- Investment strategies
- Why invest in the stock market?
- Buy and hold or technical analysis? Why you need an investment plan
- Value investing and short selling in volatile markets
- Using technical analysis to support value investing
- Investing in the unexpected
- Franking credits, explained
- What is dividend stripping and is it a sensible strategy?
- Investing in quality IPOs
- How to invest in stocks that benefit from a moving Australian dollar
- Reasons to avoid bonds when interest rates are low
- How value investors use Skaffold
- Quality, growth and value = a winning strategy
- Know your investor type and boost your performance
- Technical + fundamental analysis = better buy and sell decisions
- Fundamental investing
- Value investing and the price earnings ratio
- Intrinsic valuation models and methodology
- Value investments or value traps?
- How to find value stocks in a bull market
- Find value investments in expanding markets
- Why capital raisings struggle to add investment value
- How to value an insurance company
- Top stocks
- 5 qualities of top stocks
- How to find stocks with a competitive advantage
- Why return on equity is the best measure of business performance
- Using cash flow to find value investments
- Finding high quality dividend stocks
- Debt is not always a dirty word
- Why Skaffold share investment software makes sense
- Using economic factors to uncover the best investment options
- How do experts find top stocks to invest in?
- Investing in global stocks
- How to invest in international shares on global stock markets
- Benefits of investing in international shares
How to value insurance companies
Given that insurance is a game of probabilities and pricing, their analysis requires a unique set of evaluation criteria.
Insurance stocks are difficult beasts to value because much of their business model is wired to complex actuarial calculations.
Accurately forecasting future growth rates is also tricky, because fortunes of insurance companies is based on the unknowable frequency of natural (and man-made) disasters – plus the probability of claims against a myriad types of cover.
Even within the sector - which includes life insurance companies, personal injury, car and CTP insurance to name a few - the key drivers of individual stocks can vary dramatically.
Life insurers can sufferer from surges in claims and an increase in consumers cancelling policies. A lack of natural weather events, and strong results from a continued rise in premiums, will benefit general insurers.
How do investors value insurance companies?
Given that insurance is a game of probabilities and pricing, their analysis requires a unique set of evaluation criteria, beginning with an understanding of the term Net Earned Premium (NEP).
The NEP is simply the Gross Earned Premium (GEP) – revenue earned from the insurance policies written during a financial year – minus any reinsurance costs. Its designed to protect insurers against abnormally large risk. Reinsurance costs can and do vary depending on management’s appetite for risk.
When it comes to valuing insurance businesses, popular valuation models like the price earnings (P/E) ratio and evaluating dividend yields aren’t helpful.
Measuring cost efficiency of insurance companies
Uncovering the percentage of the net earned premium (NEP) paid out in the process of acquiring, writing and servicing insurance payments - the expense ratio (aka the underwriting expense) - provides a meaningful window into how efficiently management is running their insurance business.
Within today’s highly competitive industry dynamics, it’s crucial that insurers keep costs down. The lower the costs, the more insurers can attract new customers without compromising their profitability.
Costs and expenses aside, it’s equally important for insurers to measure the losses resulting from the risks they take.
The loss ratio helps to unearth the insurer’s skill as a disciplined underwriter and reveals the insurer’s success at correctly balancing price with risk to deliver profitability over time.
One-off ‘fat tail’ events can distort an otherwise good loss ratio, so it’s important to look for a longer-term pattern. A consistently high loss ratio - calculated as net claims expense divided by NEP - would suggest that an insurer is under-pricing its insurance.
Calculate an insurer’s Combined Ratio
Arrived at by adding expense and loss ratios together, a combined ratio below 100 per cent means an insurer is operating at an ‘underwriting profit’ - before returns from investing customers’ premiums are added.
A ratio less than 100 per cent (below 95 per cent is regarded as outstanding) means the insurance stock is less dependent on investment income to compensate for any (underwriting) losses.
Using Skaffold stock market software, its easy to compare the Combined Ratios of Australia’s largest insurance businesses.
Insurance margin relates to the transactional gains that insurers’ make on the cash they acquire in premiums (aka the float) that are invested – in cash or other asset classes - during the period between the premium being paid and a claim being made.
The ‘insurance profit’ is calculated by adding the return from investing the insurer’s float to the underwriting result. Once you know what the insurance profit is you can divide it by the Net Earned Premium (NEP) to arrive at the insurance margin. The higher the insurance margin, the better.
To make sure the insurance margin is legitimate, check if its being propped up by returns from investing their float. If yes, you need to ask whether the insurer is in the right business.
The Australian Prudential Regulation Authority (APRA) requires Australian insurance businesses to hold minimum amounts of capital. This safeguard ensures they can continue operating and fulfill their obligations to policyholders, even when confronted with unexpected losses.
Whilst its desirable for insurers to have a capital adequacy multiple well in excess of the minimum amount stipulated by the regulators, companies with a capital adequacy multiple set too high will be missing out on higher returns from deploying those funds in its insurance operations.
Price to book ratio
As a valuation method, the price to book ratio is more suitable than the traditional price earnings ratio because of the unpredictable nature of financial results produced by insurance businesses.
A price-to-book ratio is essentially the value you would see if the business was liquidated and liabilities paid out. A ratio of 1 indicates shareholders can only expect a return of book value. A ratio above 1 indicates the extent to which shareholders are potentially exposed to market risk.
Calculated by dividing the current closing price of the stock by the latest quarter's book value per share, the price-to-book ratio can be viewed in direct correlation with a bank’s return on equity (ROE).
As a rule of thumb, analysts would want to see a price-to-book ratio of one or less, if they thought an insurer was going to produce a return on equity of 10 per cent or less over time. By comparison, return on equity in excess of 12 per cent could justify a price to book multiple of more than one.