Insurance industry and rent-seeking
Certain insurance products and practices have been described as rent-seeking by critics.That is, some insurance products or practices are useful primarily because of legal benefits, such as reducing taxes, as opposed to providing protection against risks of adverse events. Under United States tax law, for example, most owners of variable annuities and variable life insurance can invest their premium payments in the stock market and defer or eliminate paying any taxes on their investments until withdrawals are made. Sometimes this tax deferral is the only reason people use these products.] Another example is the legal infrastructure which allows life insurance to be held in an irrevocable trust which is used to pay an estate tax while the proceeds themselves are immune from the estate tax.
The insurance marketplace is transforming, creating opportunities for many and challenges for all. Top Insurance Industry Issues in 2015 describes in detail the changes in the industry and how insurers can make the most of them, including:
- The central role of advanced analytics in modernizing business models and operations; how new metrics can increase efficiency, lower costs, and lead to better analytics; and recent developments in insurance contracts accounting and reserving that are helping to drive the modernization agenda.
- Recent, pending, and potential regulatory developments that insurers will be addressing in the coming year and beyond.
- Market and business developments that have affected or will affect insurers' business strategy, including autonomous vehicles and their potential impacts on auto insurance; group insurance and the rise of exchanges; and the deals environment.
- Operational change, including the state of P&C core systems transformation and managing talent strategy in a time of profound change.
- Recent, pending, and potential developments in insurance taxation.
As a result of globalization, deregulation and terrorist attacks, the insurance industry has gone through a tremendous transformation over the past decade.
- In the simplest terms, insurance of any type is all about managing risk. For example, in life insurance, the insurance company attempts to manage mortality (death) rates among its clients. The insurance company collects premiums from policy holders, invests the money (usually in low risk investments), and then reimburses this money once the person passes away or the policy matures. A person called an actuary constantly crunches demographic data to estimate the life of a person. This is why characteristics such as age/sex/smoker/etc. all affect the premium that a policy holder must pay. The greater the chance that a person will have a shorter life span than the average, the higher the premium that person will have to pay. This process is virtually the same for every other type of insurance, including automobile, health and property.
In the U.S., the Gramm-Leach-Bliley Act of 1999 legislated that banks, brokerages, insurance firms and other types of financial institutions can join together to offer their customers a more complete range of services. In the insurance business, this has led to a flurry of merger and acquisition activity. In fact, a majority of the liability insurance underwritten in the U.S. has been through big firms, which have also been scooping up other insurance names.
Ownership of insurance companies can come in two forms: shareholder ownership or policyholder ownership. If the company is owned by shareholders, it is like any other public company. That is, its shares trade on an exchange like the NYSE, and it is required to report earnings on a quarterly basis. The other type of ownership is called "mutually owned insurance companies." Here the company is actually owned by the policyholders, so an account called policyholder's surplus, rather than shareholder's equity, appears on the balance sheet. It should be mentioned that in recent years many of the top mutual insurance companies have gone through demutualization to become shareholder-owned. Today, only a small handful of companies are still policyholder-owned.
Types of InsuranceThere are several major types of insurance policies. Some companies offer the entire suite of insurance, while others specialize in specific areas:- Life Insurance - Insurance guaranteeing a specific sum of money to a designated beneficiary upon the death of the insured, or to the insured if he or she lives beyond a certain age.
- Health Insurance - Insurance against expenses incurred through illness of the insured.
- Liability Insurance - The miscellaneous category. This insures property such as automobiles, property and professional/business mishaps.
There are many factors to examine when looking at insurance companies. More than anything, both consumers and investors should concern themselves with the insurer's financial strength and ability to meet ongoing obligations to policyholders. Poor fundamentals not only indicate a poor investment opportunity, but also hinder growth. Nothing is worse than insurance customers discovering that their insurance company might not have the financial stability to pay out if it is faced with a large proportion of claims.
Over the years, there has been a big shift in the life insurance industry. Instead of offering straight insurance, the industry now tends to sell customers on more investment type products like annuities. As a result, insurance companies have been able to compete more directly with other financial services companies such as mutual funds and investment advisory firms. To capitalize on this, many insurance companies even offer services such as tax and estate planning.
Key Ratios/Terms
Return on Equity (ROE): Net Income Shareholder's Equity
ROE indicates the return a company is generating on the owners' investments. In the policyholder owned case, you would use policy holders' surpluses as the denominator. As a general rule for insurance companies, ROE should lie between 10-15%.
Return on Assets (ROA): Net Income + Interest Expense Total Assets
ROA indicates the return a company is generating on the firm's investments/assets. In general, a life insurer should have an ROA that falls in the 0.5-1% range.
Return on Total Revenue: Net Income Total Revenue
This is another variation of the profitability ratios. The insurance industry average return is approximately 3%. If possible, use the premium income and investment income as the numerator to find the profitability of each area.
Reinsurance: This is the process of multiple insurers sharing an insurance policy to reduce the risk for each insurer. You can think of reinsurance as the insurance backing primary insurers against catastrophic losses. (To learn more, read When Things Go Awry, Insurers Get Reinsured.)
The company transferring the risk is called the "ceding company"; the company receiving the risk is called the "assuming company" or "reinsurer."
Lapse Ratio: Lapsed Life Insurance Specified Period
Contracts in Force (in effect) at Start of Specified Period
This ratio compares the number of policies that have lapsed (expired) within a specified period of time to those in force at the start of that same period. It is a ratio used to measure the effectiveness of an insurer's marketing strategy. A lower lapse ratio is better, particularly because insurance companies pay high commissions to brokers and agents that refer new clients.
A.M. Best Ratings: A.M. Best dubs itself "The Insurance Information Source." This company provides data and research on almost every major insurance company in North America and abroad. Many analysts equate the quality of A.M. Best ratings to Moody's or Standard and Poor's bond ratings. A.M. Best ratings are so widely followed because they can usually obtain company information that wouldn't be accessible to the average person.
