This article aims to help investors to understand insurance companies better and thus make the right investment decisions.
Business Model
An insurance company basically agrees to take the risk of an individual in exchange for a price.
Insurance companies make profits
- by charging the right price for the risk they undertake (Underwriting) and
- also by investing the large pool of funds they collect in terms of premiums.
Income Statement
The key metrics in the income statement of an insurance company are:
* Gross Written Premium or Sales (GWP) –
- The amount of risk premiums an insurance company has underwritten in the period of the financial statement.
*Reinsurance and Net written Premium -
- Insurance companies will pass some of their premiums to other insurance companies to reduce risks.
- This outflow of premiums is known as ceding reinsurance.
- Net Written premium = GWP –Reinsurance Ceded.
* Net Earned premium-
- All written premiums may not be earned over the period of the financial statement.
- This is because customers would pay premiums in advance.
- The part of the premiums which are earned over the financial statements duration are known as net earned premiums.
* Investment Income and Other income –
- An insurance company will receive significant amounts of cash from policy holders.
- It will invest the cash.
- Investment income therefore becomes a significant line of income for an insurance company.
- Other income would be those which are earned from other insurance related activities.
- Often this would comprise various fees which an insurance company may charge policy holders for services provided.
*Revenue -
- This would be the total income earned for a financial statement period.
- It would therefore be the sum of
- Earned Premiums,
- Investment income and
- Other income.
* Benefits –
- This is the claims incurred for the period.
- Incurred includes both paid claims and reserve movements to Balance Sheet.
- In line with accounting prudence an insurance company will have to hold more or less reserves in line with changes in claims patterns and economic conditions.
* Underwriting and Acquisition costs -
- This would be Commissions paid in relation to insurance sales.
* Operating and Administrative expenses -
- These would be costs of operations of the insurance company.
Key Income Statement Metrics
The following metrics can be used when comparing between insurance companies:
Claims ratio –
- Claims (Benefits)/Net Earned Premiums.
- Other things being equal; lower the ratio better the performance.
Expense ratio –
- Total Underwriting and Operating Expenses/ Revenue.
Combined Ratio -
- Measurement of how an insurance company’s revenue when excluding investment income covers its expenses.
- Total expenses/( Revenue – Investment Income).
- Ideally the ratio should be less than 100% and this indicates that both are making profits because of investment income and not from insurance business.
Message to the Investor
The insurance business is technical and complex when compared to other industries.
By understanding the business model and the method of accounting investors can make better decisions towards shareholder value.
(By Ravi Mahendra. The writer is an accountant working in the UK).
http://www.sundaytimes.lk/071028/FinancialTimes/ft3025.html
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