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# Analyzing Insurance Companies

Insurance company revenues include premiums and investment income on the float. Premiums are the amounts paid by the purchaser of insurance products, while investment income on the float refers to income earned on premiums between their collection and the payment of claims.

There are two categories of insurance companies, namely: property and casualty (P&C) and life and health (L&H). The two differ in terms of variability of claims and contract duration. Claims for P&C insurers tend to be lumpier, while claims for L&H insurers are relatively stable and predictable.

L&H insurers’ policies usually are longer-term, which contrasts with the shorter-term P&C insurers’ policies. Insurance companies in some countries are required to prepare their financial reports following the statutory accounting rules which focus on the solvency of the companies. These accounting standards differ from IFRS and US GAAP.

## Property and Casualty (P&C) Insurance Companies

The highest source of income for P&C insurers is premium income. Keys to the profitability of an insurer are prudence in underwriting, pricing of adequate premiums for bearing risk, and diversification.

The policy period is often short, with premiums received at the beginning of the period and invested during the float period. Claim events such as fire or weather events are known with certainty but may take a long time to emerge. Multi-peril policies cover both property and casualty losses occurring during a covered event.

### P&C Profitability

The P&C insurance business is cyclical. Many competitors are willing to cut prices to obtain market share since it is a price-sensitive business. The price-cutting may drive out profitability, creating a “soft” pricing market for insurance companies, which means that the insurers have reached an uncomfortably depleted level of capital. Competition lessens, and underwriting standards tighten, creating a “hard” pricing market. Consequently, premiums rise, and the insurers return to more reasonable levels of profitability. The increase in profitability once again attracts more entrants into the market, and the cycle repeats.

Significant expenses for P&C insurers include claims expenses and underwriting expenses. Underwriting expenses depend on whether the issuer uses a direct-to-consumer model or the agency model. 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.

The industry’s combined ratio is equal to the total insurance expenses divided by the net premiums earned. A low combined ratio indicates a hard insurance market, attracting new entrants who cut prices and push the cycle downward. The lower prices for premiums decrease the total net premiums earned, and the combined ratio increases, indicating a soft market. Competitors leave the market, either because they want to forgo unprofitable underwriting or because of their failure.

For a single insurance company, a combined ratio above 100% indicates an underwriting loss. Statutory accounting practices define the combined ratio as the sum of the underwriting loss ratio and the expense ratio.

$$\text{Underwriting loss ratio}=\frac{\text{Claims paid} + (\text{Ending loss reserve} – \text{Beginning loss reserves})}{\text{Net premiums earned}}$$

The underwriting loss ratio indicates the quality of a company’s underwriting activities. On the other hand,

$$\text{Expense ratio}=\frac{\text{Underwriting expenses}}{\text{Net premiums written}}$$

The expense ratio includes sales commissions and related employee expenses. This ratio is an indicator of the efficiency of a company’s operations in acquiring and managing an underwriting business. It is also called the underwriting expense ratio. The two ratios have different denominators. For comparability in reporting, insurers may sometimes use the US GAAP, which calls for net premium earned as the denominator for both ratios.

P&C insurers incur a critical expense from the management of their loss reserves. The loss reserve is an estimated value of unpaid claims. Underestimating loss reserves lead to undercharging for risks assumed. Besides, the longer the insurer’s obligation runs, the more difficult it can be to estimate the loss reserve accurately.

In summary, to analyze P&C profitability, critical ratios to look at are as follows:

#### 1. Loss and Loss-Adjustment Expense Ratio

This ratio reflects the degree of success an underwriter has achieved in estimating the risks insured. The lower the ratio, the higher the success.

$$\text{Loss and loss adjustment expense ratio}=\frac{\text{Loss expense}+\text{Loss adjustment expense}}{\text{Net premiums earned}}$$

#### 2. Underwriting Expense Ratio

The underwriting expense ratio gauges the efficiency of money spent in obtaining new premiums. A lower ratio indicates a higher success.

$$\text{Underwriting expense ratio}=\frac{\text{Underwriting expense}}{\text{Net premium written}}$$

#### 3. Combined Ratio

The combined ratio shows the general efficiency of an underwriting operation. When it is less than 100, there is an underwriting profit, which is considered efficient.

$$\text{Combined ratio} = \text{Loss and loss adjustment expense ratio} + \text{Underwriting expense ratio}$$

#### 4. Dividends to Policyholders (Shareholders) Ratio

This ratio is a measure of liquidity as it relates the cash outflow of dividends to the premiums earned in the same period.

$$\text{Dividends to policyholders (shareholders) ratio} =\frac{\text{Dividends to policyholders (shareholders)}}{\text{Net premiums earned.}}$$

#### 5. Combined Ratio After Dividends

This ratio is a more strict measure of efficiency than the typical combined ratio. This is because it takes into account the cash satisfaction of policyholders or shareholders after consideration of the total underwriting efforts. Dividends are discretionary cash outlays, and factoring them into the combined ratio presents a fuller description of total cash requirements.

$$\text{Combined ratio after dividends} = \text{Combined ratio} – \text{Dividends to policyholders (shareholders) ratio}$$

#### Example 1: P&C Profitability Ratios

Companies A, B, and C are P&C insurers. The following table displays selected information for their most recent financial year.

$$\begin{array}{l|r|r|r} \textbf{Description} & \textbf{Company A} & \textbf{Company B} & \textbf{Company C}\\ \hline{}& \text{\m} & \text{\m} & \text{\m}\\ \hline\text{Loss and loss adjustment expense} & 5,686 & 3,498 & 2,753\\ \hline\text{Underwriting expense} & 2,397 & 2,146 & 1,673\\ \hline\text{Dividends to policyholders (shareholders)} & 368 & 188 & 104\\ \hline\text{Net earned premium} & 8,400 & 5,731 & 4,373\\ \hline\text{Net written premiums} & 8,503 & 5,634 & 4,585\\ \end{array}$$

1. Calculate the loss and loss adjustment expense ratio, underwriting expense ratio, combined ratio, and combined ratio after dividends.

#### Solution

The calculation of ratios is as shown below:

$$\begin{array}{l|r|r|r} \text{}& \textbf{Company A} & \textbf{Company B} & \textbf{Company C}\\ \hline\text{Ratio} & \% & \% & \%\\ \hline\text{Loss and loss adjustment}\\ \text{expense ratio} & 67.69\% & 61.04\% & 62.95\%\\ \hline\text{Underwriting expense ratio} & 28.19\% & 38.09\% & 36.49\%\\ \hline\text{Combined ratio} & 95.88\% & 99.13\% & 99.44\%\\ \hline\text{Dividends to policyholders}\\ \text{(shareholders) ratio} & 4.38\% & 3.28\% & 2.38\%\\ \hline\text{Combined ratio after dividends} & 91.50\% & 95.85\% & 97.06\%\\ \end{array}$$

2. Which insurer is most profitable on a combined ratio basis?

#### Solution

Company A has the least combined ratio and is, therefore, the most profitable.

3. Which insurer has the most efficient operations?

#### Solution

Company A has the most efficient operations because it has the lowest underwriting expense ratio.

4. Which insurer is most profitable overall?

#### Solution

Since A has the lowest combined ratio after dividends relative to the other insurers, it is the most profitable.

### Investment Returns

Due to P&C insurance companies’ uncertainty in the risks they insure, they conservatively invest the collected premium. They usually favor steady-return, low-risk assets while avoiding low-liquidity investments. The analysis 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.

$$\text{Total investment return ratio}=\frac{\text{Total investment income}}{\text{Investment assets}}$$

Alternatively, instead of using investment income, the ratio can be computed without unrealized capital gains. It, therefore, shows the relative importance of unrealized capital gains to the total investment income.

### Liquidity

Claims involved in P&C insurers are uncertain. This implies that a high degree of liquidity is required so that the payout obligations can be met. One way to measure the liquidity of the investment portfolio is to look at its fair value hierarchy reporting. As for banks, Level 1 assets are based on readily available prices for traded securities and therefore tend to be most liquid. Level 2 assets are based on less liquid conditions. In other words, prices for such securities are not available from a liquid market and may be inferred from similar securities trading in an active market. This makes these assets to be less liquid than Level 1 assets. Level 3 assets base their value on models and assumptions because there is no active market for the securities, implying illiquidity.

### Capitalization

While the international risk-based capital standards have existed since 1988 for banks, there are no global risk-based capital requirement standards for insurers. However, capital standards do exist in various jurisdictions. For example, regionally, the EU has adopted the Solvency II standards. On the other hand, NAIC in the United States has specified minimum capital levels based on size and risk (including asset, credit, liquidity, underwriting, and other relevant risks).

## Life and Health (L&H) Insurance Companies

Similar to P&C insurers, L&H insurers obtain their revenue primarily from premium income, while investment income is the secondary source. Life insurance policies can be basic term-life, whereby the insurer makes the payment following a death 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. Some products cover specific medical expenses and treatments, and others provide income payments if the policyholder is injured or becomes ill.

Primary considerations in the analysis of L&H insurers include:

#### 1. Revenue Diversification

Diversification reduces risks. There are various ways by which L&H insurance companies can be diversified. These include across revenue sources, product offerings, geographic coverage, distribution channels, and investment assets. The proportion of income generated from premiums, investments, and fees can vary over time and among insurers. It is crucial to note that premium income can be a more stable source of revenue. Therefore, greater diversification of revenues should be considered along with potentially more considerable variability in revenues.

#### 2. Earnings Characteristics

Similar to P&C insurers, an L&H insurers’ earnings reflect several accounting items that require judgment and estimation. Actuarial assumptions (e.g., about life expectancy) affect the value of 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).

Some profitability ratios that can be applied to L&H companies include return on assets (ROA), return on equity (ROE), growth and volatility of capital, and book value per share. However, owing to the complexity of L&H companies’ earnings, the most analysis goes beyond these general measures. Industry-specific cost ratios include (a) total benefits paid as a percentage of net premiums written and deposits, and (b) commissions and expenses incurred as a percentage of net premiums written and deposits. Finally, mismatches between the valuation approaches for assets and liabilities can distort values when the interest rate environment changes.

#### 3. Investment Returns

Investment returns are a vital attribute of the L&H insurer’s profitability. Investment activities can be analyzed by looking at diversification, performance, and interest rate risk. 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 is often used to evaluate L&H insurer’s investment portfolio performance.

$$\text{Total investment return ratio}=\frac{\text{Total investment income}}{\text{Investment assets}}$$

Where invested assets include cash and investments.

As previously mentioned, this measure can use investment income plus realized gains (losses) with and without unrealized capital gains (losses). Also, a standard metric for evaluating the interest rate risk of L&H companies is the comparison of the duration of the company’s assets with the duration of its liabilities.

#### 4. Liquidity

Liabilities to creditors and policyholders primarily drive an L&H insurance company’s liquidity requirements. An L&H insurance company can derive its liquidity from its operating cash flow and investment assets. 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. The typical “current ratio” is not directly applicable to L&H companies because their balance sheets often do not include the classifications “current” and “non-current.”

#### 5. Capitalization

As highlighted with P&C insurers, there are no global minimum capitalization standards. Domestic regulators often do specify risk-adjusted minimum capital requirements. If an insurer’s capital falls below the minimum requirement, generally, a supervisory authority gets involved. Since L&H insurers have duration mismatches between assets and liabilities, their risk-adjusted capital requirements typically incorporate interest rate risk.

## Question

William Leo is a finance analyst at InvestUK. His boss James Henry has asked him to review critical performance ratios for three P&C insurance companies in which InvestUK is invested. The ratios are as presented in the table below:

$$\begin{array}{l|r|r|r} \textbf{Component} & \textbf{Insurer A} & \textbf{Insurer B} & \textbf{Insurer C}\\ \hline\text{Loss and loss adjustment}\\ \text{expense ratio} & 57.94\% & 55.04\% & 53.24\%\\ \hline\text{Underwriting expense ratio} & 22.84\% & 26.94\% & 22.04\%\\ \hline\text{Combined ratio} & 80.78\% & 81.98\% & 75.28\%\\ \end{array}$$

The best metric of the operations of a P&C insurance company emphasized by Leo when evaluating P&C insurance companies is the:

A. Combined ratio.

B. Underwriting loss ratio.

C. Underwriting expense ratio.

#### Solution

The combined ratio shows the general efficiency of an underwriting operation. In other words, it measures the overall underwriting profitability and efficiency of an underwriting operation. It is the sum of the underwriting loss ratio (Loss and loss adjustment expense ratio) and the underwriting expense ratio.

B is incorrect. The underwriting loss ratio is a measure of the quality of a company’s underwriting activities, i.e., the degree of success an underwriter has achieved in estimating the risks insured.

C is incorrect. The underwriting expense ratio gauges the efficiency of money spent on obtaining new premiums.

Reading 12: Analysis of Financial Institutions

LOS 12 (f) Describe key ratios and other factors to consider in analyzing an insurance company.

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