Insurance companies have a reputation for being ‘black boxes’ when it comes to their earnings. The reported profit that any insurer can make is largely an accounting construct; that is, actuaries are required to estimate the profile of claims that policy holders are expected to make in the future. Insurers also use rather unique terminology in their financial statements, and the combination of these two factors may deter investors from considering insurers as viable investment opportunities.
Insurance companies can generally be divided up into two main business flows: underwriting, which is the practice of writing and collecting premiums on insurance policies, and paying claims on some of the policies; and the investment of those premiums – also known as the ‘float’ or reserves.
Underwriting is relatively easy to understand if you think about it from your own perspective. You pay an insurance company money to cover you for the risk of something undesirable befalling you. The amount you pay to the insurance company is the premium, which is usually invoiced annually.
Thousands of customers pay premiums, but not all of them will make a claim on their policies. Insurers attempt to make a profit from collecting and aggregating premiums, paying commissions and expenses for marketing, and then paying a portion out in claims.
If an insurer makes a loss on its underwriting division (that is, when the claims ratio plus the expense ratio exceeds 100%), it is still possible for it to make a profit after the investment of its float. Because these reserves are intended to reimburse policy holders soon after they make an authentic claim, insurers must hold them in assets that provide minimal risk, such as fixed income or short-term cash deposits. Insurers also have shareholders’ funds at their disposal, which they usually invest in riskier asset classes such as equities.
You can get a sense of how these main drivers are inextricably linked; an insurer must have a keen awareness of the risk profiles of its policy holders to price its policies correctly. There is an art (and a fair bit of luck) in pricing premiums, and sustainably growing the customer base while also earning a profitable margin. And overlaying this is the fact that like seats on a plane, the insurer is generally selling a commodity. And then there are black swan events – those that even the best actuarial mathematicians cannot predict. For example, many commentators are predicting that climate change may intensify the frequency and cost of weather related events.
Insurers also have to contend with fraudulent claims, those that end up in court and take years to resolve and produce unknowable cost profiles, and at times, irrational pricing by competitors. It is interesting to note the major Australian retailers, Coles and Woolworths, are following the lead of their British peers in using risk related information from their considerable customer databases to actively promote car and home insurance.
Finally, changing interest rates affect both the discount rates used to estimate future claims and the expected return generated by insurers’ reserves. Central banks around the world have dramatically cut short-term interest rates in an effort to stimulate their respective home economies. However, with green economic shoots starting to emerge, the focus has now turned to reducing this quantitative easing, and the yield for long-dated bonds has gradually increased since mid-2012. Some analysts argue that higher long term interest rates may be positive for insurers with a short duration portfolio, or a short claim cycle. Higher rates will also increase the discount rate actuaries use to assess claims profiles, and in turn this should have a positive impact on underwriting profits.
(Prior to its collapse in 2001, HIH Insurance was one of Australia’s largest general insurance companies. Readers interested in the inner workings of this general insurer as well as a chronicle of arrogance, ignorance and self-delusion should read the 2005 book Other People’s Money, by the journalist, Andrew Main).
Obscure terminology and the challenges posed by climate change, black swan events and fraudulent claims make many investors wary of looking on insurance companies as viable investments, even though insurers themselves hold their reserves in minimal risk assets. Indeed, they are difficult to analyse and subject to more unexpected external forces than most companies. Just as running an insurance company is part science and part art, there’s a fair bit of luck involved in making a good investment decision in one of them.
Roger Montgomery is the Chief Investment Officer at The Montgomery Fund, and author of the bestseller, ‘Value.able’. Within the Australian general insurance sector, The Montgomery Fund owns QBE Insurance Group.