The Industry Handbook: The Insurance Industry
As a result of globalization, deregulation and terrorist attacks, the insurance industry has gone through a tremendous transformation over the past decade.
In the simplest terms, insurance of any type is all about managing risk. For example, in life insurance, the insurance company attempts to manage mortality (death) rates among its clients. The insurance company collects premiums from policy holders, invests the money (usually in low risk investments), and then reimburses this money once the person passes away or the policy matures. A person called an actuary constantly crunches demographic data to estimate the life of a person. This is why characteristics such as age/sex/smoker/etc. all affect the premium that a policy holder must pay. The greater the chance that a person will have a shorter life span than the average, the higher the premium that person will have to pay. This process is virtually the same for every other type of insurance, including automobile, health and property.
In the U.S., the Gramm-Leach-Bliley Act of 1999 legislated that banks, brokerages, insurance firms and other types of financial institutions can join together to offer their customers a more complete range of services. In the insurance business, this has led to a flurry of merger and acquisition activity. In fact, a majority of the liability insurance underwritten in the U.S. has been through big firms, which have also been scooping up other insurance names.
Ownership of insurance companies can come in two forms: shareholder ownership or policyholder ownership. If the company is owned by shareholders, it is like any other public company. That is, its shares trade on an exchange like the NYSE, and it is required to report earnings on a quarterly basis. The other type of ownership is called "mutually owned insurance companies." Here the company is actually owned by the policyholders, so an account called policyholder's surplus, rather than shareholder's equity, appears on the balance sheet. It should be mentioned that in recent years many of the top mutual insurance companies have gone through demutualization to become shareholder-owned. Today, only a small handful of companies are still policyholder-owned.
Types of Insurance
There are several major types of insurance policies. Some companies offer the entire suite of insurance, while others specialize in specific areas:
- Life Insurance - Insurance guaranteeing a specific sum of money to a designated beneficiary upon the death of the insured, or to the insured if he or she lives beyond a certain age.
- Health Insurance - Insurance against expenses incurred through illness of the insured.
- Liability Insurance - The miscellaneous category. This insures property such as automobiles, property and professional/business mishaps.
There are many factors to examine when looking at insurance companies. More than anything, both consumers and investors should concern themselves with the insurer's financial strength and ability to meet ongoing obligations to policyholders. Poor fundamentals not only indicate a poor investment opportunity, but also hinder growth. Nothing is worse than insurance customers discovering that their insurance company might not have the financial stability to pay out if it is faced with a large proportion of claims.
Over the years, there has been a big shift in the life insurance industry. Instead of offering straight insurance, the industry now tends to sell customers on more investment type products like annuities. As a result, insurance companies have been able to compete more directly with other financial services companies such as mutual funds and investment advisory firms. To capitalize on this, many insurance companies even offer services such as tax and estate planning.
Return on Equity (ROE): Net Income
ROE indicates the return a company is generating on the owners' investments. In the policyholder owned case, you would use policy holders' surpluses as the denominator. As a general rule for insurance companies, ROE should lie between 10-15%.
Return on Assets (ROA): Net Income + Interest Expense
ROA indicates the return a company is generating on the firm's investments/assets. In general, a life insurer should have an ROA that falls in the 0.5-1% range.
Return on Total Revenue: Net Income
This is another variation of the profitability ratios. The insurance industry average return is approximately 3%. If possible, use the premium income and investment income as the numerator to find the profitability of each area.
Reinsurance: This is the process of multiple insurers sharing an insurance policy to reduce the risk for each insurer. You can think of reinsurance as the insurance backing primary insurers against catastrophic losses. (To learn more, read When Things Go Awry, Insurers Get Reinsured.)
The company transferring the risk is called the "ceding company"; the company receiving the risk is called the "assuming company" or "reinsurer."
Lapse Ratio: Lapsed Life Insurance Specified Period
Contracts in Force (in effect) at Start of Specified Period
This ratio compares the number of policies that have lapsed (expired) within a specified period of time to those in force at the start of that same period. It is a ratio used to measure the effectiveness of an insurer's marketing strategy. A lower lapse ratio is better, particularly because insurance companies pay high commissions to brokers and agents that refer new clients.
A.M. Best Ratings: A.M. Best dubs itself "The Insurance Information Source." This company provides data and research on almost every major insurance company in North America and abroad. Many analysts equate the quality of A.M. Best ratings to Moody's or Standard and Poor's bond ratings. A.M. Best ratings are so widely followed because they can usually obtain company information that wouldn't be accessible to the average person.
The A.M. ratings range from A++ (superior quality) to F (the company is in liquidation). If you are analyzing an insurance company, you may want to consider looking for the A.M. Best rating.
There are three major factors that we must consider when analyzing an insurance company. Coincidently, these are the same ones that the A.M. Best ratings (among other things) take into account.
- Leverage. The first things you want to check when considering an insurance company are the quality and strength of the balance sheet. Everyday insurers are taking in premiums and paying out claims to policyholders. The ability to meet their obligations toward these policy holders is extremely important. Companies should strike a balance between high returns while keeping leverage intact. A company that is highly leveraged might not be able to meet financial obligations when a large catastrophic event occurs. The following three things act to increase leverage:
1) Writing more insurance policies
2) Dependence on reinsurance
3) Use of debt
Reinsurance allows a company to pass off some of the risk exposure to other insurers (usually a good thing), but be careful. Too much dependence on reinsurance means that the company is not keeping a fair portion of responsibility for each premium dollar.
- Liquidity. The first test of an insurer's ability to meet financial obligations is the acid test. It tests whether a firm has enough short-term assets (without selling inventory) to cover its immediate liabilities. Also take a close look at cash flow. An insurer should almost always have a positive cash flow. Other things to keep an eye on are the investment grades of the company's bond portfolio. Too many high and medium risk bonds could lead to instability.
- Profitability. As with any company, profitability is a key determinant for deciding whether to invest. For an insurance company, there are two components of profits that we must consider: premium/underwriting income and investment income.
Underwriting income is just that: any revenue derived from issuing insurance policies. By averaging the premium's growth rates of several past years, you can determine the growth trends. Growing premium income is a "catch 22" for insurance companies. Ideally, you want the growth rate to exceed the industry average, but you want to be sure that this higher growth does not come at the expense of accepting higher-risk clients. Conversely, a company whose premium income is growing at a slower rate might be too picky, looking for only the highest quality insurance opportunities. The one thing to remember is that higher premium collections do not equate to higher profits. Lower numbers of claims (via low risk clients) contribute more to the bottom line.
The second area of profitability that you need to include in your analysis is investment income. As we mentioned earlier, a greater proportion of an insurer's income comes from investments. To evaluate this area, take a look at the company's asset allocation strategy (usually mentioned in the notes of the financial statements). You aren't likely to find any secrets in this area. A majority of the assets should be invested in low-risk bonds, equities or money market securities. Some insurers invest a substantial portion of their assets in real estate. If this is so, take a look at what type of property it is and where it is located. A building in New York City is much more liquid than one in Boise, Idaho.
ROA, ROE, and the lapse ratios (discussed above) are also useful for evaluating the profitability of the insurer. Calculate the ROA and ROE numbers over the past several years to determine whether management has been increasing return for shareholders. The lapse ratio will help to tell whether the company has managed to keep marketing expenses under control. The more policies that remain in force (are not canceled), the better.
Another major item that affects the performance of an insurance company is interest rate fluctuations. Insurance companies invest much of the collected premiums, so the income generated through investing activities is highly dependent on interest rates. Declining interest rates usually equate to slower investment income growth. Another downside to interest rate fluctuations (not exclusive to insurance companies) is the cost of borrowing. Find out when the company's debt matures and how high the interest rates are. If the company is about to borrow or reprice its debt, there could be a big shock to cash flows as interest expense rises.
Demographics play one of the largest roles in affecting sales for insurance, particularly life insurance. As people age, they tend to rely more and more on life insurance products for their retirement. Death benefit policies ensure that beneficiaries are financially secure once the insured dies, but in more recent years, the insurance industry has made great headway in offering investment/savings type insurance products. Because baby boomers are quickly approaching retirement age, take a close look at the suite of insurance products that the company is offering and, from that, see if it stands to benefit from this large portion of the population getting older.
The one problem with analyzing insurance companies is that the disclosure usually isn't enough. Proper analysis requires substantial disclosure of things like reserve ratios, exposure to catastrophic/environmental loss and details of the company's operations. This isn't to say that the financial statements are not enough for adequate analysis, but to dig really deep, a person needs more information. We should also note that A.M. Best ratings take all of this information and more into account when they determine their ratings.
Porter's 5 Forces Analysis
- Threat of New Entrants. The average entrepreneur can't come along and start a large insurance company. The threat of new entrants lies within the insurance industry itself. Some companies have carved out niche areas in which they underwrite insurance. These insurance companies are fearful of being squeezed out by the big players. Another threat for many insurance companies is other financial services companies entering the market. What would it take for a bank or investment bank to start offering insurance products? In some countries, only regulations that prevent banks and other financial firms from entering the industry. If those barriers were ever broken down, like they were in the U.S. with the Gramm-Leach-Bliley Act of 1999, you can be sure that the floodgates will open.
- Power of Suppliers. The suppliers of capital might not pose a big threat, but the threat of suppliers luring away human capital does. If a talented insurance underwriter is working for a smaller insurance company (or one in a niche industry), there is the chance that person will be enticed away by larger companies looking to move into a particular market.
- Power of Buyers. The individual doesn't pose much of a threat to the insurance industry. Large corporate clients have a lot more bargaining power with insurance companies. Large corporate clients like airlines and pharmaceutical companies pay millions of dollars a year in premiums. Insurance companies try extremely hard to get high-margin corporate clients.
- Availability of Substitutes. This one is pretty straight forward, for there are plenty of substitutes in the insurance industry. Most large insurance companies offer similar suites of services. Whether it is auto, home, commercial, health or life insurance, chances are there are competitors that can offer similar services. In some areas of insurance, however, the availability of substitutes are few and far between. Companies focusing on niche areas usually have a competitive advantage, but this advantage depends entirely on the size of the niche and on whether there are any barriers preventing other firms from entering.
- Competitive Rivalry. The insurance industry is becoming highly competitive. The difference between one insurance company and another is usually not that great. As a result, insurance has become more like a commodity - an area in which the insurance company with the low cost structure, greater efficiency and better customer service will beat out competitors. Insurance companies also use higher investment returns and a variety of insurance investment products to try to lure in customers. In the long run, we're likely to see more consolidation in the insurance industry. Larger companies prefer to take over or merge with other companies rather than spend the money to market and advertise to people.
- A.M. Best - An excellent source for insurance related information and statistics.
- Insure.com - An insurance guide comparing hundreds of companies, and offering thousands of educational articles.
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