Aeon Credit an attractive alternative stock to sector

 September 28, 2016, Wednesday

KUCHING: Aeon Credit Service (M) Bhd (Aeon Credit) high performing return on equity (ROE) generation of over 20 per cent has made in a favourable alternative to the banking sector.

Aeon Credit’ healthy receivable growth and improving asset quality are also key contributors to this growing sentiment focused in a recent company update on Aeoncs by the research arm of Affin Hwang Investment Bank Bhd (Affin Hwang Capital).

Looking at its receivables growth, the research arm expects Aeon Credit to grow at a steady 19 per cent in their financial year 2017 estimates (FY17E), 18 per cent FY18E, and 16 per cent FY19E.

Reasoning for these estimates are based on expectations that Aeoncs’ receivables will be driven by internal factors such as expansion in the personal financing space, further penetration into the high yielding small medium enterprise (SME) segment, the cross-selling of financial products Aeon’s existing customers, and expansion of customer service centres,

Additionally, the signing up of new merchant agreements which would also help drive fee income growth.

For external actors, the research arm has stated that the recent hike in civil servant wages would be an added bonus to Aeoncs receivables as it would boost consumption spending.

“The spill over effect will be on purchases of small ticket items such as electrical goods, electronic and IT gadgets, household furniture as well as increased the affordability to borrow personal loans,” explained the research arm.

In asset quality, Aeon Credit has continued to demonstrate a trend of consistent improvement since its peak in September-November in 2015 at 3.07 per cent.

The research arm affirmed their belief that this positive trend is a result of Aeoncs’s strict and prudent management on credit risk practices and their strong understanding of the consumer financing business.

As such, Affin Hwang Capital has estimated that the trend will continue into FY17 to 19.

“To further enhance its collection system, Aeon Credit has also started self-service kiosks with ATMs, cash-deposit machines and digital devices for its customers in 201,”added the research arm.

Additionally, the overall net credit cost has been slowly decreasing year-on-year and as a result, the research arm has predicted that for 2QFY17 results, “it will not be a surprise to potentially see some slight uptick in the net profit loss (NPL) ratio and credit cost since the quarter coincided with the Raya festival”.

“Based on 1QFY17’s results, the gross NPL ratio was down by five basis points (bps) quarter on quarter to 2.42 per cent, while on a YoY, it declined by 32 bps amidst a healthy growth in receivables  to RM5.8 billion.”

When compared to the banking industry’s household sector gross impaired loan ratios, it should be noted that Aeoncs’ gross net profit loss (NPL) ratio is higher as their portfolio of receivable are in riskier assets and non collateralised.

Despite this, Aeoncs cash flows are compensated by a higher effective interest rate of around 16 to 17 per cent against a borrowing cost of 4.2 per cent.

While there has also been some concern regarding defaults among lower income borrowers in the non-banking financial institutions, the research explains that these issues are mostly triggered by the abundant availability of easy credit with long tenures of up to 25 years.

Additionally, it should  be noted that the trend of easy personal financing schemes back in July 2013, did not affect Aeoncs in a significant way.

“This was due to Aeoncs’ management in-depth understanding of the consumer-financing business, adhering to proper risk management underpinned by tight credit approvals, strict scoring system as well as its prompt collection practices” explained the research arm.

As such, the research arm has opted to maintain their  ‘Buy’ rating for Aeoncs while raising their price targe to RM16.60 from RM14.50.

While the research arm has had strong justification for their positive outlook on Aeoncs, investors should note that he current dizzying household debt  to gross domestic product (GDP) of 89.1 per cent is a key risk to Affin Hwang Capital’s forecast.

“The central bank may undertake further tightening measures to control excessive growth in household debt subsequent to curbs that were imposed in 2013 on personal-loan tenures on all banks and non-banks as well as tighter limits on credit-card spending.

“Should more regulations be imposed, our FY17-19E forecasts could be negatively affected.”

http://www.theborneopost.com/2016/09/28/aeon-credit-an-attractive-alternative-stock-to-sector/



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http://klse.i3investor.com/servlets/stk/5139.jsp

Piggybank

 Earnings still on a growth path: ACSM recorded a NP growth of +10% y-y in FY16 (Feb yr-end), +8% y-y for 1QFY17 and based on street estimates, growth is expected to continue with +6.2% y-y/+7.3% y-y FY17E/FY18E (despite earnings contraction within the banking sector). In my view, there is potentially upside risk to these numbers (volume growth), as ACSM’s target market are more sensitive to interest rate cuts (we expect another 50bps) and fiscal measures targeted for the low-middle income, which we expect in 2H16, i.e. min wage & civil servant wage increases, reduction in EPF contribution, more BR1M payouts. 

 Growth much stronger for underlying receivables growth, versus the 8-10% NP growth and according to management is on track to grow +20% y-y in FY17E, (FY16: +20% y-y; 1QFY17: +21% y-y to RM5.8bn). Motorcycle financing (29.9% of receivables), auto financing (29.5% of receivables) and personal financing (22.4% of receivables) are the three top categories. We do note that there is some conscious slowing down in general easy payment (GEP i.e. white goods financing) and used car financing and a greater emphasis on personal financing and credit cards (~200k cards in circulation). 

 Slowing economy, yet NPLs declined to 2.42% 1QFY17 (from 2.74% in 1Q16), due to ACSM’s prudent risk management policies and in-house expertise and processes having been in the business for over 20 years. Mr Lee believes that borrowers typically will continue repaying as long as they are employed. Classification of NPL happens after 3 months of non-payment, written-off after 6 months of non-payment. Net credit costs also fell to 3.32%, the lowest in 9 quarters. 

 No real competitor as ACSM is sandwiched between money-lenders and banks, with >70% of its c.1mn customer base earning < RM3,000/mth and coupled with the average loan ticket size of RM8,000 and average tenure of 4 years, ACSM is in a segment which does not interest the banks. It’s direct competitors are Bank Rakyat (unlisted) and MBSB (MBS MK, RM0.86, NR) but both have been unsuccessful in migrating from super-safe civil servant salary deduction lending to the “free market” i.e. ACSM makes about 13-15mn calls a year to customers to remind them to pay on time. Parkson Credit, Singer Credit, Wilayah Credit also offer consumer financing and motorcycle financing but we understand are much smaller places in this space. 

 Not as strictly regulated unlike the banks, ACSM only needs to ensure its capital ratio (total equity/receivables) does not fall < 16% as required for all credit card issuers. ACSM is given the freedom to set pricing, with gross yield from 14% for used car financing to as much as 27% for general easy payment. 

 Beneficiary of lower interest rates? ACSM will not immediately benefit from declining interest rates in terms of lowering its funding cost as close to 70% of its funding is fixed-rate (to match its fixed rate lending base) and locked in for 5-6 years from Japanese banks (LT fixed-rate at c.4.28% which is way better than any local bank offers) and the balance (which will benefit from lower interest rates), 30% from local banks (more ST facilities), for an average funding cost of around 4.2%. This is against the overall gross yield for ACSM at ~20%. Lower interest rates should improve demand and a relief for their customers. 

 Trading at 8.3-8.7x PER, below market average 15x, with 29% ROE and 4.2-4.6% div yield: Adjusting for RM14.4mn/p.a. distribution paid to perpetual note holders (below net earnings line), ACSM is trading at trading at 8.4-8.7x ann. 1QFY17/FY17E PER or 8.3x FY18E based on consensus estimates, offering a 4.2%/4.6% FY17E/18E dividend yield. ROE were ~35% in FY2014/15 but is lower ~29% in FY16.

24/08/2016 08:19

Understanding financial statements for non-financial managers and executives (Slide show)

http://www.slideshare.net/kennygohkn/understanding-financial-statements-for-nonfinancial-executives-of-a-publishing-company?next_slideshow=2

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 Insurance Company's Revenue Model

The revenue models of insurance companies are based on premiums collected from policyholders.

Premiums are the starting point for revenues earned by all types of.

This includes

• life insurance companies, 
• auto insurance companies, 
• companies that sell homeowner’s insurance and 
• even companies that sell annuities.

Pricing of Risk by an Insurance Company

The revenue model starts with the pricing of risk and the sale of an insurance policy. 

The insurance policy’s benefit amount represents the amount that the insurance company is willing to pay should a loss occur. 

For life insurance, that loss is death.

With property and casualty insurance such as auto and homeowner’s insurance, the loss is damage, theft or destruction of property, such as a home or auto.

Risk Pooling and Premium Pricing

The willingness to accept this risk comes at a price to the policy owner.

This price is the premium amount and is based on the common occurrence of risk, as distributed among a large class of people.

This process is known as risk pooling and is performed by actuaries hired by the insurance company.

The risk pools determine the likelihood of a loss occurring for a class and the price for that risk, which becomes the premium amount.

Net Premiums

When the premium is paid, the insurance company nets out its expenses associated with keeping the coverage in force.

This includes commissions paid to agents and brokers of the insurance company.

It also includes the administrative and operational costs of the insurer such as overhead, salaries and other business related expenses.

The net amount of the premium represents the revenue amount that the insurer has to invest.

General Account versus Separate Account Assets

For life insurance companies, 2 accounts are maintained in order to address the risks associated with their products.

These accounts are the general account and separate account of the insurance company.

 In the general account, net premiums from fixed products issued by the life insurance company such as fixed annuities, term life, whole life and universal life products are deposited.

 These net premiums are invested in fixed income securities such as municipal and treasury bonds in order to back the insurer’s promise to pay.

Separate Account

The separate account is backed with net premiums from variable insurance products such as variable annuities and variable life insurance.

These product’s premiums must be segregated or maintained in a separate account by law since it is the policy owner that determines how the premiums are invested, not the insurer. 

This investment control means that the policy owner is subject to a greater risk because those premiums are in the stock market and other equity securities.

Interest Earnings and Revenue

The interest earned by the investment of assets in either the general account for life insurance and property and casualty insurance companies or separate account for the life insurer is a component of overall revenue for the insurer. 

Savings realized by lowered expenses and less than expected risk losses (i.e. deaths, illness, disability, auto accidents) leads to higher revenues for an insurance company.



Read more: http://www.finweb.com/insurance/understanding-an-insurance-companys-revenue-model.html#ixzz4LuUiuIiJ


https://www.lonpac.com/web/my/quarterly-financial-statements

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