually incorporate interest rate risk.