How to Analyse Insurance Companies

Hey readers,

I wish everyone a Happy New Year! I’ve been blessed by your outreach, give me a bit more time to reply to all the email conversations.

Something unfortunate happened to my close friend lately. He was nearly hit by a car. While he was sharing the details of his accident, he highlighted the importance of purchasing adequate insurance. After that, I was curious and I went back to read up on the insurance industry.

Generally, there are two types of insurance companies:

1. Life & health insurance
2. Property and casualty insurance

L&H insurance covers major surgery, terminal illnesses, hospitalization or death.

P&C insurance covers loss of property, damage, vehicle, elevator insurance. Some common ones are homeowners, car, terrorism, earthquake or marine insurance.

Some of the listed insurance companies are Universal Insurance, Assured Guaranty, Markel, The Allstate Corporation, Cincinnati Financial, Argo Group, Berkshire Hathaway Specialty Insurance (under Berkshire Hathaway) and The Progressive Corporation.

Business Model

An insurance company is basically an underwriter. It promises you a payout, should an event happen. It can be hospitalization, death, earthquake, terrorism, and whatnot. In return, you pay the co a premium for making the promise to you. If it does not happen, the co walks away with your money.

A good insurance company is one that underwrites low-probability events and collects good premiums. The company must be disciplined by showing willingness to walk away from underwriting high-probability events. An insurance company won’t make money if it has to pay a large amount of sum for collecting a small premium for every policyholder.

Apart from underwriting income, it also earns investment income. Why? When it collects an enormous premium (called float) from various policyholders, it can re-deployed the money to invest in money markets (bonds, corporate bonds) or stocks.

But it is dangerous for the co to deploy all of their premiums unless the co is able to predict the future claims very well.

Isn’t it incredible?

Most companies must pay for capital such as borrowing through loans. A well-run insurance company is given money that does not have any interest expenses. Each month, the policyholders will pay their premiums which add to the insurance co’s float.

Again, if the insurance co is disciplined, most of the policy will expire and it gets to keep the premium. But when a high-risk policy is being underwritten, the risk of payout is very high.

“A float is only valuable if the company can produce an underwriting profit. If it can’t, the float can turn into an expensive liability.”

Porter Stansberry

Moat (Competitive Advantage)

By now, do you realise the products of insurance companies are nothing but promises? They promise you a payout against an undesired outcome. There is no barrier to entry. The moat that I see is… the ability to be disciplined and underwrite profitable policies.

You can pick out a good insurance company by ensuring it earns an underwriting profit consistently.

An Important Ratio

CARE provided a wonderful overview of how to evaluate insurance company, click here for more. I would just talk about the combined ratio.

The formula is “(company operating expenses + insurance claims)/premiums”.

If the combined ratio > 1, you incur more expenses than the premiums received. In short, you’re making an underwriting loss. That’s undesirable.

Zhong An Online P&C Insurance (Mkt Cap US4.74b)

Zhong An Online is China first online insurance company. Tencent and Alibaba are its shareholders. Looking at their 1H 2018, I saw that their combined ratio was 124%. Until they can be profitable in their insurance business, I don’t think I’d be interested.

You see, that’s why I like combined ratio. In an instant, it tells me whether I should investigate it further. Look for consistency in combined ratio trends.

Markel Corporation (Mkt Cap US $14.4b)

Markel is an underwriter of specialty insurance products in USA, UK, Canada and internationally. It does reinsurance as well. It has three business lines: insurance, investments (using premiums), and Markel Ventures.

It is managed by CEO Tom Gayner. He is a fantastic investor, watch his video here.

Some years, they were more catastrophes which caused Markel’s combined ratio to exceed 100%. On average, they are around 95.7%. As long as the ratio is below 100% on the average, this gives Markel permanent and free capital to invest in stocks or privately owned businesses. Money makes more money. More money makes more money. It is compounding money.

From year 2009 to 2017, the combined ratios for P&C industry were… 102.4%, 101.5%, 102.1%, 110.6%, 102.2%, 97%, 98.8%, 97.6%, 99.7%, and 100.6%. The source is from the National Association of Insurance Commissioners (NAIC).

With this comparison, you can see Markel does fairly well.

While insurance business lost money in FY2017, Markel earned 10% on its investment portfolio consisting 26% on their equity holdings and 3% on fixed income holdings.

Markel decides to focus on niche areas where other P&C insurance companies are not present. This allows them to price their premiums and earn reasonable returns.

It can be quite daunting to calculate all of their past investment returns to form a view on their investment skills. To keep things simple, we can assess the book value per share (compounded annual growth rate)

Markel ended FY2008 with $222.2 book value per share and it grew to $704.7 by FY2018. The book value compounded at 12.23% for the past 10 years.

Its peer, The Allstate Corporation, compounded at 10.12% in the same time frame.

This gives me some knowledge that Markel has been growing well.

How would I value it?

Its P/B  traded between 0.95x to 1.79x for the past 10 years. I should be comfortable purchasing this at P/B 1.2x.

Markel’s book value is $704.7, multiply it by 1.2, it gives me $845.64.

Should You Buy Insurance?

Since now you know what insurance companies do with your money, and assuming you’re a good investor, would you still buy insurance?

Using PRUshield Standard Plan premium for age 21 to 40, assume I did not pay the premiums and compound it at 20%, the initial amount of $348 saved would’ve compounded to $78,698.29 by year 20.

Did you know PRUshield Standard Plan’s policy year limit is S$150,000? It is still more than $78,698.29 that you would have saved and compounded. It still pays more to buy insurance because insurance companies take on huge risks in order to earn your premium.

Hope to connect more with all of you! It’s going to be a busy year where I will devote time and energy to nurturing a community of quality investors.