For Fools interested in learning the basics on auto, life, and other types of insurance policies, The Motley Fool has an invaluable Insurance Center. More enterprising Fools may also be interested in investing in the space, in which case there are some industry basics to cover.
The insurance biz
There are many types of insurance; the primary categories consist of life, health, and property and casualty (a.k.a. P&C insurance) that covers items such as homes, automobiles, and other types of property. In a nutshell, insurance firms generate revenue by collecting premiums and earning income by investing the capital obtained from policies sold. The primary expense consists of paying insurance claims when unfortunate events occur. Other expenses include paying commissions to agents who sell policies and the overall costs of running and maintaining insurance operations.
The tricky part of running an insurance firm is that future policyholder claims due to accidents and catastrophes are difficult to forecast. Think of the process as more art than science, as the magnitude and frequency of adverse events is highly uncertain. Additionally, the time it takes to pay a claim can vary considerably from when an accident or incident occurred. As a result, a firm has to do its best to ensure that it has build up sufficient reserves and its investments have sufficient liquidity to match when it might have to pay claims. For instance, at the end of last year Allstate (NYSE: ALL), one of the largest P&C insurers, had $118 billion in total investments on its balance sheet as insurance against multiple catastrophes hitting its covered markets.
Actuaries take care of the related number crunching to sufficiently protect policyholders against future calamities and have many categories measuring types of losses and the certainty with which they can occur. Basically, insurance companies can run into major trouble when claims exceed reserves or premiums are priced too low and do not end up covering future liabilities. To help investors discern how successfully an insurance company is operating, discussed below are some of the most common industry metrics.
Industry metrics
On the revenue side, net premiums written simply represent insurance policies sold or issued during a certain period of time, such as a quarterly or annual basis. Insurance companies don't realize new policies as revenue right away, but instead earn them over time -- generally a year. Net investment income measures how well a company earns a return from the assets it invests.
The combined ratio is one of the most important industry measures, as it helps investors discern whether an insurance company is generating an underwriting profit. A ratio under 100 means an underwriting profit, while more than 100 means a company is paying too much in claims or overspending on writing new premiums. Mathematically:
The combined ratio = loss ratio + expense ratio + dividend ratio.
The loss ratio represents how premiums are eaten up by claims and is calculated as claim losses and adjustment expenses divided by earned premiums. The expense ratio measures the extent to which premiums are used on things such as agent commissions, overhead, and marketing costs. It is calculated by dividing operating expenses by written premiums. The dividend ratio is policyholder dividends divided by earned premiums.
Other general investment metrics are also useful in the insurance space. Return on assets and return on equity measure how effective a firm is in earning returns off assets and shareholder equity on the balance sheet. The higher the better, and it's also beneficial to compare peers to see who has the most consistent track record of generating industry-leading numbers.
As one would imagine, the insurance industry is highly regulated as state and other agencies look to ensure the overall health of insurers should a major catastrophe occur and drain industry reserves. For instance, regulators measure the amount of net premiums written to statutory surplus, which is a measure of insurance operating leverage. A ratio greater than 3 to 1 is generally outside the comfort zone of regulators and ratings agencies and suggests a company is being too aggressive in writing new business. Industry watchdogs also make sure insurers are not overcharging policyholders.
A final word
So, there you have it. Insurance companies provide an invaluable service by allowing individuals to pool and share risk. But in the meantime, they must deal with the unpredictability of Mother Nature, fluctuating stock markets and interest rates, and cutthroat industry competition. The challenge is locating companies with proven abilities to profitably navigate an uncertain future.
To learn more, it's always a good idea to check out the largest firms in the industry. There's Allstate in the P&C space, and Chubb (NYSE: CB) and Progressive (NYSE: PGR) are also widely followed. AIG (NYSE: AIG) is one of the largest and most diversified insurers, as are MetLife (NYSE: MET) and Prudential (NYSE: PUK).
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Fool contributor Ryan Fuhrmann has no financial interest in any company mentioned. The Fool has an ironclad disclosure policy. Feel free to email him with feedback or to discuss any companies mentioned further.
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