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Industry Analysis: Insurance (Property and Casualty)
The Property/Casualty Insurance Industry differs from many other sectors under Value Line coverage. The income, balance sheet and cash flow statements are unique, relative to those of the average industrial company. Below we discuss the operating measures and characteristics of, and provide investment guidance for, the P/C group.
The Income Statement
The top line of P/C Insurance companies differs from that of industrials. Instead of Revenues, insurers list Net Premiums Earned and Net Premiums Written. Net Premiums Written is the dollar amount of policies that the insurer underwrites. Net Premiums Earned is the actual dollar amount that the insurer receives from policyholders. Therefore, Net Premiums Written may be viewed as a leading indicator for Net Premiums Earned. In general, a NPW/NPE ratio of greater than 1.0 implies that the top line is in a growth phase.
Another measure that is unique to insurance companies is the Combined Ratio. The Combined Ratio is the sum of the Loss and Expense ratios. The Loss Ratio is the dollar amount of losses/claims that an insurer incurs divided by Net Premiums Earned. (Losses above $5 million are considered catastrophes.) The Expense Ratio is general operating costs for an insurance company divided by Net Premiums Written. Also, 100% minus the Combined Ratio is the Underwriting Margin. A Combined Ratio of over 100% shows that an insurer operates with an underwriting loss, while a ratio under 100% indicates an underwriting income. For example, if an insurer has a Loss Ratio of 60% and an Expense Ratio of 30%, its Combined Ratio would be 90%. This translates into an Underwriting Margin of 10%. The insurer generates $1 of pretax income for every $10 of policies in effect.
Another key line item on an insurer's income statement is Investment Income. Investment Income, net of immediate expenses, is known as Float. During times of rising interest rates, yields on alternative investments (and funds) increase. These yields represent an opportunity cost, or Cost of Float, to the insurer. Naturally, during periods of falling rates, the Cost of Float declines. Investment Income can be especially important for companies in times when disasters drive up losses or when there is a heavy buildup of business. Often, underwriting losses are substantial, leaving Investment Income as an insurer's sole source of earnings.
The Balance Sheet
Insurance companies tend to be conservative with regard to investment holdings. Therefore, high-quality fixed-income securities and blue chip stocks are typically found in their portfolios. In keeping with this posture, an insurer's debt-to-total capitalization ratio is usually below 35%. The group's risk-averse managements like to avoid high leverage.
One line item on the balance sheet that deserves special attention is Reserves. This is the buffer that an insurer has in place for catastrophic events. Generally, the Reserves-to-anticipated loss (over a 12-month period) ratio should be at least 2.5 to 1.0. Reinsurers, companies that undertake risk for primary insurers, prefer larger multiples.
Insurance company managers run challenging, complex businesses. For example, sometimes, it's opportune to cede policies to a reinsurer. In other words, if management feels that the risk of insuring a policy is too great, and the cost of reinsurance is reasonable, then it will sell it to a reinsurer. The dollar amount of business that a primary insurer cedes is the difference between Gross and Net Premiums Written.
Another measure of management's prowess that investors should consider is policy retentions. This is the total value of policies that stay on a company's books from one year to the next. A general rule is the higher an insurer's policy renewal rate, the lower the expense ratio.
Reserves on the balance sheet, and their impact on the bottom line, is another indication of management's ability. A company might, for instance, announce a sizable reserve-strengthening charge, which would curtail profits and may be an indication that management underestimated losses for a particular period. On the other hand, if an insurer releases reserves, boosting earnings, this reveals that reserve levels are healthy, or possibly excessive.
Also, the quality of an insurer's investment portfolio impacts profits. If a company holds a lot of poor investments, related write-offs could be significant. We don't include investment portfolio capital gains and losses in our Net Profit presentation, but it should be noted that these items are reflected in Shareholder's Equity.
Finally, managements have to deal with broader market conditions. A situation of industry overcapacity, for example, would likely curtail pricing power. Too, a large number of catastrophes, though detrimental to short-term earnings, might result in rate increases down the road, assuming the supply of available policies falls.
Earnings in the P/C Insurance industry tend to be a bit more volatile than average, given their close correlation with weather patterns and other difficult-to-predict events. Nevertheless, the Stock Price Stability of these equities is generally quite solid. Dividends provide a fair degree of support. We advise investors pay special attention to an insurer's balance sheet, focusing on reserves. What's more, an insurer that specializes in select market segments, or geographic regions, might be more exposed to a single catastrophic event than one that is broadly diversified.