By Hyun Jun Kim, firstname.lastname@example.org
- Demand Side
Primary insurance is a commodity-like product. In general, consumers of primary insurers care mainly about price and service only and therefore, there is not much product differentiation within the industry. In many cases, this environment creates extensive price competitions and inadequate pricing of their policies in a short term.
Reinsurance, however, can have product differentiation power if it has capacity of paying out a large amount of claims by its available funds when it is most needed (e.g. mega-catastrophic hurricane/terrorism attack).
- Supply Side
Insurance companies have funds available to invest from three sources: 1. Policy holders, 2. Debt holders, and 3. Equity holders (i.e. Insurer’s investment is roughly equal to “Float” plus Debts plus Shareholders’ Equity.) In analyzing operation performance of an insurer, the main focus should be on the policy holder money (i.e. “float”) and its cost (i.e. underwriting performance) over a long period of time.
- Operation Side
* Float = Policy holder money held – Policy holder money not held yet
= [loss and loss adjustment reserves + unearned premium + fund held under reinsurance assumed + other policy holder liabilities] – [premium receivables + loss recoverable + deferred policy acquisition costs + deferred charges on reinsurance + prepaid taxes]
* Combined ratio = (Incurred Losses + Expenses) / Earned Premium
“Float”, or available reserve, is policyholder money held, but not owned, by insurers, which comes about because there exist time intervals between received premiums and incurred losses to be paid out, usually more than a year. During that time, the money can be invested for insurers. Under a good management, insurance companies can have negative cost of funds, while other depository institutions such as banks always have positive cost of funds, regardless of management quality. If an insurer operates under underwriting profits, it means the cost of float is free (i.e. combined ratio = 100), or even negative (combined ratio < 100). In other words, insurers are paid to use the float. In this case, the float, defined as liability on the balance sheet, functions as an asset, which determines the value of the insurer. However, if the cost of the float is more than the cost that the company otherwise incurs to borrow the money, it is no value to the company. In an insurance operation, the combined ratio equal to 111 is, more or less, the break-even point, depending on its investment performance and environment.
- Investment Side
As in other depository institutions, insurance firms should invest funds intelligently. Bonds-to-equity ratio in its investment gives an idea of how conservatively managers allocate available capital. Long-term investment performance shows profitability of the float.
Long-term Top Performers and Valuation Metrics
Due to extensive price competitions among thousands of insurers, most of insurers in the United States could not keep up with long-term (more than 5 years) underwriting profits. However, there are a small number of top performers that have managed underwriting profits and in addition, have increased float at an attractive rate in the past. If the managements stick with the same disciplined pricing and quality of service in the future, it is likely that they will continue to make companies profitable in the long term.
In the event of subprime mortgage crisis, market value of these fundamentally excellent companies has plummeted along with mediocre insurers. It created opportunities to purchase good insurance businesses at a discount, compared to its intrinsic value. For the purpose of the valuation, Market Cap / Float (M/F) can be used after screening insurers by their long-term underwriting performance. The M/F ratio below 0.5 is extremely undervalued since the float of these companies functions as assets, or even better. In other words, the M/F may be roughly considered the same as Market-to-Book under two conditions: 1. Long-term underwriting profits and 2. No shrinkage of the float.