Analysing insurance companies

In simple terms

An insurer collects premiums today and pays claims later, sometimes much later. In between, it holds and invests the money. So an insurer has two sources of profit:

• Underwriting: premiums exceed the claims and costs of providing the cover.
• Investment: returns on the money held between receiving premiums and paying claims, often called the float.

The challenge for analysts is that an insurer's true profit on a policy is known only when all claims have been paid, which may take years. Reported profit relies heavily on estimates of future claims.

General insurers

General insurers cover motor, health, property, travel and similar risks, usually with one-year policies. Their key measures are:

A combined ratio below 100% means an underwriting profit; above 100% means an underwriting loss, which must be made up by investment income.

Watch also reserves: the money set aside for claims that have happened but not yet been settled. If reserves prove too small, later profits will be hit. Look for reserve releases or strengthening in the notes: frequent strengthening means earlier profits were overstated.

Life insurers

Life insurance policies last many years, and the profit on a policy emerges slowly over its life. Upfront costs, such as commissions, are high, so a fast-growing life insurer can report low profits even while selling profitable business. Reported profit is therefore a poor guide on its own.

Analysts use:

• Embedded value: the net worth of the insurer plus the present value of future profits from the policies it has already sold. It is an estimate of the value of the existing business.
• Value of new business (VNB): the present value of future profits from policies sold during the year.
• VNB margin: VNB divided by the premium equivalent of new business, showing how profitable each rupee of new business is.
• Persistency: the share of policies still being paid for after a period. Low persistency means customers drop policies, which hurts profits and may signal mis-selling.

Life insurers are often valued as a multiple of embedded value, much as banks are valued on book value.

Solvency

An insurer must hold capital beyond its expected claims to absorb unexpected ones, such as a disaster or a pandemic. The solvency ratio compares available capital with the required level. Regulators set minimum ratios. An insurer near the minimum has little room for bad surprises and may need to raise capital.

Why growth alone misleads

Insurance is one of the few businesses where selling more can be dangerous. An insurer can grow quickly by pricing policies cheaply, and the losses appear only years later when claims are paid. The best insurers grow steadily while keeping combined ratios, VNB margins and persistency healthy.

Why it matters

Insurers' accounts look very different from those of ordinary companies, and the usual ratios mislead. Understanding underwriting, reserves, embedded value and solvency lets you separate an insurer creating value from one buying growth with future losses.

Limitations

Insurance accounting depends heavily on actuarial estimates of future claims, lapses, mortality and investment returns, which outsiders cannot check. Embedded value rests on assumptions about the future. Ratios differ across lines of business, so compare insurers with similar business mixes. Insurance rules and accounting are set by regulators and accounting standards and change over time.

Common mistakes

• Judging an insurer by premium growth alone.
• Ignoring the expense ratio and looking only at claims.
• Using reported profit to judge a fast-growing life insurer.
• Ignoring reserve changes that reveal past optimism.

Try it yourself

1. Choose a listed general insurer and find its claims ratio, expense ratio and combined ratio for several years.
2. Choose a listed life insurer and find its embedded value, value of new business, VNB margin and persistency.
3. Compare each insurer's premium growth with these measures.
4. Write a sentence on whether each one's growth looks profitable.