Overview
Chances are, you have some form of insurance in your life, or at least have been a beneficiary of an insurance policy in the past. Perhaps you’re under a health insurance plan, whether it’s private and/or public, that helps cover certain medical costs. If you drive, virtually every jurisdiction requires drivers to have auto insurance. If you’ve travelled internationally, then perhaps you had travel insurance to help cover any surprise medical expenses.
Some expenses prove too much to shoulder, or can still be a burden despite having the means to pay out of pocket – insurance exists to help alleviate that burden, whether entirely or even partially.
At their most basic level, insurance companies operate on a very simple business model. Despite this simplicity, many of them go on to become very large companies, with operations all over the world and with countless clients under their care.
This robust yet reliable business model understandably attracts the attention of certain investors. In this article, we will explore how an investor may want to go about analyzing insurance equities.
Understanding How Insurance Companies Work
Before trying to assess whether a certain insurance company has investment merit or not, the first step is to understand how exactly they work. Fortunately, in a previous article, we already looked at how insurance (and by extension, insurance companies) works. However, we will quickly go over how they work, whether it’s to help jog your memory or familiarize you for the first time.
Insurance companies help alleviate the financial burden of certain expenses incurred by their clients by paying a certain percentage of the total cost, while the client pays for the remainder. The percentage of a cost that’s covered will vary based on specific plans and expenses.
How are insurance companies able to do that?
When a client is covered by a specific insurance plan, they are responsible for making routine payments known as “premiums”. The amount that each client pays depends on their specific insurance policy and circumstances/variables that are unique to them. The money collected from premiums creates a “pool” of funds, which insurance companies draw upon to pay for the expenses that clients come forward with, known as “claims”.
Now, just because insurance companies are responsible for honouring claims doesn’t mean they need to honour all of them. If they did, they would quickly run out of funds and shut down operations soon after.
So, if not all claims are honoured, then that means insurance companies will have leftover money in their pool of funds. What do they do with these surplus funds? They use it to make investments. The types of investments that insurance companies make usually include marketable securities (primarily equities and fixed-income instruments), loans, and even real estate.
Many of these investments generate income, which insurance companies use as an additional source of revenue in addition to the premiums they collect. Long-term investments, and the returns they generate, can strategically be used to pay for claims they anticipate will be made in the future (e.g., a large life insurance claim).
Investment Factors to Focus on When Looking at Insurance Companies
At their core, insurers aren’t very complicated to understand. When looking at them from a high level, insurers take on clients, the clients pay premiums while also submitting claims, and the insurer pays those claims (though not all of them) while investing surplus funds to create an additional revenue stream.
This straightforward business model also means assessing an insurance company’s investment merit isn’t an overly complicated affair. That being said, this doesn’t mean this is a trivial matter: it’s important for investors to understand which factors to look at and to make sure they’re scrutinized thoroughly.
We will go over some factors that may be worth an investor’s time and attention.
Steadily Increasing (Or at Least Consistent) Premiums
When it comes to an insurer’s financial health, everything starts with the premiums they collect. Without adequate revenue from premiums, they won’t have any surplus capital on hand to make investments, meaning they won’t be able to earn any investment income either. Although insurance companies earn revenue from additional sources (typically marked as “other revenue”), this usually isn’t a major contributor to total revenue (though there may be some exceptional cases).
So, one of the first things investors will want to look at when assessing prospective insurance companies is how their premium revenue changes over time.
First, it’s important for investors to keep a certain expectation in check: it’s unrealistic to expect premium revenue to grow every single year, ad infinitum. Adverse economic conditions, changes in client numbers, and adjustments to how certain policies are structured all have the potential to affect premium revenue. Because of this, fluctuations in premium revenue are to be expected.
That being said, just because premium revenue is subject to fluctuations doesn’t mean trends cannot be observed. Assuming an investor has an abundance of financial data at their disposal (e.g., financial statements for the past 10 years), then the effects of short-term fluctuations are smoothed out, and broader business trends can be observed.
If premium revenue is slowly but surely moving up (or at least stays consistent) during this time, then that’s a positive sign in the eyes of investors – this is a clear sign that business is going smoothly. Relatively consistent revenue means there’s some room for improvement but is by no means a bad thing to see. Steadily decreasing premiums, however, will definitely warrant special attention.
Having Adequately Diversified Sources of Premiums
Collecting premiums is one thing, but any competently run insurance company will know the importance of diversifying the different sources they collect their premiums from.
Collecting premiums from different types of policies means an insurance company isn’t overly reliant on a single source, and if a single source isn’t performing as well as expected, total revenue doesn’t take a very heavy hit.
Most companies accomplish this by offering different types of coverage. It’s common for large insurance companies to offer a wide variety of policies such as health, home, auto, travel, and business in order to cater to all sorts of potential clients. To further entice clients, many companies bundle various types of coverage and offer them as a single policy but at a reduced price.
Another way to achieve adequate diversification would be to cast a wider geographical net, which we will expand on shortly.
Constant Expansion of Their Client Base/Areas Served
Insurance plays an important role in many people’s lives, and those who are able to get an insurance policy will usually do so. However, over time, almost everyone who can afford an insurance policy will eventually have one.
Certain countries, especially countries with advanced economies, usually have populations with high insurance penetration (i.e., a large percentage of the populace is insured), but this leads to a certain problem – how can insurance companies hope to grow their operations if almost everyone who has a policy already has one, and the fact that not all of those people are their clients?
Raising premiums may temporarily lead to increased revenue, but higher premiums may cause an exodus of clients to competitors who offer the same policies but at lower prices.
So what’s another option? Do business in markets that have low insurance penetration. One prominent example of a region ripe for rapid insurance growth is the Asia-Pacific region; this can be attributed to countries in this region turning into “emerging markets”, whereby more people are exiting poverty and are starting to firmly establish themselves as middle class.
These people who now find themselves with more disposable income will most likely seek to improve their quality of life, and one of the ways they may want to do that is to purchase an insurance policy.
Insurers who successfully establish themselves in markets with low insurance penetration stand to gain a lot, especially if they’re one of the first (or at least the first few) to operate in that space. These insurance companies have the possibility to take on droves of new clients, meaning more premium revenue. If a large portion of those new customers is young, then they may pay premiums for many years, and even decades, to come.
Establishing themselves in new markets is also a great way for insurance companies to diversify their source of premiums, which we discussed previously. If a certain market is starting to reach maximum insurance penetration or an adverse economic event happens, then an insurance company won’t be as heavily affected because they still collect premiums from clients elsewhere.
From an investor’s point of view, this represents an excellent form of sustainable, long-term growth. If new clients are being taken on, then there’s no need to raise premiums; in fact, premiums can even be lowered, further enticing new clients, whereby the increased volume of premiums being collected will compensate for the reduced prices.
Maintaining Adequate Float and Sensibly Using It
Earlier, we discussed how insurers create a pool of funds by charging their clients premiums, which they then use to pay claims. While a large portion of those funds is used to pay claims, some funds are retained in order to make investments to generate investment income.
These surplus funds are known as an insurance company’s “float”. Insurance companies don’t disclose how much float they have because there’s no standardized accounting method to calculate it. Therefore, the onus rests on investors to calculate this figure using their own assumptions. One method, for the sake of example, would be to take net premiums and subtract gross claims.
If this float is used to make high-quality investments, then the returns generated from them can be used to pay for claims further down the road and can be reinvested to further earn more income.
Insurers are therefore faced with a two-fold challenge. First, they must find the right balance of maintaining adequate float. Too little float means no significant investments can be made, while too much means surplus capital isn’t being effectively deployed, as well as possible suspicions from clients that they’re being ripped off.
Second, insurers are responsible for making sure the investments they choose to pursue are sensible. Different insurers have different investment philosophies: some choose to have portfolios that are heavily comprised of fixed-income securities, while others may be a bit more comfortable taking on more equities.
Every insurance company collects premiums, but one of the areas they can set themselves apart from the competition is how effectively they use their float. Therefore, keeping a close eye on how insurance companies deploy these excess funds will certainly be of great importance to investors.
Risk Factors and Challenges Faced by Insurance Companies
In the preceding section, we mentioned that, because of the relative simplicity of an insurance company’s operations, assessing their investment merit isn’t too complicated. A handful of key factors are usually all it takes to greatly influence their investment merit.
However, if a handful of factors can impact an insurance company’s investment merit, then the opposite is also true: a handful of risk factors and challenges can result in a heavy hit to their investment merit.
Let’s go over what some of those risks and challenges are.
Being Undercut by Smaller, Cheaper Competitors
If there’s one thing people with insurance policies do on an intermittent basis, it’s looking for cheaper alternatives. Insurance, at its core, is a luxury; you don’t need insurance to sustain your day-to-day needs, unlike food, clothing, and housing. If people can find similar coverage at a more attractive price, they will most likely avail of that opportunity right away.
Many smaller insurers are aware of this, and as a result, try to poach clients by offering cheaper insurance policies. Smaller insurers may not offer the same suite of coverage that large, established players do, but if they can successfully undercut these large companies then they at least have a fighting chance.
Additionally, smaller insurers may not have the same level of bureaucracy and internal politics that large insurers do, so they may be able to move more swiftly and make faster decisions due to a potentially leaner organizational structure.
For investors who are tied up with these large insurers, this can pose a serious risk. If these large players don’t find a way to counter these smaller, cheaper competitors, then they may find themselves dealing with a steadily declining client base, earn less revenue, and in turn be unable to provide the returns that investors are looking for.
Investors who are slow to detect this may find themselves on a sinking ship and could end up sustaining heavy losses if they don’t divest fast enough.
Expanding Into New, Though Fiercely Competitive Markets
In the previous section, we talked about how one strategy insurers can pursue to grow their operations is to expand into new markets, ideally ones with a populace that have a low percentage of people who are insured.
In theory, this idea sounds like a no-brainer. In practice, things can get a bit tricky.
Insurance, just like many other industries, is highly competitive. Companies are always looking for new ways to attract and retain as many clients as they can. So, if a new market teeming with prospective business opportunities presents itself, chances are there are already several players looking to enter and make a name for themselves in that space.
Some insurance companies are able to successfully set up shop in new markets because they knew exactly what to expect in terms of the competition they will face and planned accordingly.
But, if an insurance company decides to enter a new market, but fails to properly anticipate and prepare for inevitable competitors, then they may be in for a very nasty surprise. At best, they may initially struggle to get any sort of meaningful market share, but eventually, increase their slice of the pie over time. At worst, this expansion may be doomed to fail right from the start, wasting prodigious amounts of time and money in the process.
There’s nothing wrong with trying to pursue growth opportunities, especially if this growth can increase shareholder value. However, inadequately preparing to take on those opportunities may backfire and end up doing more harm to investors in the process.
Poor Investment Portfolio Performance
As we know, an insurance company’s revenue can generally be derived from two major sources: premiums and investment income. Although there are other, miscellaneous sources of revenue, premiums and investment income make up the bulk of it.
As long as an insurance company manages to maintain or grow its client base, then the revenue they earn from premiums will more or less be stable (barring any extraordinary circumstances). However, things are different when it comes to investment income.
Based on the types of investments an insurance company owns, their investment income may be steady, gradually increase, or gradually decrease. Additionally, any changes in financial markets will also affect the investment income an insurer can hope to earn.
Many insurers choose to own a large number of fixed-income securities (e.g., bonds), and for good reason: assuming these bonds are high quality (i.e., the contractual claim that underpins them can be honoured), then insurance companies can expect to receive regular interest payments, without having to worry about those payments being slashed due to changes in economic conditions (as is the case with many equities).
Of course, insurance companies can decide how much capital to allocate to certain investments, but the onus rests on them to ensure that the performance of their investment portfolio is adequate enough to meet their needs.
If certain investments start to turn sour, such as equities slashing dividends or bonds being unable to pay interest on time, then an insurance company’s investment income can quickly take a turn for the worst.
An infamous, high-profile example of poor investment decisions catching up with an insurance company was AIG’s credit default swaps of subprime mortgage-backed securities leading up to the Financial Crisis. Once these securities fell apart, AIG lost a major source of revenue in the process, and their own investment merit tumbled along with it.
Investing will always have some form of risk associated with it, and some of it is well beyond the control of an insurance company. Insurance companies can’t possibly hope to control what financial markets will do at any given moment, nor can they control broader economic conditions. The best an insurance company can do is make decisions based on the best information they can get their hands on.
However, investment risk can be contained and kept as low as possible. This can be achieved by having a proper risk management system in place and taking the time to properly analyze prospective investments. If an insurance company fails to do these things and their portfolio tanks because of it, then that’s entirely on them.
If an insurance company doesn’t take the time to make sure the excess funds they receive from clients are put to good use, then how can they possibly assure investors that they’ll make the most of the capital they have given?
An Increase in Claims, but Insufficient Funds to Pay For Them
Previously, we talked about how one of the factors that investors will want to keep a close eye on is how an insurance company’s premium revenue changes over time. Of course, short-term fluctuations can artificially inflate or deflate those numbers, but over the long term, the effects of fluctuations are smoothed out and a more realistic look at how premium revenue is changing becomes more visible.
If investors should monitor how premiums change over time, then the same can be said for claims (in this particular case, gross claims). After all, claims almost always make up the bulk of an insurer’s total expenses.
As an insurer takes on more clients, it’s not unusual to see gross claims slowly creep up as well – in fact, this is more or less to be expected. After all, more clients mean more people will be filing claims. However, more clients also mean more premiums will be collected, so the increase in expenses will be offset by an even greater increase in revenue.
A potential red flag to keep out for is if an insurance company’s claims are slowly creeping up, but the premiums they’re collecting are unable to keep up. This could be due to an insurance company taking on clients who pose a high risk of filing hefty claims, such as those with serious health conditions (health insurance), those who live in areas prone to natural disasters (home insurance), or those who are very old (life/health insurance).
Virtually every insurance company has actuarial scientists on hand to make sure they don’t take on high-risk clients, helping them prevent being on the hook for many expensive claims. But if their focus is on bringing in as much premium revenue as possible, despite the heightened level of risk, then this may turn into a very big problem when all that risk materializes, and an insurance company is left scrambling to deal with it.
If insurance companies find themselves needing to pay a multitude of hefty claims, then what money is left for them to pursue growth projects or to give to investors as dividends?
Wrapping Up
While many people view insurance companies as businesses that help provide coverage for certain expenses, investors may view them in a slightly different manner. That is, they may be seen as a sensible place to park some capital.
Insurance companies may appear to be relatively plain, but their simple yet highly effective business model means they can reliably earn revenue while also having healthy growth prospects; meanwhile, investors stand to gain quite a bit by way of steady share price increases and consistent dividends.
Of course, there are certain risks that can easily throw a wrench in an insurer’s plans. Operating in an increasingly saturated market, being unable to establish themselves in new markets, or suffering from poor investment performance can all hamper an insurance company’s operations, and in turn, hurt their investment merit too.
