Insurance companies offer products that most of us need and in doing so take on many of the risks that we don't want. Insurance companies tend to be viewed as big, relatively boring financial institutions, but they are, in fact, in the business of protecting others from financial harm and risk management.
- Until fairly recently, most insurance companies were organized as mutuals, owned by their policyholders rather than external investors.
- Demutualization has been the process of converting these mutuals into stock companies, where they are now listed on major stock exchanges.
- When buying insurance stocks, there are fundamental differences in the business models of life and health insurers vs. property causality insurers.
Demutualization of the Insurance Industry
Historically, insurance companies were structured as mutual companies, owned by the policyholders and operated only for the benefit of policyholders. On the other hand, stock companies are owned by shareholders and they seek to maximize return to shareholders. In recent years, many mutual companies have converted into stock companies in a process called demutualization. Because mutual companies do not issue shares to the public, only stock companies can be invested in the stock market.
Insurance companies sell policies that promise to payout a benefit to the policyholder if a covered event occurs during the term of the policy. With life insurance, the covered event would be death of the insured. With homeowners insurance that might be a house fire, storm damage or theft.
Investing in Insurance Companies
Insurance companies have unique circumstances that make their analysis different from other financial institutions such as banks or lenders.
All insurance companies have a set of future liabilities that they are contractually obliged to pay out given a qualifying event. As a result, they must invest premiums received conservatively in order to have a ready reserve of liquid assets on hand to pay out those claims. Insurance company portfolio managers utilize asset-liability management (ALM) by matching assets to liabilities; rather than the more familiar asset-only management that looks to maximize return while minimizing portfolio risk.
Generally speaking, there are two general types of insurance companies outside the health sector: Life insurance and property and casualty insurance. Each has special considerations that investors should consider.
Life Insurance Companies
When evaluating life insurance companies, it is important to know that government regulation directs them to maintain an asset valuation reserve (AVR) as a cushion against substantial losses of portfolio value or investment income. Therefore, these companies tend to have less financial leverage at work than other kinds of financial institutions. This poses potential valuation problems since it implies that insurers value assets at market value but liabilities at book value.
Actuarial science has developed mortality tables that are very good at determining on average when life insurance claims will come due as policyholders pass away. The size of those liabilities are also known in advance because life insurance policies are issued with stated death benefits which do not adjust with inflation. Since both the amount and expected timing of liabilities are fairly well known, these companies seek to invest in portfolios that match the size and duration of those liabilities. The amount of excess return, or the amount by which assets exceed liabilities is referred to as the surplus. Maximizing surplus value and stability are the main objectives of life insurance portfolios. Because life insurance policies typically do not pay a benefit for many years, the investment portfolio of these companies tend to consist of high-quality bonds with maturities many years out.
Life insurance companies must also consider disintermediation risk when policyholders withdraw cash value (take loans against that cash value) from permanent policies causing increased demand for liquidity from the portfolio. This usually occurs during periods of high interest rates. At the same time, high interest rates cause the portfolios of insurers to decline since they are mainly invested in bonds, and the prices of bonds go down as interest rates go up. This combination of factors can lead to increased volatility of returns and greater risk during periods of high interest rates.
Investing in Property & Casualty Companies
Asset-liability management is crucial to property and casualty companies as well, but the risk exposures of these companies vary from life insurers in a number of areas. While the product offerings are more diverse – home, automobile, motorcycle, boat, liability, umbrella, flood etc. – the durations of these liabilities are much shorter: generally a year or less per policy. Therefore, the investment portfolios of these companies will tend to consist of high-quality bonds with maturities of a few months to a year.
Additionally, claims can take a long time to be resolved and paid out. The claims process can be contentious and possibly spend years in litigation before the claim is paid – if it is paid at all.
Many non-life policies also carry inflation risk, as the policies promise to fully replace the value of an item, even if that item is nominally more expensive in the future due to inflation. Taken together, both the timing and amount of liabilities are more uncertain than for life companies.
Property and casualty insurance companies also undergo an underwriting cycle or profitability cycle, which typically lasts 3-5 years. During period of intense business competition, prices on policies are reduced to retain business and capture market share (think of all the advertisements claiming to lower the cost of your car insurance). Frequently, prices of securities in the insurance company's portfolio fall below sustainable levels and lead to losses as claims on policies are paid out. The company must then liquidate portfolio assets to supplement cash flow, and share prices may drop. Insurers are forced to raise the prices of policies and profitability begins to grow once again, opening the door for renewed competition. As a result, property casualty insurance companies will tend to invest in a portfolio of taxable bonds during the period of the cycle where losses occur and switch to non-taxable bonds such as municipal bonds during periods of positive profits.
Some of the largest property and casualty insurance companies listed on stock exchanges where investors can buy shares are: Allstate (ALL), Progressive (PGR), Berkshire Hathaway (which owns Geico and a number of other insurance companies), Travelers (TRV), and Zurich (ZURVY:OTC).
Several ETFs now exist to give investors more broad exposure to the insurance industry, including: SPDR S&P Insurance ETF (KIE); Invesco KBW Property & Casualty Insurance ETF (KBWP); and iShares U.S. Insurance ETF (IAK).
The Bottom Line
Knowing the special circumstances that insurance companies operate under helps in evaluating whether or not a listed insurance company is a good investment and whether the economic environment is conducive to profitability for these companies.
High interest rate environments can be detrimental to life insurance companies as they face disintermediation risk. Property and casualty insurance companies are subject to the ebbs and flows of the profitability cycle. Being able to recognize when the economics of these industries are changing might make for buy or sell signals accordingly. Also keeping in mind the duration and maturities of the bonds in the portfolios of different kinds of insurance companies can help determine how change in interest rates will effect each.