CHAPTER 4

INSURANCE INDUSTRY GROUP

The Insurance Industry group includes five sub-industries. Each has unique characteristics, but all are involved in the business of transferring risk. Further, the core of the group is Life & Health Insurance (L&H) and Property & Casualty Insurance (P&C). The other three sub-industries are derivatives of these two: the Brokers sub-industry sells the insurance, Reinsurance offers insurance to insurers and Multiline Insurers is a combination of insurers.

Accordingly, in most major global indexes, the largest sub-industries are typically L&H and P&C, combined averaging about 70% of the Insurance weight.1 Additionally, because most insurance industries are similar across the globe and the US is the world’s largest insurance market (about 35% of the global market),2 much of this chapter will focus on the US.

This chapter covers the characteristics of the two major sub-industries but also touches on the smaller groups. Topics include:

• Characteristics of L&H and P&C
• The makeup of an insurance company
• How do insurance companies make money?
• How do insurance stocks act?
• Drivers of L&H and P&C
• Insurance regulation

CHARACTERISTICS OF INSURERS

First, what is insurance? An insurance contract is the transfer of risk—a legally binding agreement between an insurer and an insured whereby the insurer will indemnify the insured in exchange for a fee. Insurance spreads risk, sharing the losses of a few among the many. Insurers generally take on certain risks, such as death or accident, in exchange for a fee, referred to as a premium. Premium prices are determined by advanced calculations which attempt to predict the probability and severity of loss. Insurers help the insured mitigate the potential impact of an unforeseen negative event in exchange for a fee from which they expect to overall profit.

The L&H Insurance sub-industry is the largest in most global insurance benchmarks (Table 4.1). These companies offer insurance for personal and family loss by death, disability, sickness, old age, accident and unemployment. Products typically include individual annuities, ordinary life insurance, group annuities, group accident and health, other accident and health, group life and others. In 2010, annuities were the largest revenue source in US L&H, with around $346 billion in premiums, or 51% of total premiums.4 (See Figure 4.1.) Accident & health is the second largest, with about $176 billion, followed by group annuities at about $161 billion.5

Table 4.1 Insurance Weights in Major Benchmarks

Source: Thomson Reuters; S&P 500 and Russell Indexes; MSCI, Inc. 3 As of 12/31/2011.

Figure 4.1 Distribution of Premiums by Business

Source: “Understanding Profitability in Life Insurance,” Swiss Re (January 2012).

Property & Casualty Insurance, the second largest sub-industry in most insurance benchmarks, insures against damages to people or property. This primarily includes auto, homeowner and commercial policies such as workers’ compensation (Figure 4.2). The government plays no small role in making these types of policies most prevalent—in many cases, it’s the law. While in the US we refer to the industry as Property & Casualty Insurance, or P&C Insurance, outside the US, it’s usually called General Insurance.

Figure 4.2 2008 US Property and Casualty Premiums (in billions)

Source: AM Best Company, The Guide to Understanding the Insurance Industry 2009–2010: Check Out the Vital Signs of Financially Fit Insurers (BookSurge Publishing, October 28, 2009).

The Makeup of an Insurance Company

Just like in the banking industry, the makeup of an insurance company’s assets and liabilities is a critical component of that company.

Assets are mostly composed of bonds, stocks, mortgages and policy loans—which back the insurer’s liabilities. In the L&H group, most assets are investments divided between general account and separate account assets. The general account supports contractual obligations with fixed benefit payments (US L&H insurers had general account assets of $3.3 trillion in 2009), while the separate account represents pass-through vehicles such as variable annuities (US L&H insurers had separate account assets of $1.6 trillion in 2009).6

Most of the P&C industry’s assets are found in the Invested Assets category, which often includes investment categories like short term, equities, fixed and other. In 2011, US P&C companies had $1.4 trillion in assets, with more than 80% classified as “invested assets.”7

P&C and L&H companies both manage investment portfolios, but the dynamics of the portfolios are often different. Since potential outcomes with P&C insurance are usually shorter term in nature than L&H (in the US, there were 124,000 accidental deaths in 2007, compared to 10.8 million motor vehicle accidents)8 and catastrophic events usually have more covered property damages than covered deaths, P&C companies typically invest more conservatively—making them less sensitive to trends in capital markets. In fact, as a percent of total assets, L&H companies have considerably more exposure to equities and corporate bonds than P&C. Not only do L&H insurers take on more credit risk by owning more equities or riskier bonds, but they also typically invest in longer-duration securities relative to P&C—which amounts to increased interest rate risk.

Another common asset which can be rather impactful is the Deferred Policy Acquisition Cost, or DAC. Since insurance companies incur large upfront expenses upon acquiring new business, such as commissions or policy credits, accounting rules allow insurers to amortize the cost over the policy’s life. This deferral accumulates as an asset that is slowly eroded as the expense of the policy is realized over time in the form of Deferred Acquisition Expenses (DAE).

A great way to understand DAC and DAE is to consider an annuity transaction from an insurance company’s perspective. Annuities are big money makers for insurance salespeople. They often come with hefty 5%, 6% or 7% commissions on the principal—sometimes more! This means a salesperson could make more than $50,000 selling a million-dollar annuity. In this example, the commission paid would be an expense to the insurance company—an expense the revenue earned from the annuity on day one doesn’t come close to matching. So rather than realizing a sizable loss upfront, the insurance company defers the expense over the annuity’s life. As more revenue is realized, it releases some of the expense to offset.

Since insurance products’ lives and profitability can vary significantly over time, DAC and DAE are based on numerous assumptions—meaning small changes, like a drop in interest rates, for example, can significantly impact DAC calculations and drive earnings deviations.

Liabilities are equally as important as assets. For insurers, liabilities are mostly reserves held to back claims paid to policyholders and beneficiaries. There are several different types of reserves, but policy and asset fluctuation reserves are the most common. Nearly 80% of L&H company liabilities are considered reserves.9 P&C companies are similarly exposed.

Insurance companies actively manage asset and liability exposures in an effort to control the company’s interest rate risk, among other things. These companies usually control the amount of duration mismatch—making sure the interest rate exposures of their assets do not far exceed those of their liabilities, and vice versa. This way, if interest rates move, the company would see a similar impact on both sides.

An insurer’s net value is the difference between its assets and liabilities, which also equals its surplus plus its capital stock. Net value is a core metric used in determining an insurer’s solvency, which we discuss further in a bit.

HOW DO INSURANCE COMPANIES MAKE MONEY?

Primary revenue sources are:

• Premiums
• Fee income
• Net investment income

L&H and P&C both generate revenue primarily from premiums, fees and investments—all critical components of their profitability.

Insurance is commoditized, and differentiation is slim in the developed world—as a result, insurers can gain market share with either pricing or distribution. Since gaining share with pricing puts the insurer at risk of not earning enough to compensate for claims, distribution is a core way to gain and maintain share. There are a few core distribution platforms: agents, brokers and direct. The most cost-effective platform is offering insurance directly—the insurance company doesn’t have to pay commissions to a third party. But agents and brokers can quickly increase an insurer’s platform. Bancassurance is a platform where insurance companies and banks partner—the bank offers the insurance company’s product via its distribution network, and the commission is shared.

Premiums

The term premium refers to the amount the insured pays in exchange for insurance coverage. However, when first collected, only a portion of the premium—the earned premium—will be booked as revenue. Earned premiums funnel down the income statement and contribute to net income for the period.

The remainder is considered unearned premiums (UEP)—the portion of the premium not yet earned and parked on the balance sheet as a liability. The liability is reduced as unearned premiums morph into earned premiums and are reflected on the income statement as revenue. The reason for this accounting method is in the event the policy’s canceled, the premium would be returned to the insured. However, during the float cycle, it is also considered an asset as it is typically turned into some form of investment.

To see how UEP works, consider a single-pay term life policy. Say the insured purchases a 10-year term life policy and pays a single premium of $1,000 on day one. The insurance company books 10% of that written premium as earned premium in year one, and the remaining $900 represents a liability to the insurer. In year two, it books another $100 in earned premiums, leaving an $800 liability and so on. At the end of year 10, the policy expires and the insurer has no more liability—all income has been earned.

Hard and Soft Markets

The P&C insurance industry is very cyclical, but it is also inelastic since many P&C insurance policies are mandated by law. As such, the cyclical nature is not tied to the economic cycle, but to an underwriting cycle.

Like most insurance, P&C insurance is mostly commoditized—so the most important factor for most customers is price.10 It also has low barriers to entry. These two dynamics create an underwriting cycle which generally drives “hard market” or “soft market” conditions.

During a “soft market,” prices are low or falling, which results in falling underwriting standards as companies compete for market share. Ultimately, either prices or underwriting standards fall too much, leading in turn to losses. As these losses mount, some companies shut their doors, and eventually, supply is reduced enough to restore the market’s pricing power.

In a “hard market,” insurance companies have pricing power, which typically leads to higher profitability. This in turn attracts new players to the market in pursuit of profit. Eventually, this turns into oversupply, and the soft market cycle starts anew. (See Figure 4.3.)

Figure 4.3 P&C Underwriting Cycle

Hard markets are often event-driven. Consider a hurricane’s impact during a soft market: The catastrophe would drive substantial covered losses, and the industry would likely witness insolvent insurers, given already low underwriting standards and pricing. Following the event, demand for insurance would surge as people are reminded of its benefits, but supply would have dwindled, leading to hard market conditions where the remaining insurers would have pricing power and benefit from the increased demand at higher prices.

Earnings from premium income are typically referred to as underwriting income. A common measure of underwriting income is the combined ratio, which combines the loss ratio and the expense ratio. The loss ratio measures incurred losses and loss-adjustment expenses to earned premiums. The expense ratio measures incurred expenses to earned premiums. So the combined ratio measures losses plus expenses to premiums—essentially, the profitability of the underwriting side of the business.

A combined ratio of 100% means the insurance written is equivalent to losses and expenses incurred, excluding any gains or losses on investments. A ratio above 100% means the insurer is losing money writing insurance; below 100% means its underwriting business is profitable.

But a ratio above 100% does not mean the company as a whole is losing money—in fact, an insurer can run its underwriting at a loss for extended time periods, provided it’s making money on its investment portfolio (see Figure 4.4). Since the P&C market is highly penetrated in the developed world, competition is fierce—insurance companies usually price their policy pools very close to expected loss payouts. In fact, from 1980 to 2006, US P&C insurance companies recorded underwriting profits in only two years.11

Figure 4.4 P&C Insurance Workflow

Investment Income

Investment portfolios also provide another important income source in the form of dividends, interest and gains or losses on securities (as with any portfolio). Insurance companies are some of the largest institutional investors in the world, with over $6 trillion in US insurer investments alone.

Since most of an insurance company’s expenses are accounted for on the underwriting side of the business (combined ratio), most gains or losses on the investment portfolio go directly to the bottom line. Understanding an insurer’s investment portfolio is an important step to investing in an insurance company. Finding an insurer with an investment portfolio positioned to benefit from your market expectations could give you a leg up.

Fee Income

Globally, insurance companies manage nearly $25 trillion.12 This makes investment management a huge component of fee income, primarily for L&H insurers, and means L&H companies are directly impacted by asset and savings trends (see Chapter 3). Again, if you can find an insurer that manages assets you expect to outperform, this could put it at an advantage to its peers if your forecasts play out.

Expenses

The largest expense for an insurance company is usually policyholder claims, or paying out on insured losses. Insurance companies expect these expenses—they’re a core component of pricing in the sense they’ll generally price their policies in an effort to turn a profit despite an expected amount in losses on a pool of insurance contracts. This is similar to banks’ pricing loans partly based on expected losses on a pool of loans.

The next largest expense is generally amortization of deferred costs and expenses. Other notable expenses include commissions, salaries, legal fees and other overhead, not unlike expenses witnessed in non-financial sectors.

HOW DO INSURANCE COMPANIES ACT?

As could be expected, Insurance industries are positively correlated to the broader Financials sector. However, Insurance Brokers tends to be lower beta, has a lower correlation than the other industries and is less volatile when measured using standard deviation.

Brokers is typically referred to as the more “defensive” component of Insurance because whereas the other sub-industries may pay out large claims, insurance brokerages simply sell the other sub-industries’ insurance products, so there’s no event risk. On the contrary, if a hurricane hits Florida, Brokers could benefit as demand for protection from the next hurricane increases, but the P&C or Multiline insurers would likely take substantial losses due to the event. Insurance brokers also typically don’t have investment portfolios, making them less susceptible to (positive or negative) capital markets trends.

The Multiline industry has the highest beta, the highest correlation to the Financials sector and the highest standard deviation. However, the primary reason for that is stock-specific issues during 2008’s financial panic (Table 4.2). In particular, American International Group’s (AIG) rise, fall and subsequent government bailout tied to its exposures to derivatives and various guarantees greatly skew the data. In fact, prior to its downfall, AIG was the single largest component of the S&P 500 Insurance Index—at one point accounting for more than 30% of the group.13 Analyzing the group prior to 2008 shows a more muted variance, but the general trends remain.

Table 4.2 Insurance Sub-Industry: Beta & Correlation to the Financials Sector and Standard Deviation of Returns

Source: Thomson Reuters; S&P 500 Indexes, monthly data from 12/31/1995 to 12/31/2011.

The general relationship between the industries can be summed up by ranking them by volatility or sensitivity to economic conditions: Multiline is the most volatile, followed by L&H, then P&C and finally Brokers. This ranking holds up through most economic cycles—whether employment, interest rates, inflation, recessions, expansions, bulls or bears.

Drivers

Insurance growth rates tend to go hand-in-hand with economic activity and the growth in economic wealth. The more activity and the more wealth, the more insurance (Figure 4.5). This is magnified in frontier and Emerging Markets, since there’s a threshold where insurance becomes widely accepted—a threshold the developed world passed decades ago. Developed markets are rather penetrated, so growing much more than an economy’s growth rate becomes a fight for market share—as laid out in the market cycle discussion.

Figure 4.5 Economic Wealth Versus Insurance Spending by Country

Source: Organisation for Economic Co-operation and Development, “Total Gross Insurance Premiums,” 2010; Thomson Reuters, as of 12/31/2011.

In the developing world, growth is still robust. Not only are economic growth rates overall higher, but as nations become wealthier, there’s a tipping point where an economy is wealthy enough to support an insurance market. P&C insurance can be supported earlier on in the growth cycle, but it takes per-capita GDP of around $8,000 before a local life insurance market can be sustained.14

Regardless of geography, following are a few high-level drivers influencing the industry globally.

Life and Health

The L&H group tends to be sensitive to savings trends, asset values and interest rates. Moreover, considering the importance of annuities, an understanding of drivers there is important.

For insurance companies, offering annuities and life insurance is a calculated bet based on mortality tables. With life insurance, companies would prefer the insured live as long as possible to extend premium payments and/or expense income. With annuities, companies would prefer shorter life spans so annuity payments end sooner rather than later.

A big distinction in the annuity space is fixed versus variable. Fixed annuities offer payments at a fixed interest rate which is not tied to the stock market but could be adjusted based on certain interest rate benchmarks. A variable annuity typically offers a range of investment options—many of which are tied to investing in stocks or bonds. Fixed annuities tend to sell better in periods of uncertainty—not unlike bonds, which are also typically more popular during bear markets. Conversely, variable annuities sell better during bull markets—when investor confidence is improving.

Variable annuities often offer some sort of guarantee on principal—they allow investors market exposure but with some sort of insurance on the portfolio. These guarantees earn enormous fees for the annuity companies, but during a market downturn, they can be disastrous because the insurers may be held liable for insured investor losses. During 2008–2009’s financial crisis, they pushed many to the brink of insolvency.

Property and Casualty

Considering the typically saturated nature of property and casualty insurance and the prevalence of automobile insurance, general economic growth (i.e., GDP and population growth) and automobile trends are core drivers of the group. However, since insurance is a business of risk, unexpected catastrophes can easily change things.

REGULATION

As with the other Financials industry groups, the government plays a huge role in insurance—from regulation mandating compulsory coverage to licensing requirements and regulation controlling how much risk an insurance company can take, regulation can have a measurable impact. Globally, regulation isn’t that different—regulators generally provide a framework within which insurance companies must operate. The framework can differ around the world, but it is usually rather robust, covering everything from competition to disclosure to cross-border cooperation. However, nearly all regulatory regimes include some form of leverage and/or risk controls. In doing so, there are some common metrics used to ensure soundness and solvency in the industry.

Ratios

In the US, individual states determine capital levels required to be considered solvent. While not all of these are used by all regulators, following are a few common ratios.

US Regulation

The US insurance industry has historically been regulated by a state-based regulatory regime, although many additional regulatory bodies now take part under Dodd-Frank. Each state has an insurance commissioner assisted by the National Association of Insurance Commissioners (NAIC), which is a voluntary organization of chief state insurance regulators. The NAIC’s mission is protecting policyholders, claimants and beneficiaries first and foremost while also facilitating an effective and efficient marketplace. The NAIC also monitors and enforces seven financial solvency core principles:

For now, each state can interpret, enact and enforce its interpretation of these principles as it sees fit—though Dodd-Frank may eventually move toward a national regulatory body.

Solvency II (Europe)

Solvency II is a full-scale revision of the solvency framework and prudential regime applicable to insurance and reinsurance companies. It was adopted November 2009, and each state in the European Economic Area (EEA) is required to implement Solvency II by January 2013. The European Commission developed Solvency II using a three-pillar approach in an effort to unify a single European Union insurance market while also implementing a more risk-sensitive and sophisticated solvency requirement.

At the time of this writing, the core ruling on required capital levels under Pillar I is still unknown. Insurance companies in Europe have been making progress in implementing the new rules, but as with Basel III, the rules are still being written and are subject to change.

The International Association of Insurance Supervisors

The International Association of Insurance Supervisors provides the Insurance Core Principles (ICPs), which is a globally accepted framework for the supervision of the insurance sector. The principles are similar to the US core principles but are more numerous—at last count, there are 26 ICPs, ranging from maintaining a clearly defined supervisor to cooperating during cross-border crises.16

1. Thomson Reuters, as of 12/31/2011.

2. National Association of Insurance Commissioners, “NAIC Industry Overview State of the Insurance Industry” (2011). Defined by premiums. www.naic.org/documents/fin_summit_pres_10_industry_overview.pdf (accessed March 27, 2012).

3. MSCI. The MSCI information may only be used for your internal use, may not be reproduced or redisseminated in any form and may not be used to create any financial instruments or products or any indices. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the “MSCI Parties”) expressly disclaims all warranties (including, without limitation, any warranties of originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages.

4. A.M. Best, The Guide to Understanding the Insurance Industry, 2009–2010.

5. Ibid.

6. ACLI, “ACLI Life Insurers Fact Book 2010” (October 10, 2010), www.acli.com/Tools/Industry%20Facts/Life%20Insurers%20Fact%20Book/Pages/GR10-242.aspx (accessed March 28, 2012).

7. US Federal Reserve, “Flow of Funds Accounts of the United States: Flows and Outstandings Second Quarter 2011” (September 16, 2011), www.federalreserve.gov/releases/z1/20110916/z1.pdf (accessed March 28, 2012).

8. US Census Bureau, “Table 120. Deaths and Death Rates by Selected Causes: 2006 and 2007” (May 2007), www.census.gov/compendia/statab/2012/tables/12s0120.pdf (accessed March 27, 2012).

9. Bloomberg Finance L.P., as of 12/31/2011.

10. Capgemini, “2007 World Insurance Report” (2007), www.efma.com/wir07/pdf/WIR_Roadshow_London.pdf (accessed March 28, 2012).

11. American Insurance Association, “Insurance 201: Property-Casualty Finance,” AIA Advocate (September 2006), www.aiadc.org/AIAdotNET/docHandler.aspx?DocID=298116 (accessed March 28, 2012).

12. TheCityUK, “Financial Market Series: Fund Management” (October 2011), www.thecityuk.com/assets/Uploads/Fund-Management-2011.pdf (accessed March 28, 2012).

13. Thomson Reuters; S&P 500 Insurance Index, as of December 2006.

14. Rodney Lester, “Introduction to the Insurance Industry,” The World Bank (March 2009), http://siteresources.worldbank.org/EXTFINANCIALSECTOR/Resources/282884-1242281415644/Introduction_to_Insurance_Industry.pdf (accessed March 29, 2012).

15. Ibid.

16. International Association of Insurance Supervisors, “Insurance Core Principles, Standards, Guidance and Assessment Methodology” (October 2011).