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Industry Analysis: Life Insurance
Modern life insurance was introduced in 17th century England to seafaring traders who wished a measure of financial protection for their families should an accident befall them. The sale of life insurance in the United States began in the late 1760s. As you would expect of a sector with a history about as long as that of this nation, the Life Insurance Industry is mature. Growth opportunities are essentially limited to increasing the geographic footprint and developing new offerings. The industry is comprised of large multinational corporations, as well as smaller regional and niche carriers.
There are two major categories of life insurance contracts: protection policies and investment policies. Protection policies are designed to provide a benefit, typically a lump sum payment, in the case of a specified event, most commonly the death of the insured person. Term life insurance, which provides death protection for a stated period of time, is a good example of this type of policy. All life insurance was originally term in nature. However, over time, surviving policyholders became dismayed that they could pay premiums for as many as 30 years and receive no benefit. In response, investment policies were created.
The main objective of an investment policy is to facilitate the growth of capital. Premiums may be paid on a regular or one-time basis. While premiums of investment policies are usually higher than those of protection plans, investment contracts offer a cash value. This cash value builds over time, and is paid to the policyholder (or beneficiary) upon maturity (or death). Common forms of investment polices are whole life, universal life, and variable life. Over the years, many life insurers expanded their offerings to include retirement products, e.g., variable and fixed annuities. Each state has its own set of insurance regulations, thus the specific provisions of policies can vary based on the sales location.
The life insurer receives premium payments from policyholders and gathers a pool of money from which it can pay claims and finance operations. These premiums are the primary source of cash flow. By law, insurers are required to maintain a minimum level of cash and cash equivalents, called the reserve, which may not be used for investing. The reserve requirements serve as a safeguard for policyholders, helping to ensure that insurers have enough cash on hand to pay claims as they arise. Any cash generated above the reserve may be invested to supplement income. Indeed, many investment policies are structured so that the policyholder and the life insurance company share in the proceeds from invested premiums.
While investment income often is an important earnings driver, it typically is not enough to cover claims, even under favorable market conditions. Writing new policies helps to diminish this risk. Under poor market conditions, an insurer may need to raise capital to maintain adequate reserves and shore up the balance sheet. This is especially true of companies that generate premium income largely through hybrid (insurance and investment) products.
Key line items in the data array on the Value Line page of Life Insurance companies are Premium Income, Investment Income, Benefits & Reserves, Insurance in Force, and Total Assets (i.e., the size of the overall investment portfolio).
Barriers to enter this industry are quite high because of the strict reserve requirements for life insurance and related financial products. Even so, there is ample competition among those within the sector. The term life segment is the most competitive. Such policies are essentially generic, with price and convenience of purchase being the main differentiators. Still, customers might be inclined to pay a modest premium for a simple term policy if they have already done business with a particular company. The breadth of product offerings and degree of innovation can determine the market share and degree of success of an insurer.
The ability to give guarantees on investment contracts is a strong selling point for insurers. However, there are limits to what can be offered, since the more a company guarantees, the more risk it assumes. While these products tend to have high margins, and are huge profit generators during boom times, they often can be loss leaders when the market turns sour. Therefore, to optimize profitability, it's important that insurers strike a proper balance between new policy growth and the maintenance of underwriting discipline.
Life insurers typically generate stable streams of income, thanks to the long-term contractual nature of life policies. But investors must pay special attention to the composition of an insurer's book of business before making a commitment. Indeed, the types of policies offered go a long way in determining an insurer's earnings performance. While high-risk policies may suggest richer returns, they could result in a rather volatile earnings record or, if managed poorly, losses.
Investors may find favor in the stocks of well-capitalized, big, brand name insurers, which usually have no problem gaining customers, especially during times of economic turmoil. Too, when there is little product differentiation among competitors, the larger companies typically prevail. Life Insurance stocks are generally considered moderate-risk growth issues; some provide dividends to attract the interest of growth-and-income investors.