The insurance industry is next up for BoomBustBlog subscriber scrutiny. Quite frankly, it’s amazing this industry has gone this long without getting the bank treatment, ex. Shorted into oblivion. Just imagine, and industry that is:
1. extremely cyclical,
2. prone to booms and busts (the fodder of BoomBustBlog),
3. and relies as much, if not more, on investment income borne from bonds (primarily sovereign debt [whaaaat?] and bank/financial institution debt [whoa!!!??] for earnings as much as their core business of underwriting risk.
If this is not a group of shorts made in investor heaven, I truly don’t know what is! This article is the first in several to help my subscribers make sense of the list of insurers that I posted for download earlier this week (Addressing Risks In The Insurance Industry)
Since some of the lexicon in the insurance/risk management industry may be a little jargon-ish, let’s take it from the top and work our way down – courtesy of heavy excerpting from the web’s most useful collaborative, groupthink knowledge utility, Wikipedia.
How Do Insurance Companies Make Money?
Insurance is a form of risk management primarily used to hedge against the risk of a contingent, uncertain loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for payment. An insurer is a company selling the insurance; an insured, or policyholder, is the person or entity buying the insurance policy. The insurance rate is a factor used to determine the amount to be charged for a certain amount of insurance coverage, called the premium.
The transaction involves the insured assuming a guaranteed and known relatively small loss in the form of payment to the insurer in exchange for the insurer's promise to compensate (indemnify) the insured in the case of a financial (personal) loss. The insured receives a contract, called the insurance policy, which details the conditions and circumstances under which the insured will be financially compensated.
The insurance industry has it own lexicon of performance and risk, with the most pertinent being the following three measures:
Relatively easily calculated as the underwriting expenses divided by net premiums earned. Since many insurers bill periodically (i.e. annually), they collect monies that they haven’t performed for. As they perform for said monies, they earn them. So, P/C insurer accepts a $10,000 premium payment on January 1. By February 1 it has only “Earned” 1/12th of that premium although it has had physical possession of the (investable, very important concept here that we will review in a moment) full amount of the funds. The expense ratio measures an insurer's efficiency in conducting its business. The lower the expense ratio the better the insurance operation is run. Expenses include typical business outlays, ex:
2. commissions to sales force whether in-house (insurance agents) or external (brokers)
4. taxes and other operational expenses.
Keep in mind that every single penny sucked in in the expense ratio through underwriting expense is a penny that doesn’t get to stay in the insurer's pocket, thus tight expense ratios are a must.
The loss ratio is simple enough – the monies lost divided by the net monies acquired through underwriting (not investment, which we will get to in a minute). It is calculated as loss and loss adjustment expense (the expense of minimizing loss) divided by the net premium earned (as explained up top). The loss ratio measures the proportion of acquired premium paid out in claims and claims related expenses. The loss ratio, over the longer term (shorter term are really just a matter of happenstance and luck) is an indicator of an insurer's risk management skills combined with its underwriting discipline.
The combined ratio is, simply enough, the combination of the loss ratio and the expense ratio. It is a simple, yet effective measure that reflects the operational excellence (or lack thereof) of an insurer. It measures what an insurer has to pay out in claims and expenses. Of course, even this metric has flaws, primarily in that it doesn't reflect the investment expertise of the insurer, which (particularly in the longer tail risks) can have a very significant effect on the bottom line.
A combined ratio of 104% means that an insurer is underwriting at a loss -- for every $1 in premiums taken in, $1.04 in claims and expenses are paid out. Fortunately, insurers also earn investment income from their float, so an insurer can still earn a profit even with a combined ratio in excess of 100%.
In general, those who invest in the low long-term combined ratio companies have been handsomely rewarded with above market returns. One of the most famous combined ratio consumers is the venerable Warren Buffett. Now, the riskier forms of insurance that entail insuring risks with very long tails (basically, insurable events that can take many years in the making, as opposed to car insurance which has a 1 year or so maximum [short] tail) are also some of the potentially most rewarding. Medical malpractice is a good example. The field is treacherous, and the risks are murky and hard to see. But the possibility arises for claim to be made 3 or 4 years after the insured incident, and even after the claim is made payout may not occur for another 4 or 5 years due to litigation. Even after litigation is settled, the claim can be paid out as an annuity (if the plaintiff is foolish enough to accept such), which extends even further the amount of time the insurer has access to the investable premiums. Add all of this time up, and you have insurers that can invest monies for 12 to 20 years and rake investment income off of said funds for all of that time. This is why asset/liability management is so important in the insurance industry. A medical malpractice insurer that manages to earn 10% after taxes and expenses on its investments on premiums earned on long-tail risk business written with even a 104 combined ratio can do very well if payouts don't start until 8 years after the claim and don't end until 26 years after the claim (due to annuitized payouts). How many businesses do you know of that can do so well while making an operating loss?
Think about it. This is one of the few industries where you can take a distinct and material operating loss and still post a material accounting AND economic profit! Of course this works both ways. If the insurer with a high combined ration takes significant losses, then you (as an investor) had best grab your ass cheeks with both hands and hold on tight. It's going to be a sickening ride.
Let's use the data from the BoomBustBlog post How Greece Killed Its Own Banks! to further illustrate this point. Assume we had Insurer EuroX, who wrote long tale risks and invested heavily in European sovereign debt, including the sterling credit (at least as asserted by the big rating agencies) of Greece, Portugal and Ireland...
... imagine what happens when a very significant portion of your bond portfolio performs as follows (please note that these numbers were drawn before the bond market route of the 27th)...
Of course, insurers don't use the leverage that banks do - or at least they don't use it explicitly. AIG did, and my analysts and I busted other US insurers packing the leverage in through the use of exotic derivatives, sold to them by.... Who the hell else? Banks! Subscribers, see the reports dated between 11/08 to 1/09 in the Life and Health Insurance subcategory for examples. Even without the use of leverage, significant losses are being taken in insurance company portfolios. The Greek bonds are being bid at 18 cents on the dollar. Try paying claims with that investment portfolio, purchased at par! Now, imagine you have a near 100 combined ratio - with no margin for error, god forbid the 82% margin that is needed just to break even. Wait, it gets worse...
The underwriting cycle (excerpted from Wikipedia)
Because most insurance policies are commodities, insurers generally lack pricing power. In other words, most people don't care who writes their insurance policy as long as the price is cheap. Thus, insurance prices are a function of supply and demand. When times are good, insurers make underwriting profits, and loss ratios decrease. As a result of the smaller losses, some insurers, driven by short-term greed, increase capacity by writing more policies. This increase in supply results in decreasing prices. Eventually, the cycle turns, losses increase, and insurers who wrote a lot of policies at low prices are left holding the bag. This situation is extremely similar to the boom-bust cycle of the stock market.
Have experienced a boom in the stock, credit and real estate markets? Are we know in a boom? 'Nuff said? No, not this time. Next to banks, insurance companies are the largest sources of cash for mortgages and private equity/mezzanine financiing for real estate deals. Despite massive bubble blowing by .govs, you know where we stand with real estate, right?
- Reggie Middleton's Real Estate Recap: As I Have Clearly Illustrated, It's a Real Estate Depression!!!
... It is the reporting company’s responsibility to report, not to obfuscate. The big problem with this “hide the market marks” thing is that markets tend to revert to mean. Unless said market values fundamentally catch up with said market prices, you will get a snapback. That is what is happening in residential real estate now. That is what happened in Japan over the last 21 years!!! That’s right, it wasn't a lost decade in Japan, it was a lost 2.1 decades!
And here we are full circle, back to the list that I asked my subscribers to study earlier this week (Addressing Risks In The Insurance Industry). My next post on this topic this weekend will go over the number one pick from that list, along with the reasons for such pick using the logic outlined in this post. This will be quickly followed up by a forensic summary. Shortly after that will be either a full forensic report on said company or another shortlist of companies from another industry at risk from the impending debt crisis.