Diversity Investment Group Analyzing Insurance Stocks Differences in Life, Health and P&C Companies

Better Investing Magazine, July, 2006

by Steven Jones-D'Agostino

In the wake of Hurricane Katrina and the big hit the insurance industry took, you may be hesitant to invest your hard-earned money in insurance stocks. Not all insurance companies are in property and casualty, however. Even within the P&C sector, some companies may be doing much better than others.

Insurance companies come in three basic types: life, some of which offer annuities as well as tax and estate planning; property and casualty, which includes auto insurance; and health. Clearly, big differences exist between individual insurance companies when it comes to whether their stocks make for good investments.

Major differences also exist in the economics of the three basic types of insurance companies as well as in the analysis of their stocks, according to Paul Newsome, a vice president and securities analyst for brokerage company A.G. Edwards & Sons, Inc., in St. Louis.

Structural Differences

At the risk of oversimplifying, Newsome describes health insurers as principally transaction-focused. Their main asset -- a network of doctors and other health-care providers -- is intangible. They don't take in a lot of capital, so investors tend to focus on actual and expected earnings.

P&C insurers are different from health insurers because the former are capital-intensive, Newsome says. A P&C insurer's earnings, by their very nature, are highly volatile. As a result, investors tend to focus on a P&C insurer's book value (a company's value after subtracting liabilities and intangible assets from total assets) and return on equity (how much a company earned using money shareholders invested in it) over time.

Life insurers are somewhere between health and P&C insurers in the sense that they're capital-intensive, but the accounting is quite different, Newsome says. Life insurers, like P&C companies, are really investment businesses. Therefore, investors need to study the quantity and quality of earnings growth. Most life insurers are, like banks, so-called spread-based businesses.

Insurance companies can be either shareholder-owned (publicly traded) or policyholder-owned (mutuals). In recent years, many policyholder-owned life insurance firms have converted themselves into publicly traded companies. Still, many of them continue to be owned by policyholders.

The P&C-insurer sector also presents a mixed bag, with most companies owned by shareholders. Some large mutual P&Cs remain, however.

The health-insurance sector is dominated by a handful of large publicly traded companies. Nevertheless, nonprofits (mutuals) still control about one-third of the sector.

If you're a policyholder with a policyholder-owned insurer, you're essentially an investor as well as a customer. But comparing policyholder-owned with shareholder-owned insurers for risk to investors is hard. It's too much of an apples-and-oranges comparison, Newsome says.

When considering the risk to investors, Newsome says, it's much easier to compare insurance stocks in general with industrial or service stocks. Overall, insurance, industrial and service stocks pose comparable risks.

That being said, P&C insurers tend to have more risk, and health and life insurers less risk, to their earnings, Newsome says. For the most part, from a credit perspective publicly traded insurers are highly rated companies. As a result, few of them are "junk" rated.

Sources of Revenue

Life, P&C and health insurers do four basic things: manage risk among their clients, sell insurance policies, collect and invest premiums and pay off claims. Life insurance companies are different from P&C and health insurers in two major ways: Policyholders transfer their mortality risks to their life insurers, and life insurers are largely investment companies.

The two main sources of revenue for insurance firms are premiums from policyholders and investment income from premiums. The latter sources can come in three forms: dividends, interest and capital gains. Life insurers also derive income from deposit-oriented products, which work like those of banks. A fixed annuity is an example of such a product.

To make a profit, insurance companies -- particularly P&C insurers -- do the following:

• Collect premiums, invest the cash and pay claims to policyholders.


• Make sure premiums and investment earnings exceed payment of claims.


• Hold the money -- in other words, let it float -- a long time to make as much profit as possible before paying claims.

Health insurers, on the other hand, have little opportunity to float money because they pay claims quickly, Newsome says. Therefore, investors need to compare how much a health insurer collects in premiums with how much it pays in claims. Also, health insurers generate a large amount of their revenue by processing claims for a fee. They face less underwriting risk than P&C insurers as well.

Life insurers, meanwhile, offer a variety of products. Some of these, like variable annuities, involve charging a fee to manage assets, Newsome says. They may sell fixed annuities -- similar to bank certificates of deposit -- for which they hope to make a profit by investing the money in a policyholder's account. The investments typically are in municipal and corporate bonds.

When analyzing the sales figures of insurance companies, industry experts recommend using total revenue or total income. They suggest breaking down the figure into premium income and investment income to see each source of income and its growth trend.

Life-insurance companies have essentially two types of products to sell: investment and mortality. For investment products, investors need to look at deposits, and for mortality products, premiums.

Once you have done the revenue analysis, your own judgment becomes the most critical component. Using BetterInvesting stock study tools will tell you much of what you need to know about an insurance company, and other ratios and figures will help you fill in the gaps of your analysis.

Loss and Expense Ratios

For insurance stocks, this consists of analyzing an insurance company's loss ratio, expense ratio, combined loss-expense ratio, return on revenues and return on invested assets.

• Loss ratio: This is loss adjustments divided by premiums earned, showing the percentage of payouts to insured customers. The lower the ratio, the better.


• Expense ratio: This is underwriting expenses divided by net premiums written. It shows the cost to gain new business as compared with new premiums. The lower the ratio, the better.


• Combined loss-expense ratio: This measures the costs to run the business and pay claims compared with net premiums. A level below 100 percent indicates underwriting profitability. Over 100 percent indicates a failure to earn sufficient premiums to cover claims. For P&C insurers, the combined loss-expense ratio is the most carefully viewed measure, Newsome says. Although this ratio works reasonably well as a measure for health insurers, it doesn't work at all for life insurers. This is because there's an important investment component and the accounting is quite different.


• Return on revenues: This is net operating income divided by total revenues. It indicates a level of profitability. This measurement works well for health insurers, Newsome says. But investors need to exercise caution when using this measurement for P&C companies because of the investment-risk component. As for life insurers, ROR isn't a very good measurement because of the deposit-oriented accounting used for the investment products.


• Return on invested assets: This is net operating income divided by average annual invested assets. The percentage of ROIA shows the profitability of existing investment securities and premiums. The higher the ratio, the better. Look closely at ROIA for life insurers, Newsome says. But don't rely on this measurement when analyzing P&C and health insurers. It doesn't really tell you much about these companies' profitability because of the way such companies account for their profits.

With all this in mind, here's what Newsome recommends you look for when sizing up insurance stocks:

• Net profit growth.
• Good return on equity.
• Growth in insurance in force. This measures the size of a traditional life-insurance business. It's typically the aggregate face amount of a policy.
• Growth in net operating income.
• Good percentage of investment yield on invested assets.

No One-Size-Fits-All Approach

When investing in insurance stocks, look at each company individually -- particularly when they offer a mix of life-, P&C- and health-insurance lines, Newsome says. If you try to take a one-size-fits-all approach to analyzing insurance stocks, you could end up with a misleading analysis.

Steven Jones-D'Agostino is a free-lance financial journalist based in Worcester, Mass.

If you have questions or comments, write to: DIGnet@mindspring.com.

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Diversity Investment Group | Atlanta, Georgia, USA | DIGnet@mindspring.com

07/01/2006