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

How do you identify an exceptional company with a durable competitive advantage from the CASH FLOW STATEMENTS?

How do you identify an exceptional company with a durable competitive advantage?

Financial statements are where you can search for companies with a durable competitive advantage that is going to make one super rich.

CASH FLOW STATEMENTS

The cash flow statement keeps track of the actual cash that flows in and out of the business.

A company can have a lot of cash coming in, through the sale of shares or bonds and still not be profitable.

A company can be profitable with a lot of sales on credit and not a lot of cash coming in.

The cash flow statement will tell us if the company is bringing in more cash than it is spending (“positive cash flow”) or if it is spending more cash than it is bringing in (“negative cash flow”).

Cash flow statements like income statements cover a set period of time.

The cash flow statement has three sections:

·               Cash flow from operating activities

·              Cash flow from investing activities

·              Cash flow from financing activities

Cash flow from operating activities

Net income + depreciation & amortization = Total Cash from Operating Activities

Depreciation and amortization are real expenses from an accounting point of view.

They don't use up any cash because they represent cash that was spent years ago.

Cash flow from investing activities

This area includes an entry for all capital expenditures made for that accounting period.

Capital expenditure is always a negative number because it is an expenditure which causes a depletion of cash.

Total Other Investing Cash Flow Items adds up all the cash that gets expended and brought in, from the buying and selling of income producing assets.

If more cash is expended than is brought in, it is a negative number.

If more cash is brought in than is expended, it is a positive number.

Capital Expenditure + Other Investing Cash Flow Items = Total Cash from Investing Activities

Cash flow from financing activities

This measures the cash that flows in and out of a company because of financing activities.

This includes all outflows of cash for the payment of dividends.

It also includes the selling and buying of the company’s stock.

When the company sells shares to finance a new plant, cash flows into the company.

When the company buys back its shares, cash flows out of the company.

The same thing happens with bonds.

Sell a bond and cash flows in; buy back a bond and cash flows out.

Cash Dividends Paid + Issuance (Retirement) of Stock, Net + Issuance (Retirement) of Debt, Net  = Total Cash from Financing Activities

Net Change in Cash

Total Cash from Operating Activities + Total Cash from Investing Activities + Total Cash from Financing Activities = Net Change in Cash

Some of the information found on a company’s cash flow statement can be very useful in helping us determine whether or not the company in question is benefiting from having a durable competitive advantage.

Capital Expenditures

Capital expenditures are outlays of cash or the equivalent in assets that are more permanent in nature – held longer than a year – such as property, plant and equipment.

They also include expenditures for such intangibles as patents.

They are assets that are expensed over a period of time greater than a year through depreciation and amortization.

Capital expenditures are recorded on the cash flow statement under investment operations.

When it comes to making capital expenditures, not all companies are created equal.

Many companies must make huge capital expenditures just to stay in business.

If the capital expenditures remain high over a number of years, they can start to have deep impact on earnings.

As a rule, a company with durable competitive advantage uses a smaller portion of its earnings for capital expenditures for continuing operations than do those without a competitive advantage.

Coca Cola spent 19% of its last ten years total earnings for capital expenditure.  Moody spent 5% of its total earnings for the last ten years for capital expenditure.

GM used 444% more for capital expenditure than it earned over the last ten years.  Goodyear (tire maker) used 950% more for capital expenditure than it earned over the last ten years.

For GM and Goodyear, where did all that extra money come from?

It came from bank loans and from selling tons of new debt to the public.

Such actions add more debt to these companies’ balance sheets, which increases the amount of money they spend on interest payments and this is never a good thing.

Both Coke and Moody’s, however, have enough excess income to have stock buyback programs that reduce the number of shares outstanding, while at the same time either reducing long-term debt or keeping it low. 

Both these activities helped to identify the businesses with a durable competitive advantage working in their favour.

When looking at capital expenditures in relation to net earnings, add up a company’s total capital expenditures for a ten year period and compare the figure with the company’s total net earnings for the same ten year period.

The reason we look at a ten year period is that it gives us a really good long term perspective as to what is going on with the business.

Historically, durable competitive advantage companies used a far smaller percentage of their net income for capital expenditures.

If a company is historically using 50% of less of its annual net earnings for capital expenditures, it is a good place to look for a durable competitive advantage.

If it is consistently using less than 25% of its net earnings for capital expenditures, that scenario occurs more than likely because the company has a durable competitive advantage working in its favour.

Stock Buybacks

Companies that have a durable competitive advantage working in their favour make a ton of money.

The companies can sit on this cash, or they can reinvest it in the existing business or find a new business to invest in. 

If they don’t require the cash for the above, they can also either pay it out as dividends to their shareholders or use it to buy back shares.

Shareholders have to pay income tax on the dividends.  This doesn’t make anyone happy.

A neater trick is to use some of the excess money that the company is throwing off to buy back the company’s shares.

This reduces the number of outstanding shares – which increases the remaining shareholders’ interest in the company – and increases the per share earnings of the company, which eventually makes the stock price go up.

If the company buys back its own shares it can increase its per share earnings figure even though actual net earnings don’t increase.

The best part is that there is an increase in the shareholders’ wealth that they don’t have to pay taxes on until they sell their stock.

To find out if a company is buying back its shares, go to the cash flow statement and look under Cash from Investing Activities, under a heading titled “Issuance (Retirement) of Stock, Net”.

This entry nets out the selling and buying of the company’s shares.

If the company is buying back its shares year after year, it is a good bet that it is a durable competitive advantage that is generating all the extra cash that allows it to do so.

One of the indicators of the presence of a durable competitive advantage is a “history” of the company repurchasing or retiring its shares.

How do you identify an exceptional company with a durable competitive advantage from the SHAREHOLDERS' EQUITY OF THE BALANCE SHEET?

How do you identify an exceptional company with a durable competitive advantage?

Financial statements are where you can search for companies with a durable competitive advantage that is going to make one super rich.

BALANCE SHEET

The balance sheet is a snapshot of the company's financial condition on the particular date that the balance sheet is generated.

Assets minus Liabilities = Net worth or Shareholders' Equity

Shareholders’ Equity/Book Value

Shareholders’ Equity is accounted for under the headings of

·         Capital Stock (Preferred and Common Stock);

·         Paid in Capital and

·         Retained Earnings

Shareholders’ Equity is an important number as it allows us to calculate the return on shareholders’ equity.

Return on shareholders’ equity is one of the ways we determine whether or not the company in question has a long-term competitive advantage working in it favour.

Preferred and Common Stock, Additional Paid in Capital

From a balance sheet perspective preferred and common stocks are carried on the books at their par value, and any money in excess of par that was paid in when the company sold the stock will be carried on the books as “paid in capital.”

If the company’s preferred stock has a par value of $100/share, and it sold it to the public at $120 a share, a $100 a share will be carried on the books under preferred stock and $20 a share will be carried under paid in capital. 

The same thing applies to common stock, with say, a par value of $1 a share.  If it is sold to the public at $10 a share, it will be booked on the balance sheet as $1 a share under common stock and $9 a share under paid-in capital.

Companies that have durable competitive advantage tend not to have any preferred stock. 

This is in part because they tend not to have any debt. 

They make so much money that they are self financing.

While preferred stock is technically equity, in that the original money received by the company never has to be paid back, it functions like debt in that dividends have to be paid out.

Interest paid on debt is deductible from pretax income.  

However, dividends paid on preferred stock are not tax deductible, which tends to make issuing preferred shares very expensive money.

Because it is expensive money, companies like to stay away from it if they can. 

One of the markers we look for in our search for a company with durable competitive advantage is the absence of preferred stock in its capital structure.

Retained Earnings

A company’s net earnings can either be paid out as dividends or used to buy back the company’s shares, or they can be retained to keep the business growing

When they are retained in the business, they are added to an account on the balance sheet, under shareholders’ equity called retained earnings.

If the earnings are retained and profitably put to us, they can greatly improve the long-term economic picture of the business.

To find the yearly net earnings that are going to be added to the company’s retained earnings pool, take the company’s after tax net earnings and deduct the amount that the company paid out in dividends and the expenditures in buying back stock that it had during the year.

Retained Earnings is an accumulated number, which means that each year’s new retained earnings are added to the total of accumulated retained earnings from all prior years.

If the company loses money, the loss is subtracted from what the company has accumulated in the past. 

If the company loses more money than it has accumulated, the retained earnings number will show up as negative.

Retained Earnings is one of the most important number, on the balance sheet that can help us determine whether the company has a durable competitive advantage. 

If a company is not making additions to its retained earnings, it is not growing its net worth.

If it is not growing its net worth, it is unlikely to make any of us super rich over the long run.

Simply put:  the rate of growth of a company’s retained earnings is a good indicator whether or not it is benefiting from having a durable competitive advantage. 

Not all growth in retained earnings is due to an incremental increase in sales of existing products; some of it is due to the acquisitions of other businesses. 

When two companies merge, their retained earnings pools are joined, which creates an even larger pool.

General Motors and Microsoft both show negative retained earnings.

General Motors:  it shows a negative number because of the poor economics of the auto business, which causes the company to lose billions.

Microsoft:  it shows a negative number because it decided that its economic engine is so powerful that it doesn’t need to retain the massive amount of capital it has collected over the years and has instead chosen to spend its accumulated retained earnings and more on stock buybacks and dividend payments to its shareholders.

Berkshire Hathaway:  Warren Buffett stopped its dividend payments the day he took control of the company.  This allowed 100% of the company’s yearly net earnings to be added into the retained earnings pool.  As opportunities showed up, he invested the company’s retained earnings in businesses that earned even more money and that money was all added back into the retained earnings pool and eventually invested in even more money making operations.   As time went on, Berkshire’s growing pool of retained earnings increased its ability to make more and more money.

From 1965 to 2007, Berkshire’s expanding pool of retained earnings helped grow its pretax earnings from $4 a share in 1965 to $13,023 a share in 2007, which equates to an average annual growth rate of approximately 21%.

The more earnings that a company retains, the faster it grows its retained earnings pool, which in turn will increase the growth rate for future earnings. 

The catch is, it has to keep buying companies that have a durable competitive advantage.

Treasury Stock

When a company buys back its own shares, it can do two things with them. 

It can cancel them (and the shares cease to exist) or it can retain them with the possibility of reissuing them later on (and they are carried on the balance sheet under shareholders’ equity, as treasury stock).

Shares held as treasury stock have no voting rights, nor do they receive dividends and though arguably an asset, they are carried on the balance sheet at a negative value because they represent a reduction in the shareholder’s equity.

Companies with a durable competitive advantage because of their great economics, tend to have lots of free cash that they can spend on buying back their shares. 

One of the hallmarks of a company with a durable competitive advantage is the presence of treasury shares on the balance sheet.

When a company buys its own shares, and holds them as treasury stock, it is effectively decreasing the company’s equity, which increases the company’s return on shareholders’ equity.

Since a high return on shareholders’ equity is one sign of a durable competitive advantage, it is good to know if the high returns on equity are being generated by financial engineering or exceptional business economics or because of a combination of the two.

To see which is which, convert the negative value of the treasury shares into a positive number and add it to the shareholders’ equity instead of subtracting it. 

Then divide the company’s net earnings by the new total shareholders’ equity. 

This will give us the company’s return on equity minus the effects of financial engineering.

Treasury shares are not part of the pool of the outstanding shares, when it comes to determining control of the company.

The presence of treasury shares on the balance sheet and a history of buying back shares, are good  indicators that the company in question has a durable competitive advantage working in its favour.

Return on Shareholders’ Equity

Shareholders’ equity equal to the total sums of preferred and common stock, plus paid in capital, plus retained earnings and less treasury stock.

Shareholders in a company would be interested in how good a job management does at allocating their money so that they can earn even more.

Financial analysts developed the return on shareholders’ equity equation to test management’s efficiency in allocating the shareholders’ money.   

It measures the management’s ability to profitably put shareholders’ equity to good use.

Warren Buffett use the return on shareholders’ equity in his search for the company with a durable competitive advantage.

Return on Shareholders’ Equity = Net Earnings / Shareholders’ Equity

Companies that benefit from a durable or long term competitive advantage show higher than average returns on shareholders’ equity.

Companies with no sustainable competitive advantage tend to have low returns on equity.

High returns on equity mean that the company is making good use of the earnings that it is retaining. 

As time goes by, these high returns on equity will add up and increase the underlying value of the business, which over time, will eventually be recognized by the stock market through an increasing price for the company stock.

Some companies are so profitable that they don’t need to retain any earnings, so they pay them all out to the shareholders.  

In these cases, its shareholders’ equity may be a negative number.

Insolvent companies will also show a negative number for shareholders’ equity.

If the company shows a long history of strong net earnings, but shows a negative shareholders’ equity, it is probably a company with a durable competitive advantage.

If the company shows both negative shareholders’ equity and a history of negative net earnings, we are probably dealing with a mediocre business that is getting beaten up by the competition.

High returns on shareholders equity means “come play.”

Low returns on shareholders equity means “stay away.”

Leverage

Leverage is the use of debt to increase the earnings of the company.

A company using leverage can increase its earnings and its return on equity.

The problem with leverage is that it can make the company appear to have some kind of competitive advantage when it, in fact is just using large amounts of debt.

Wall Street investment banks are notorious for the use of very large amounts of leverage to generate earnings.

It creates the appearance of some kind of durable competitive advantage, even if there isn’t one.

In assessing the quality and durability of a company’s competitive advantage, avoid businesses that use a lot of leverage to help them generate earnings. 

In the short run they appear to be the goose that lays the golden eggs, but at the end of the day, they are not.