Friday, 8 June 2012
Art & science of insurance company analysis—how to understand your risk transfer partners
Creating financial statements are as much an art as science. The statement is basically a set of opinions, rather than an observable fact, and there is no industry for which this is more true than non-life re/insurance. As a result all analysis of insurance company finances by regulators, equity investors, rating agencies and other interested parties must use numbers that are inherently inaccurate.
Stuart Shipperlee, Partner at Litmus
The key to getting the most accurate picture therefore lies in taking a rounded view by looking at a range of numbers and ratios to build an overall picture of financial health with a reasonable chance of accuracy.
This was the honest and thought-provoking introduction to a training day run by consultancy firm Litmus Analysis attended by Commercial Risk Europe. Aimed at professionals from across the risk transfer industry, including risk managers and insurance buyers, the Understanding Re/Insurer Financial Statements session shed light on the key ideas, figures, ratios and terminology that Litmus’ team of insurance market analysts believe are key to better understanding the goings on at commercial insurance companies.
Going back to basics, the training day’s host, Stuart Shipperlee, Partner at Litmus, who has worked in insurance ratings and credit analysis for over 25 years, most recently as global head of S&P’s insurance products, explained that the two pillars of re/insurers’ financial statements are the income statement and balance sheet.
Although they reflect different elements of the financial profile, the first being a short-term reflection of success over a certain time period and the latter revealing a more sustained and underlying picture, they are fundamentally connected.
An income statement simply identifies the revenues and expenses for a financial period, usually a year, which produces a calculation of pre and post tax profits or losses and feeds into the balance sheet.
The balance sheet shows cumulative effects of profits, or losses, from trading activity as shown in each year’s income statement, plus any money a company is owed (an asset) or owes to others (a liability).
Of course, given the nature of the corporate risk transfer industry, with future losses unknown, all analysis must take a prospective view based on a re/insurer’s financial profile to include not just historical financials but a firm’s strategy, risk profile and management quality, among other criteria, explained Mr Shipperlee.
In financial analysis this forward view is based on volatility, or in other words the potential for a result to differ from the average expected outcome. Obviously the more volatile an outcome the more risk it presents but with potentially more reward.
Using a betting analogy, a gambler would expect to win more, or get a higher return, for betting on an outsider in a horse race than the favourite. This is an expectation of ‘not risk adjusted return’, attendees were told.
“Risk adjusted return is measured by calculating the minimum risk approach, ie betting only on favourites in horse racing, how much capital is employed (how much is bet), how much risk is taken, (how many outsiders versus favourites have been backed) and finally, as a result of these variables, the level of performance over the minimum risk return that has been achieved,” said Mr Shipperlee.” And the same principles apply to re/insurance.
To reduce the impact of luck insurance companies make lots of bets, better known as a portfolio. By reducing the impact of luck they reduce the overall volatility of their results.
An insurance company’s underwriting performance is dealt with in its income statement within the ‘technical account’ section. The second part of the income statement, the ‘non-technical account’, focuses primarily on investment results.
This separation allows for the calculation of specific underwriting Key Performance Indicators (KPIs) such as loss ratios, combined ratios and expense ratios. The majority of analysis begins with these ratios, though they are usually expressed as percentages, explained Mr Shipperlee.
“When CEOs at insurance companies talk about ‘underwriting for profit not market share’ and ‘not accepting business below the technical rate’ they are basically talking about what will drive the results that these ratios address,” he continued.
The (Net) Loss Ratio refers to the relationship between Net Losses Paid and Outstanding (NLPO) and Net Earned Premiums (NEP).
The lower the ratio, or percentage, the better for the insurer as it proves that less has been paid out in claims for every pound of premium income earned.
The (Net) Commission and Underwriting Expense Ratio is the relationship between Net Commissions and Underwriting Expenses (NCUE) and Net Written Premium (NWP). Once more the lower the number the better because it means less premium is being spent to acquire business and run a firm’s underwriting and claim handling teams.
An insurer’s combined ratio measures the percentage of premiums an insurer has to pay out in claims and expenses.
This is achieved by simply combining the expense and loss ratios. A combined ratio of lower than 100% reveals an underwriting profit and one over 100% reflects a loss.
“The combined ratio is a big deal in terms of perceptions of non-life re/insurer financial performance because of the way it conveniently indicates if underwriting is profitable and to what degree,” noted Mr Shipperlee.
Historically some re/insurers targeted a combined ratio of over 100% because their expected investment income, plus the degree of underwriting leverage they had, could turn this underwriting loss into their required return on capital.
“But drastic reductions in expected investment returns, particularly since the credit crunch, but also previously, means combined ratio targets today tend to be significantly lower than was one the case,” attendees were told.
Thinking back to the idea that bigger risks should pay more rewards because they could potentially cause heavier losses, different types of insurers and reinsurers will target different combined ratios. The more risky, or volatile, the line of business the lower the combined ratio needs to be because the insurer needs to plan for such a loss by making large underwriting gains in the good times.
“Of course most of the large commercial insurance companies will look to spread their bets, or risks, to manage the volatility and will seek safety through diversity of portfolio,” said Litmus.
The non-technical side of an income statement focuses on a re/insurer’s non-underwriting technical activity. Pre and post-tax profits then reflect the technical and non-technical accounts combined.
The operating ratio is a key metric of this overall result and builds on the combined ratio to give a simple snapshot of performance.
It is calculated by subtracting net investment income, expressed as a percentage of net earned premiums (NEP), from the combined ratio. This effectively cancels out the equivalent amount of claims paid and outstanding, or adds to them if there was an investment loss. So if a company has a combined ratio of 95%, net investment income of £70m and a NEP of £1bn that produces a ratio of 7%, the operating ratio would be 88%.
The balance sheet structure is much like a house investment backed by a mortgage, Mr Shipperlee told those gathered for the training session.
The value of a house minus any outstanding mortgage equals a homeowner’s equity. In re/insurance company accounts the company’s assets (the house) minus liabilities (the mortgage) equals what is most commonly referred to as shareholder’s funds (the equity).
Shareholder’s funds are the risk-taking part of a re/insurer balance sheet that can absorb underwriting or investment losses. So the smaller the shareholders-funds’, relative to the risks that the re/insurer takes, the riskier the business is.
“This is at the heart of understanding a re/insurer’s financial strength,” said the Litmus trainer. Therefore the main ratios used to assess balance sheet risks consider falls or rises in asset value or changes in liabilities, he added.
The single most widely used ratio, according to Litmus, is referred to as ‘the solvency margin’ or ‘underwriting leverage’, and divides the last published net written premium (NWP) figures of a company by its shareholder’s funds (SF).
The next most important ratio measures the relationship between SF and (net) technical reserves (TR). The latter is divided by the first figure. This is known as ‘reserve leverage’.
“So the NWP/SF is a proxy for what this year’s underwriting may do to the balance sheet, while the TR/SF is a measure of the risk represented by all of the prior year’s underwriting, or all of the claims ever incurred but not yet paid,” said the analyst.
The NWP/SF ratio reflects the level of underwriting supported by each pound of risk capital. Therefore a well diversified less ‘risky’ primary insurer might often operate with a ratio of 200% to 275% whereas a mono-line catastrophe reinsurer that carries more risk might operate with a ratio of less than 100%, or less business written than capital, according to Litmus figures.
A high level of TR relative to SF could imply a very prudent approach to reserving. But, even if it does, it also means there is relatively little room for any further increases in reserves, attendees were told.
“So having details on the likely adequacy of reserves is key to a view of reserve leverage. However, as a rule of thumb, few re/insurers will have reserves so prudent that there is no chance that reserve increases will never be required. So, high reserve leverage is always a red flag to some degree,” explained Mr Shipperlee.
The training session went into greater detail on further key ratios and ideas that underpin insurance company analysis including a look at capital models, solvency rules and the effects of reinsurance.
-Litmus Analysis was established in 2010 to help the re/insurance markets in the complex areas of credit risk and ratings. Litmus helps insurers manage their relationships with the rating agencies, buyers and brokers with market security, runs training programmes and is working on new tools to increase efficiency and transparency in the insurance world. Anyone wishing to attend a future session should contact email@example.com.