Insurance Accounting

THE TOPIC
MARCH 2014

Accounting is a system of recording, analyzing and verifying an organization’s financial status. In the United States, all corporate accounting is governed by a common set of accounting rules, known as generally accepted accounting principles, or GAAP, established by the independent Financial Accounting Standards Board (FASB). The Securities and Exchange Commission (SEC) currently requires publicly owned companies to follow these rules. Over time, both organizations intend to align their standards with International Financial Reporting Standards (IFRS).

Accounting rules have evolved over time and for different users. Before the 1930s corporate accounting focused on management and creditors as the end users. Since then GAAP has increasingly addressed investors’ need to be able to evaluate and compare financial performance from one reporting period to the next and among companies. In addition, GAAP has emphasized “transparency,” meaning that accounting rules must be understandable by knowledgeable people, the information included in financial statements must be reliable and companies must fully disclose all relevant and significant information.

Special accounting rules also evolved for industries with a fiduciary responsibility to the public such as banks and insurance companies. To protect insurance company policyholders, states began to monitor solvency. As they did, a special insurance accounting system, known as statutory accounting principles, or SAP, developed. The term statutory accounting denotes the fact that SAP embodies practices required by state law. SAP provides the same type of information about an insurer’s financial performance as GAAP but, since its primary goal is to enhance solvency, it focuses more on the balance sheet than GAAP. GAAP focuses more on the income statement.

Publicly owned U.S. insurance companies, like companies in any other type of business, report to the SEC using GAAP. They report to insurance regulators and the Internal Revenue Service using SAP. Accounting principles and practices outside the U.S. differ from both GAAP and SAP.

In 2001 the International Accounting Standards Board (IASB), an independent international accounting organization based in London, began work on a set of global accounting standards. About the same time, the European Union (EU) started work on Solvency II, a framework directive aimed at streamlining and strengthening solvency requirements across the EU in an effort to create a single market for insurance – see Issues Updates on U.S. Solvency Regulation Solvency II.

Ideally, a set of universal accounting principles would facilitate global capital flows and lower the cost of raising capital. Some 100 countries now require or allow the international standards that the IASB has developed.

Some insurers have been concerned that some of the initially proposed standards for insurance contracts will confuse more than enlighten and introduce a significant level of artificial volatility that could make investing in insurance companies less attractive.

RECENT DEVELOPMENTS

Insurance Contracts: It appears unlikely that the U.S. Financial Accounting Standards Board (FASB) and the International Accounting Standard Board (IASB) will be able to achieve a convergence of the two systems with regard to property/casualty insurance. In February 2014 Accounting Today reported that FASB decided to focus on improving U.S. GAAP instead of continuing with the convergence project. For short-duration contracts – which includes most property/casualty insurance – FASB will target changes that enhance disclosures. For long-duration contracts like life insurance, the board concluded it should consider IASB’s approach, though the auditing and consulting firm of Deloitte notes that even in this regard convergence is not the primary objective of the changes.

Financial Reporting: An SEC report published in July 2012 made no recommendations about whether the IFRS should be incorporated into the U.S. financial reporting system although it did say that there was little support among major U.S. corporations for adopting the IFRS as authoritative guidance.


BACKGROUND

Insurance Basics:

Insurers assume and manage risk in return for a premium. The premium for each policy, or contract, is calculated based in part on historical data aggregated from many similar policies and is paid in advance of the delivery of the service. The actual cost of each policy to the insurer is not known until the end of the policy period (or for some insurance products long after the end of the policy period), when the cost of claims can be calculated with finality.

The insurance industry is divided into two major segments: property/casualty, also known as general insurance or nonlife, particularly outside the United States, and life/health. Broadly speaking, property/casualty policies cover homes, autos and businesses; life/health insurers sell life, long-term care and disability insurance, annuities and health insurance. U.S. insurers submit financial statements to state regulators using statutory accounting principles, but there are significant differences between the accounting practices of property/casualty and life insurers due to the nature of their products. These include:

Contract duration:

Property/casualty insurance policies are usually short-term contracts, six-months to a year. Their final cost will usually be known within a year or so after the policy term begins, except for some types of liability contracts. They are known as short-duration contracts. By contrast, life, disability and long-term care insurance and annuity contracts are typically long-duration contracts — in force for decades.

Variability of Claims Outcomes Per Year:

The range of potential outcomes with property/casualty insurance contracts can vary widely, depending on whether claims are made under the policy, and if so, how much each claim ultimately settles for. The cost of investigating a claim can also vary. In some years, natural disasters such as hurricanes and man-made disasters such as terrorist attacks can produce huge numbers of claims. By contrast, claims against life insurance and annuity contracts are typically amounts stated in the contracts and are therefore more predictable. There are few instances of catastrophic losses in the life insurance industry comparable to those in the property/casualty insurance industry.

Financial Statements: 

An insurance company’s annual financial statement is a lengthy and detailed document that shows all aspects of its business. In statutory accounting, the initial section includes a balance sheet, an income statement and a section known as the Capital and Surplus Account, which sets out the major components of policyholders’ surplus and changes in the account during the year. As with GAAP accounting, the balance sheet presents a picture of a company’s financial position at one moment in time—its assets and its liabilities—and the income statement provides a record of the company’s operating results from the previous period. An insurance company’s policyholders’ surplus—its assets minus its liabilities—serves as the company’s financial cushion against catastrophic losses and as a way to fund expansion. Regulators require insurers to have sufficient surplus to support the policies they issue. The greater the risks assumed, and hence the greater the potential for claims against the policy, the higher the amount of policyholders’ surplus required.

Asset Valuation: 

Property/casualty companies need to be able to pay predictable claims promptly and also to raise cash quickly to pay for a large number of claims in case of a hurricane or other disaster. Therefore, most of their assets are high quality, income-paying government and corporate bonds that are generally held to maturity. Under SAP, they are valued at amortized cost rather than their current market cost. This produces a relatively stable bond asset value from year to year (and reflects the expected use of the asset.)

However, when prevailing interest rates are higher than bonds’ coupon rates, amortized cost overstates asset value, producing a higher value than one based on the market. (Under the amortized cost method, the difference between the cost of a bond at the date of purchase and its face value at maturity is accounted for on the balance sheet by gradually changing the bond’s value. This entails increasing its value from the purchase price when the bond was bought at a discount and decreasing it when the bond was bought at a premium.) Under GAAP, bonds may be valued at market price or recorded at amortized cost, depending on whether the insurer plans to hold them to maturity (amortized cost) or make them available for sale or active trading (market value).

The second largest asset category for property/casualty companies, preferred and common stocks, is valued at market price. Life insurance companies generally hold a small percentage of their assets in preferred or common stock.

Some assets are “nonadmitted” under SAP and therefore assigned a zero value but are included under GAAP. Examples are premiums overdue by 90 days and office furniture. Real estate and mortgages make up a small fraction of a property/casualty company’s assets because they are relatively illiquid. Life insurance companies, whose liabilities are longer term commitments, have a greater portion of their investments in commercial mortgages.

The last major asset category is reinsurance recoverables. These are amounts due from the company’s reinsurers. (Reinsurers are insurance companies that insure other insurance companies, thus sharing the risk of loss.) Amounts due from reinsurance companies are categorized according to whether they are overdue and, if so, by how many days. Those recoverables deemed uncollectible are reported as a surplus penalty on the liability side of the balance sheet, thus reducing surplus.

Liabilities and Reserves: 

Liabilities, or claims against assets, are divided into two components: reserves for obligations to policyholders and claims by other creditors. Reserves for an insurer’s obligations to its policyholders are by far the largest liability. Property/casualty insurers have three types of reserve funds: unearned premium reserves, or pre-claims liability; loss and loss adjustment reserves, or post claims liability; and other.

Unearned premiums are the portion of the premium that corresponds to the unexpired part of the policy period. Premiums have not been fully “earned” by the insurance company until the policy expires. In theory, the unearned premium reserve represents the amount that the company would owe all its policyholders for coverage not yet provided if one day the company suddenly went out of business. If a policy is canceled before it expires, part of the original premium payment must be returned to the policyholder.

Loss reserves are obligations that an insurance company has incurred – from claims that have been or will be filed on the exposures the insurer protected. Loss adjustment reserves are funds set aside to pay for claims adjusters, legal assistance, investigators and other expenses associated with settling claims. Property/casualty insurers set up claim reserves only for accidents and other events that have happened.

Some claims, like fire losses, are easily estimated and quickly settled. But others, such as products liability and some workers compensation claims, may be settled long after the policy has expired. The most difficult to assess are loss reserves for events that have already happened but have not been reported to the insurance company, known as "incurred but not reported" (IBNR). Examples of IBNR losses are cases where workers inhaled asbestos fibers but did not file a claim until their illness was diagnosed 20 or 30 years later. Actuarial estimates of the amounts that will be paid on outstanding claims must be made so that profit on the business can be calculated. Insurers estimate claims costs, including IBNR claims, based on their experience. Reserves are adjusted, with a corresponding impact on earnings, in subsequent years as each case develops and more details become known.

Revenues, Expenses and Profits:

Profits arise from insurance company operations (underwriting results) and investment results.

Policyholder premiums are an insurer’s main revenue source. Under SAP, when a property/casualty policy is issued, the pre-claim liability or unearned premium is equal to the written premium. (Written premiums are the premiums charged for coverage under policies written regardless of whether they have been collected or “earned.” Each day the policy remains in force, one day of unearned premium is earned, and the unearned premium falls by the amount earned. For example, if a customer pays $365 for a one-year policy starting January 1, the initial unearned premium reserve would be $365, and the earned premium would be $0. After one day, the unearned premium reserve would be $364, and the earned premium would be $1.

Under GAAP, policy acquisition expenses, such as agent commissions, are deferred on a pro-rata basis in line with GAAP’s matching principle. This principle states that in determining income for a given period, expenses must be matched to revenues. As a result, under GAAP (and assuming losses and other expenses are experienced as contemplated in the rate applied to calculate the premium) profit is generated steadily throughout the duration of the contract. In contrast, under SAP, expenses and revenues are deliberately mismatched. Expenses associated with the acquisition of the policy are charged in full as soon as the policy is issued but premiums are earned throughout the policy period.

SAP mismatches the timing of revenues and acquisition expenses so the balance sheet is viewed more conservatively. By recognizing acquisition expenses before the income generated by them is earned, SAP forces an insurance company to finance those expenses from its policyholders’ surplus. This appears to reduce the surplus available to pay unexpected claims. In effect, this accounting treatment requires an insurer to have a larger safety margin to be able to fulfill its obligation to policyholders.

The IASB Proposal for International Insurance Accounting Standards: IASB’s aim in establishing accounting standards for the insurance industry is to facilitate the understanding of insurers’ financial statements. Insurance contracts had been excluded from the scope of international financial reporting standards, in part because accounting practices for insurance often differ substantially from those in other sectors — both non-insurance financial services and nonfinancial businesses, and from country to country.

http://www.iii.org/publications/insurance-handbook/regulatory-and-financial-environment/insurance-accounting

Reading and Analyzing Insurance Ratios.

Financial institutions such as banks, financial service companies, insurance companies, securities firms and credit unions have very different ways of reporting financial information.

This guide gives you the most pertinent information to analyze an insurance company's financial statements.


Underwriting Ratios


Loss Ratio

USBR calculates the loss ratio by dividing loss adjustments expenses by premiums earned.

The loss ratio shows what percentage of payouts are being settled with recipients.

The lower the loss ratio the better.

Higher loss ratios may indicate that an insurance company may need better risk management policies to guard against future possible insurance payouts.

Loss Ratio = ( Loss Adjustments / Premiums Earned )





Expense Ratio

USBR calculates the expense ratio of an insurance company by dividing underwriting expenses by net premiums earned.

Underwriting expenses are the costs of obtaining new policies from insurance carriers.

The lower the expense ratio the better because it means more profits to the insurance company.

Expense Ratio = ( Underwriting Expenses / Net Premiums Written )





Combined Ratio

This figure just measures claims losses and operating expenses against premiums earned.

The lower the figure the better.

The combined ratio is the total of estimated claims expenses for a period plus overhead expressed as a percentage of earned premiums.

A ratio below 100 percent represents a measure of profitability and the efficiency of an insurance firms underwriting efficiency.

Ratios above 100 percent denote a failure to earn sufficient premiums to cover expected claims.

High ratios can usually occur either because of underpricing and/or because of unexpected high claims.

Combined Ratio = ( Loss Ratio + Expense Ratio )



Ratio of Net Written Premiums to Policyholder Surplus

This ratio measures the level of capital surplus necessary to write premiums.

An insurance company must have an asset heavy balance sheet to pay out claims.

Industry statuary surplus is the amount by which assets exceed liabilities.

For instance: a ratio 0.95 -to 1 means that insurers are writing less than $1.00 worth of premium for every $1.00 of surplus. A ratio of 1.02-to-1 means insures are writing about $1.02 for every $1.00 in premiums.







Profitability Ratios


Return on Revenues

This figure determines the profitability of an insurance company .

It is the profits after all expenses and taxes are paid by the insurance company.

Return on Revenues = ( Net Operating Income / Total Revenues )



Return on Assets

USBR calculates the return on assets by dividing net operating income by Mean average assets.

This figure shows the profitability on existing investment securities and premiums.

The higher the return on assets the better the company is enhancing its returns on existing liquid assets.

Return on Assets ( Net Operating Income / Mean Average Assets )





Return on Equity

This figure shows the net profits that are returned to shareholders.

The higher the return on equity, the more profitable the company has become and the possibility of enhanced dividends to shareholders.

Return on Equity = ( Net Operating Income (less preferred stock Dividends / Average Common Equity )





Investment Yield

This is the return received on an insurance company's assets.

The investment yield is obtained by dividing the average investment assets into the net investment income before income taxes.

Investment Yield = ( Average investment Assets / Net Investment Income )


http://activemedia-guide.com/busedu_insure.htm



https://www.group.qbe.com/investor-centre/reports-presentations

Understanding an Insurer's Balance Sheet

By Emil Lee | More Articles | Save For Later 
January 26, 2007 | Comments (4)

Insurance companies are magical creatures that, in the hands of a skilled operator, perform alchemistic feats and literally mint money. However, reading and understanding their financial statements are a little difficult, so let's try to break this task down into bite-sized chunks. First we'll get familiar with the terms and calculations; later on, we'll see how the statements are linked and flow into each other.

Balancing Sheet ActInsurance companies are balance-sheet-driven businesses, so we'll start here with the assets. Let's look at the 2005 balance sheet assets of two auto insurers, Progressive(NYSE: PGR  ) and Mercury General (NYSE: MCY  ) .

2005 Assets (Millions of Dollars)

	PGR	MCY
Fixed Maturity Securities	10,222	2,646
Preferred Stock	1,220	0
Common Equities	2,059	276
Short-Term Investments	774	321
Cash	6	35
Accrued Investment Income	133	33
Premiums Receivable	2,501	310
Premium Notes		27
Reinsurance Recoverable	406
Prepaid Reinsurance Premium	104
Deferred Acquisition Cost	445	198
Income Taxes	138	11
Property and Equipment	759	137
Other Assets	133	47
Total Assets	18,899	4,041

This is way too complicated, so let's make some simplifications. 

1.   We'll group all investments (bonds, stocks) into "investments" and throw cash in there as well. 

2.   Then we'll make a category called "policyholder money we don't have yet." This refers to:

• future premiums to be received (premiums receivable)
• money that the reinsurers owe (reinsurance recoverable)
• money already paid to reinsurers for future reinsurance policies (prepaid reinsurance premium)
• money already paid -- but not expensed yet -- such as agent commissions and premium taxes, to acquire policies (deferred acquisition cost).

3.   Everything else we'll call "other assets." (PLEASE -- when investing in an insurer, read the footnotes -- I'm simplifying here for clarification purposes)

Our simplified balance sheet reads:

2005	PGR	MCY
Investments	14,280	3,278
Policyholder Money We Don't Have Yet	3,455	535
Other Assets	1,163	228
Total Assets	18,899	4,041

Now that you've got the hang of how I'm simplifying things, we'll reduce liabilities and shareholder's equity. 

1.   First, we see "policyholder money we have" -- made up of:

• unearned premiums (policyholder money paid for future coverage)
• loss and loss adjustment expense (policyholder money set aside for already incurred losses, incurred but not reported losses, and the cost of settling claims)
• other policyholder liabilities

2.   We also have "debt," which is made up of -- you guessed it -- debt.

3.   "Other liabilities," made up of items such as accounts payable and accrued expenses. 

4.   Finally, there is shareholder's equity (assets minus liabilities, similar to liquidation value). 

Our simplified balance sheet looks like this (to make this even more readable, I am reformatting numbers in billions):

Simplified 2005 Balance Sheet (Billions of dollars)

Assets	PGR	MCY
Investments	14.3	3.3
Policyholder Money We Don't Have Yet	3.5	0.5
Other Assets	1.2	0.2
Total Assets	18.9	4.0

Liabilities & Equity	PCR	MCY
Policyholder Money We Have	10.0	2.0
Debt	1.3	0.1
Other Liabilities	1.5	0.3
Shareholders' Equity	6.1	1.6
Total Liabilities + Equity	18.9	4.0

The first thing to note here is float. In a nutshell, float refers to the money that policyholders give to insurers in return for insurance. With our simplified balance sheet, calculating float is simple:

Float = Policyholder money we have - Policyholder money we don't have yet

In this case, we can see Progressive has about $6.5 billion in float, and Mercury has roughly $1.5 billion. We can also see "Other Assets" and "Other Liabilities" are about equal, so we'll net and ignore these. Lastly, we have debt and shareholder's equity value.

Thus, we have three main pieces that comprise the balance sheet (ignoring other assets and liabilities, which we've netted out): 

• float, 
• debt, and 
• shareholder's equity.

The reason I simplified to these three points is because each of these represents the different pieces of financing: 

• float is money provided by policyholders, 
• debt is provided by creditors, and 
• shareholder's equity (estimated liquidation value) is provided by equity holders.

Back to basics

An insurer takes money from these three sources of funding (policyholders, creditors, and stock holders) and invests it. If we take Progressive's float ($6.5 billion), debt ($1.3 billion), and shareholder's equity ($6.1 billion) we get $13.9 billion -- notice this is about equal to Progressive's $14.3 billion in investments. In other words, an insurer takes money from policyholders (float) and creditors (debt), and pays out operating expenses, claims and claims expenses, and interest payments. The remainder is left over for the stock holders and taxes -- this money is reinvested into investments and increases shareholder's equity, which increases the value of the insurance company to stock holders. However, if the insurer is taking bad risks it'll end up owing a lot of claims (if the losses fall to the bottom line, this eats into shareholder's equity) -- the money to pay out claims comes out of float and investments, which is bad.

By now it should be clear what drives an insurer's balance sheet value: the more shareholder's equity and float, the better. (Quick note: In the short run, if an insurer under-prices its policies it can grow premiums and float very quickly; in the long run losses will eat up the float and shareholder's equity. Watch out for the fools that rush in.) Progressive's $6.5 billion in float (at the end of 2005) and $6.1 in estimated liquidation value were valued at $21 billion. Mercury General's $1.5 billion in float and $1.6 billion in liquidation value were valued at $3.2 billion at the end of 2005.

Hopefully this provides a simplistic and clear understanding of the different pieces of an insurer's balance sheet. Later on we'll look at the other financial statements and link them together to see how an insurer creates or destroys shareholder value.

For some other insurance commentary, check out:

• Getting to Know the Insurance Industry
• Insurance Industry Basics: Float
• Rounding the Second Curve Part 2

Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above and appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.

http://www.fool.com/personal-finance/insurance/2007/01/26/understanding-an-insurers-balance-sheet.aspx

Understanding financial statements of an insurance company

Financial Times
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

https://www.lonpac.com/web/my/quarterly-financial-statements
https://www.group.qbe.com/investor-centre/reports-presentations

A Guided Tour of the Market 5

Asset Management and Insurance

With huge margins and constant streams of fee income, asset managers are perennial profit machines. However, these companies are so tied to the markets that their stock prices often reflect oversized doses of the current optimism or pessimism prevailing in the economy, which means it pays off to take a contrarian approach when you're thinking about when to invest.

Asset management firms run money for their customers and demand a small chunk of the assets as a fee in return. This is lucrative work and requires very little capital investment. The real assets of the firm are its investment managers, so typically compensation is the firm's main expense. Even better, it doesn't take twice as many people to run twice as much money, so economies of scale are excellent.

The single biggest metric to watch for any company in this industry is assets under management (AUM), the sum of all the money that customers have entrusted to the firm. Because an asset manager derives its revenue as a percentage of assets under management, AUM is a good indication of how well – or how badly – a firm is doing.

Investors should look for asset management companies that are able to consistently bring in new money and don't rely only on the market to increase their AUM. Look for new inflows (inflows higher than outflows) in a variety of market conditions. This is a signal that the asset manager is offering products that new investors want and that existing investors are happy with the products they have.

Given the commodity-like products of the life insurance industry, it is next to impossible for one insurer to successfully grow – without acquisitions – above the industry's long-term annual revenue growth rate.

http://books.danielhofstetter.com/the-five-rules-for-successful-stock-investing/

Property/Casualty Insurance Accounting

Property/Casualty Insurance Accounting

Income Statement of Property/Casualty Insurance Company

Premium revenue is also known as earned premium.  This premium revenue is used to fund:

1. Claim payments (loss expense).
2. Sales commissions for insurance agents (commission expenses)
3. Operating expenses (OPEX)

Claim expenses, for example, typically consume 75% of an insurer’s net revenues.

(1)    + (2) + (3) / Premium revenue = Combined ratio

Combined ratio is an insurance company’s key underwriting profit measure.

A combined ratio under 100 indicates an underwriting profit. 

For example:  A combined ratio of 95 means that the insurer paid out 95% of its premium revenue for losses.  The 5% remaining is the underwriting profit.

A combined ratio exceeding 100 indicates an underwriting loss. 

For example:  An insurer with a combined ratio of 105 paid out 105% of its premium revenue to cover losses,  meaning that it had an underwriting loss equal to 5% of revenues.

Companies with combined ratios exceeding 105 for more than a short time have a difficult time recouping their losses via investment earnings, and this type of poor underwriting track record suggests that an insurer’s competitive position is unusually weak.  Insurers unable to earn even the occasional underwriting profit will produce the industry’s poorest returns and may be tempted to accept large investment risks to boost profitability.

Investment income of Insurance companies

Insurers also make money from investment income.  They are often reported as a ratio of premium.

Adding the investment ratio to the combined ratio yields the operating profit ratio.  In many instances, investment income is a key profit determinant because it offsets underwriting losses.

Combined ratio  + Investment ratio  = Operating Profit ratio

Balance Sheet of Property/Casualty Insurance Company 

In addition to float, most insurers invest a large portion of their own retained earnings as well.  The investment account reveals the size of an insurer’s investments relative to its asset base and details the asset allocation employed.

Investment account = Float deployed + Retained Earnings deployed.

Look at the asset allocation of this investment account.  Look for insurers with no more than 30% invested in equities (unless the company is run by Warren Buffett).

Unearned Premiums of Property/Casualty Insurance Company

Unearned premiums represent premiums received but not yet considered revenue.

This oddity reflects an accounting convention.  When an insurer receives a premium, it is deemed to earn it gradually across the year.  After all, if a customer cancels a policy, the insurer must refund that portion of the coverage not consumed.  After six months, an annual auto policy would be 50% earned, and half the premium would be considered revenue.  Before this occurs, the premiums are held in the unearned premium account, and the insurer is free to invest them.

The best property/casualty insurer is one that is able to consistently earn underwriting profits on a large, growing customer base.  In effect, this insurer would be getting paid to profit from investing other people’s money and could retain this float indefinitely (as long as it grows).  Unfortunately, for investors, these situations rarely occur.



Insurance Companies of Malaysia
Click here: https://docs.google.com/open?id=0B-RRzs61sKqRWmp5ZEFEREw4VWM

Buffett Loves The Insurance Operations that deliver "float" or costless capital of $70 BILLION .

• Our insurance operations continued their delivery of costless capital that funds a myriad of other opportunities.

• This business produces “float” – money that doesn’t belong to us, but that we get to invest for Berkshire’s benefit. 
• And if we pay out less in losses and expenses than we receive in premiums, we additionally earn an underwriting profit, meaning the float costs us less than nothing. 
• Though we are sure to have underwriting losses from time to time, we’ve now had nine consecutive years of underwriting profits, totaling about $17 billion. 
• Over the same nine years our float increased from $41 billion to its current record of $70 billion. Insurance has been good to us

http://www.berkshirehathaway.com/letters/2011ltr.pdf

Characteristics of Financial Service firms (banks, insurance companies and investment banks) and their Value Drivers

Characteristics of financial service firms

            There are many dimensions on which financial service firms differ from other firms in the market. In this section, we will focus on four key differences and look at why these differences can create estimation issues in valuation. The first is that many categories (albeit not all) of financial service firms operate under strict regulatory constraints on how they run their businesses and how much capital they need to set aside to keep operating. The second is that accounting rules for recording earnings and asset value at financial service firms are at variance with accounting rules for the rest of the market. The third is that debt for a financial service firm is more akin to raw material than to a source of capital; the notion of cost of capital and enterprise value may be meaningless as a consequence. The final factor is that the defining reinvestment (net capital expenditures and working capital) for a bank or insurance company may be not just difficult, but impossible, and cash flows cannot be computed.

The Regulatory Overlay

Financial service firms are heavily regulated all over the world, though the extent of the regulation varies from country to country. In general, these regulations take three forms. First, banks and insurance companies are required to maintain regulatory capital ratios, computed based upon the book value of equity and their operations, to ensure that they do not expand beyond their means and put their claimholders or depositors at risk. Second, financial service firms are often constrained in terms of where they can invest their funds. For instance, until a decade ago, the Glass-Steagall Act in the United States restricted commercial banks from investment banking activities as well as from taking active equity positions in non-financial service firms. Third, the entry of new firms into the business is often controlled by the regulatory authorities, as are mergers between existing firms.

            Why does this matter? From a valuation perspective, assumptions about growth are linked to assumptions about reinvestment. With financial service firms, these assumptions have to be scrutinized to ensure that they pass regulatory constraints. There might also be implications for how we measure risk at financial service firms. If regulatory restrictions are changing or are expected to change, it adds a layer of uncertainty (risk) to the future, which can have an effect on value. Put more simply, to value banks, insurance companies and investment banks, we have to be aware of the regulatory structure that governs them.

Differences in Accounting Rules

            The accounting rules used to measure earnings and record book value are different for financial service firms than the rest of the market, for two reasons. The first is that the assets of financial service firms tend to be financial instruments (bonds, securitized obligations) that often have an active market place. Not surprisingly, marking assets to market value has been an established practice in financial service firms, well before other firms even started talking about fair value accounting. The second is that the nature of operations for a financial service firm is such that long periods of profitability are interspersed with short periods of large losses; accounting standard have been developed to counter this tendency and create smoother earnings.

a.     Mark to Market: If the new trend in accounting is towards recording assets at fair value (rather than original costs), financial service firms operate as a laboratory for this experiment. After all, accounting rules for banks, insurance companies and investment banks have required that assets be recorded at fair value for more than a decade, based upon the argument that most of a bank/s assets are traded, have market prices and therefore do not require too many subjective judgments. In general, the assets of banks and insurance companies tend to be securities, many of which are publicly traded.  Since the market price is observable for many of these investments, accounting rules have tilted towards using market value (actual of estimated) for these assets.  To the extent that some or a significant portion of the assets of a financial service firms are marked to market, and the assets of most non-financial service firms are not, we fact two problems. The first is in comparing ratios based upon book value (both market to book ratios like price to book and accounting ratios like return on equity) across financial and non-financial service firms. The second is in interpreting these ratios, once computed. While the return on equity for a non-financial service firm can be considered a measure of return earned on equity invested originally in assets, the same cannot be said about return on equity at financial service firms, where the book equity measures not what was originally invested in assets but an updated market value.

b.     Loss Provisions and smoothing out earnings: Consider a bank that makes money the old fashioned way – by taking in funds from depositors and lending these funds out to individuals and corporations at higher rates. While the rate charged to lenders will be higher than that promised to depositors, the risk that the bank faces is that lenders may default, and the rate at which they default will vary widely over time – low during good economic times and high during economic downturns. Rather than write off the bad loans, as they occur, banks usually create provisions for losses that average out losses over time and charge this amount against earnings every year.  Though this practice is logical, there is a catch, insofar as the bank is given the responsibility of making the loan loss assessment. A conservative bank will set aside more for loan losses, given a loan portfolio, than a more aggressive bank, and this will lead to the latter reporting higher profits during good times.

Debt and Equity

            In the financial balance sheet that we used to describe firms, there are only two ways to raise funds to finance a business – debt and equity. While this is true for both all firms, financial service firms differ from non-financial service firms on three dimensions:

a. Debt is raw material, not capital: When we talk about capital for non-financial service firms, we tend to talk about both debt and equity. A firm raises funds from both equity investor and bondholders (and banks) and uses these funds to make its investments. When we value the firm, we value the value of the assets owned by the firm, rather than just the value of its equity. With a financial service firm, debt has a different connotation. Rather than view debt as a source of capital, most financial service firms seem to view it as a raw material. In other words, debt is to a bank what steel is to a manufacturing company, something to be molded into other products which can then be sold at a higher price and yield a profit. Consequently, capital at financial service firms seems to be narrowly defined as including only equity capital. This definition of capital is reinforced by the regulatory authorities, who evaluate the equity capital ratios of banks and insurance firms.

b. Defining Debt: The definition of what comprises debt also is murkier with a financial service firm than it is with a non-financial service firm. For instance, should deposits made by customers into their checking accounts at a bank be treated as debt by that bank? Especially on interest-bearing checking accounts, there is little distinction between a deposit and debt issued by the bank. If we do categorize this as debt, the operating income for a bank should be measured prior to interest paid to depositors, which would be problematic since interest expenses are usually the biggest single expense item for a bank.

c. Degree of financial leverage: Even if we can define debt as a source of capital and can measure it precisely, there is a final dimension on which financial service firms differ from other firms. They tend to use more debt in funding their businesses and thus have higher financial leverage than most other firms. While there are good reasons that can be offered for why they have been able to do this historically - more predictable earnings and the regulatory framework are two that are commonly cited – there are consequences for valuation. Since equity is a sliver of the overall value of a financial service firm, small changes in the value of the firm.s assets can translate into big swings in equity value.

Estimating cash flows is difficult

            We noted earlier that financial service firms are constrained by regulation in both where they invest their funds and how much they invest. If, as we have so far in this book, define reinvestment as necessary for future growth, there are problems associated with measuring reinvestment with financial service firms. Note that, we consider two items in reinvestment – net capital expenditures and working capital. Unfortunately, measuring either of these items at a financial service firm can be problematic.

Consider net capital expenditures first. Unlike manufacturing firms that invest in plant, equipment and other fixed assets, financial service firms invest primarily in intangible assets such as brand name and human capital. Consequently, their investments for future growth often are categorized as operating expenses in accounting statements. Not surprisingly, the statement of cash flows to a bank show little or no capital expenditures and correspondingly low depreciation. With working capital, we run into a different problem. If we define working capital as the difference between current assets and current liabilities, a large proportion of a bank's balance sheet would fall into one or the other of these categories. Changes in this number can be both large and volatile and may have no relationship to reinvestment for future growth.

            As a result of this difficulty in measuring reinvestment, we run into two practical problems in valuing these firms. The first is that we cannot estimate cash flows without estimating reinvestment. In other words, if we cannot identify how much a company is reinvesting for future growth, we cannot identify cash flows either. The second is that estimating expected future growth becomes more difficult, if the reinvestment rate cannot be measured.

Financial Service Companies: Value Drivers

Equity Risk

In keeping with the way we have estimated the cost of equity for firms so far in this book, the cost of equity for a financial service firm has to reflect the portion of the risk in the equity that cannot be diversified away by the marginal investor in the stock. This risk is estimated using a beta (in the capital asset pricing model) or betas (in a multi-factor or arbitrage pricing model).  There are three estimation notes that we need to keep in mind, when making estimates of the cost of equity for a financial service firm:

1.     Use bottom-up betas: In our earlier discussions of betas, we argued against the use of regression betas because of the noise in the estimates (standard errors) and the possibility that the firm has changed over the period of the regression. We will continue to hold to that proposition, when valuing financial service firms. In fact, the large numbers of publicly traded firm in this domain should make estimating bottom up betas much easier.

2.     Do not adjust for financial leverage: When estimating betas for non-financial service firms, we emphasized the importance of unlevering betas (whether they be historical or sector averages) and then relevering them, using a firm's current debt to equity ratio. With financial service firms, we would skip this step for two reasons. First, financial service firms tend to be much more homogeneous in terms of capital structure – they tend to have similar financial leverage primarily due to regulations. Second, and this is a point made earlier, debt is difficult to measure for financial service firms. In practical terms, this will mean that we will use the average levered beta for comparable firms as the bottom-up beta for the firm being analyzed.

3.     Adjust for regulatory and business risk: If we use sector betas and do not adjust for financial leverage, we are in effect using the same beta for every company in the sector. As we noted earlier, there can be significant regulatory differences across markets, and even within a market, across different classes of financial service firms. To reflect this, we would define the sector narrowly; thus, we would look the average beta across large money center banks, when valuing a large money center bank, and across small regional banks, when valuing one of these. We would also argue that financial service firms that expand into riskier businesses – securitization, trading and investment banking – should have different (and higher betas) for these segments, and that the beta for the company should be a weighted average.

4.     Consider the relationship between risk and growth: Through the book, we have emphasized the importance of modifying a company's risk profile to reflect changes that we are assuming to its growth rate. As growth companies mature, betas should move towards one. We see no need to abandon that principle, when valuing banks. We would expect high growth banks to have higher betas (and costs of equity) than mature banks.  In valuing such banks, we would therefore start with higher costs of equity but as we reduce growth, we would also reduce betas and costs of equity.

Quality of growth

To ensure that assumptions about dividends, earnings and growth are internally consistent, we have to bring in a measure of how well the retained equity is reinvested; the return on equity is the variable that ties together payout ratios and expected growth. Using a fundamental growth measure for earnings:

Expected growth in earnings = Return on equity * (1 – Dividend Payout ratio)

For instance, a bank that payout out 60% of its earnings as dividends and earns a return on equity of 12% will have an expected growth rate in earnings of 4.8%.  When we introduced the fundamental equation in chapter 2, we also noted that firms can deliver growth rates that deviate from this expectation, if the return on equity is changing.

Expected Growth_EPS 

Thus, if the bank is able to improve the return on equity on existing assets from 10% to 12%, the efficiency growth rate in that year will be 20%. However, efficiency growth is temporary and all firms ultimately will revert back to the fundamental growth relationship.

            The linkage between return on equity, growth and dividends is therefore critical in determining value in a financial service firm. At the risk of hyperbole, the key number in valuing a bank is not dividends, earnings or growth rate, but what we believe it will earn as return on equity in the long term. That number, in conjunction with payout ratios, will help in determining growth. Alternatively, the return on equity, together with expected growth rates, can be used to estimate dividends. This linkage is particularly useful, when we get to stable growth, where growth rates can be very different from the initial growth rates. To preserve consistency in the valuation, the payout ratio that we use in stable growth, to estimate the terminal value, should be:

Payout ratio in stable growth 

The risk of the firm should also adjust to reflect the stable growth assumption. In particular, if betas are used to estimate the cost of equity, they should converge towards one in stable growth.

Regulatory Buffers

The cashflow to equity is the cashflow left over for equity investors after debt payments have been made and reinvestment needs met. With financial service firms, the reinvestment generally does not take the form of plant, equipment or other fixed assets. Instead, the investment is in regulatory capital; this is the capital as defined by the regulatory authorities, which, in turn, determines the limits on future growth.

FCFE_{Financial Service Firm} = Net Income – Reinvestment in Regulatory Capital

To estimating the reinvestment in regulatory capital, we have to define two parameters. The first is the book equity capital ratio that will determine the investment; this will be heavily influenced by regulatory requirements but will also reflect the choices made by a bank.  Conservative banks may choose to maintain a higher capital ratio than required by regulatory authorities whereas aggressive banks may push towards the regulatory constraints. For instance, a bank that has a 5% equity capital ratio can make $100 in loans for every $5 in equity capital. When this bank reports net income of $15 million and pays out only $5 million, it is increasing its equity capital by $10 million. This, in turn, will allow it to make $200 million in additional loans and presumably increase its growth rate in future periods. The second is theprofitability of the activity, defined in terms of net income. Staying with the bank example, we have to specify how much net income the bank will generate with the additional loans; a 0.5% profitability ratio will translate into additional net income of $1 million on the additional loans.

Little Book on Valuation

Aswath Damodaran