How to value insurance companies

Unlike industrial stocks, the fortunes of listed insurance companies spin on their own unique set of dynamics, and if you're going to include them within your share portfolio, you've got to understand some guiding principles to help you find value.

What fundamentally differentiates insurance stocks from industrials, banks or cyclicals, is that the underlying insurance business is fundamentally a game of ‘probabilities and pricing’, which requires different evaluation criteria.

What makes insurance stocks innately difficult to value is that much of their business model is wired to complex actuarial calculations. It’s also tricky to accurately forecast future growth rates because fortunes of insurance companies is based on the unknowable frequency of natural (and man-made) disasters – plus the probability of claims against different 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. For example, while life insurers can suffer from surges in claims and an increase in consumers cancelling policies, an unexpected pause in frequency of ‘natural’ weather events and strong results from a continued rise in premiums, will benefit general insurers.

While no single performance ratio should be looked at isolation, some ratios provide more meaningful measures depending on the type of stock. For example, popular valuation models like the price earnings (P/E) ratios and evaluating dividend yields are less relevant for insurance businesses, than other types of stocks.

So with that mind, we’ve outlined seven key criteria to look at when valuing insurance companies.

1. 1. Net Earned Premium (NEP): Is designed to protect insurers against abnormally large risk, and is simply the Gross Earned Premium (GEP) – revenue earned from the insurance policies written during a financial year – minus any reinsurance costs.
      Reinsurance costs can and do vary depending on management’s appetite for risk.
   2. Measuring cost efficiency: 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 insurance sector, insurers need to keep these costs down. The lower the costs, the more insurers can attract new customers without compromising profitability.
   3. Measuring loss: 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.
      But remember, one-off ‘fat tail’ events can distort an otherwise good loss ratio, so it’s important to look for a longer-term trend here. A consistently high loss ratio – calculated as net claims expense divided by NEP – typically indicates that an insurer is not charging enough for its insurance.
   4. Insurance margin: Relates to the transactional gains 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.Remember, the higher the insurance margin, the better. To make sure the insurance margin is valid, check to see if it’s being propped up by returns from investing their float. If yes, you need to ask whether the insurer is in the right business.
   5. Minimum capital: The Australian Prudential Regulation Authority (APRA) mandates that Australian insurance businesses hold minimum amounts of capital to ensure they can continue operating and fulfill their obligations to policyholders, even when confronted with unexpected losses.While capital adequacy should be well in excess of the minimum amount stipulated by APRA, companies with a capital adequacy multiple that’s set too high will miss out on higher returns from deploying those funds in its insurance operations.
   6. Price-to-book ratio: Due to some unpredictably associated within insurers financial results; a price-to-book ratio is more suitable than a traditional price to earnings measure.Within an insurance context, price-to-book ratio is 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. To calculate a Price-to-book ratio, 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 general rule, analysts 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% or less over time. Conversely, an ROE in excess of 12% could justify a price-to-book multiple of more than one.
   7. Adding up an insurer’s Combined Ratio: This is arrived at by adding expense and loss ratios together, a combined ratio below 100% means an insurer is operating at an ‘underwriting profit’ – before returns from investing customers’ premiums are added.A ratio less than 100% (below 95% is regarded as outstanding) means an insurance business is less dependent on investment income to compensate for any (underwriting) losses. We used stock market software, to compare the Combined Ratios of Australia’s largest insurance businesses, along with more some more traditional performance ratios. 

Six large insurers to compare

Stock	Code	Market cap	Forecast return on equity	Dividend yield	Combined ratio
QBE Insurance	QBE	$14.20 Bn	9.29%	5.38%	100.02%
Suncorp Group Ltd	SUN	$11.8 Bn	9.83%	12.06%	95.21%
Insurance Australia Group	IAG	$13.31 Bn	13.52%	5.21%	87.52%
Medibank Private Ltd	MPL	$8.20 Bn	21.47%	5.23%	93.97%
Genworth Mortgage	GMA	$0.79 Bn	10.78%	34.02%	85.90%
NIB Holdings Ltd	NHF	$2.15Bn	21.25%	4.88%	92.8%

Source: Bloomberg (July 2020)