Understanding insurance business

The management's view of the insurance business

Is the business profitable? Is the return on total capital excellent?

An insurance company has 2 streams of income, namely from:
• underwriting and
• investing.

Insurance company aims for long term total return. This involves strict discipline and nurturing proper behaviour. It can grow its business either organically or through acquisition. It can also grow by expanding its business overseas and into specialty insurance.

The assets allowed in the investment management portfolio of insurance company include:
• fixed income securities and
• equity securities.

Fixed income security is one where money invested is received with interest in a specific time. Equity security does not give explicit promises on returns.

In the balance sheet of the insurance company, the largest item of its source of fund (liability section) is the loss reserve. This is generally invested in high quality fixed income security (e.g. bonds), with the invested duration matching those of the claims and ensuring a positive spread. The other source of fund is the shareholders equity. There is never the need to repay this. Therefore, this can be invested with unlimited time horizon, usually in more conservative equity securities.

Here is what the management team of an insurance company hopes to achieve:

“The management hopes to compound book value per share over a long time for the business. This incorporates the total return from underwriting and investing, aiming for a ROE > 20%.
Underwriting can be in various types of insurances; including specialty niches. Insurance is a competitive business that is also cyclical. The incentive compensation plan for the employees shall be aligned to the results generated. We will always focus on the long term compound total return. The business shall be without excessive leverage, perhaps 1/3 debt and 2/3 equity. Though smooth and consistent results are to be expected in many industries or businesses, this is not so for the insurance business. The results can be lumpy at time, as the role of the insurance businesses is to smooth the losses incurred by the insured. For example, a hurricane can occur anytime and this may result in a lower profit or a loss that year. In the next year, the higher premium factoring the event, the profit may be better if no major calamity occurs. Therefore, we can expect and accept short term uncertainties in this insurance business. It is better to look at the rolling 5 years goal measurement which is also the one we aim for.”

Measuring talent and Integrity

Talent and integrity are difficult to measure in any business. In general, judge the future of the business by its past performance. Also, check that the compensation to the employee is fair. There should be no misappropriation of shareholder funds. There should be no stock option abuse. The management should be focused on the long term return. Reports to shareholders should be clear, concise and complete. There should be no excessive leverage. The management should have good honest relationship with the shareholders, always conscious that shareholders are the owners of the company.

Reinvestment dynamic

The future of the insurance business is bright. The insurance premium/GDP ratio is still low and trending upwards. There is a lot of room to grow this business. The business will grow when society grows. New insurance risks require new products, growing the insurance market. Growth can also be by reinvestment in new geographical areas.

Fair price

What is the role of the management in determining the share price?.

E.g. Valuing insurance company X
Price peaked at $550 giving a P/BV of 2x.
Historical P/BV 1.5 – 2.0x.
At today’s price of $300, P/BV is 1.3x

The managers of the insurance business have little or no control over the short term stock price swings. They should focus on building up the book value per share over the long term through superior underwriting and excellent investing. A good business should last a long period producing results to the investor over time.


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