Hustle and Cash Flow

In an earlier article, we discussed understanding an insurer's balance sheet. Using Progressive (NYSE:PGR) and Mercury General (NYSE:MCY) as examples, we simplified their balance sheets. On the asset side, we basically had investments, and on the liability side we had three main sources of financing of those investments: float (policyholder money), debt (creditor money), and equity (stockholder's money).

Now, let's take a look at how the balance sheet links to the income and cash flow statement.

Capacity
Daimler Chrysler's capacity is the number of car manufacturing plants it has and how many cars those plants can produce.

An insurer's capacity is its shareholder's equity (it's technically statutory surplus, but close enough), which is simply total assets minus total liabilities. The more policies an insurer writes, the greater its risk of losses if those policies result in claims. Because losses eat into equity, an insurer can't write too much insurance or it'll risk serious impairment. For example, if an insurer writes premiums equal to 10 times its equity and ends up taking a 10% underwriting loss, then those losses would nearly wipe out its entire equity and render the insurer insolvent.

To prevent this from happening, insurance regulators generally don't allow insurers to write premiums more than three times their equity, although most insurers stay well below this limit. Thus, the equity on the balance sheet determines how much capacity it has to write insurance and collect premiums.

An insurer's balance sheet is also where it carries its investments. As mentioned earlier, an insurer uses float, debt, and equity to invest in stocks and bonds to earn investment income. Meanwhile, it must also pay interest on its debt. Putting it all together, here's how an insurer uses its balance sheet assets and liabilities to generate revenue:

From balance sheet to income
Let's use property and casualty insurer Markel (NYSE:MKL) as an example. In fiscal 2005, Markel's balance sheet showed about $1.7 billion in equity, $4.4 billion in float, and $850 million in debt, totaling roughly $6.95 billion of financing. These sources of cash were reinvested into $6.2 billion worth of investments (the difference resulting from cash and goodwill). The simplified balance sheet looks like this:

Now let's link this to the income statement. Markel used its $1.7 billion in equity as capacity to write about $2 billion in premiums, of which it earned $1.95 billion in 2005. Of that $1.95 billion in premiums earned, Markel incurred about $1.96 billion in losses (for claims and claims expenses) and operational expenses. Thus, for every $1 in premiums, Markel estimates it will ultimately pay out about $1.01 in losses and expenses -- resulting in a 1% loss per dollar of premium written. Markel paid interest on its $850 million in debt, but earned investment income on its $6.2 billion investment portfolio.

To demonstrate how this works:

To summarize, Markel pays 7.5% on its $850 million in debt, resulting in $64 million in interest payments. It also uses its $1.7 billion in equity capacity and earns $1.9 billion in premiums, on which it loses about 0.6%, or $10 million, because it wrote insurance at a slight underwriting loss. Using that $1.7 billion in equity, $850 million in debt, and $4.4 billion in float, Markel invests $6.2 billion in investments and earns 4.2%, or $260 million in investment income and realized gains. Totaling this all up equals about $186 million in pre-tax income, which is what Markel earned in 2005. After taxes, Markel earned about $150 million in net income for 2005 -- and that's a very simplified version of how balance sheet accounts flow into the income statement.

From income statement to cash flow
Linking the income statement to the cash flow statement is quite simple. Markel's $150 million in net income flows directly to operating cash flow (CFO). CFO includes this $150 million, working capital adjustments, and increases or decreases in float. Because most insurers grow their float on an annual basis, CFO is often much greater than net income.

As we can see, via net income, float, and working capital adjustments, Markel had $551 of operating cash flow to work with. The insurer then puts this cash into investments, as well as some minor outlays for capital expenditures and other activities. This resulted in a $567 million outflow of cash from investment activities (the bulk of which was used to increase Markel's investments). In CFF -- cash flow from financing activities -- insurers pay out dividends, repurchase or issue stock, and issue or redeem debt. In this case, Markel made some minor adjustments to its financing sources by buying back a small amount of stock and debt. Thus, CFO is usually where net income and float come in from the income statement. This CFO is put back to work in investments, which shows up on the balance sheet, and increases or decreases in debt and stock -- as well as dividend payments -- go through CFF, which are subtracted or added to their respective balance sheet accounts.

Hopefully, this summary provides a better understanding of how an insurer's financial statements link to each other. As you can see, insurers that have strong balance sheets and underwrite profitably can quickly reinvest that cash into more invested assets -- and thus use its increased capacity (equity) to write more premiums. And that's how disciplined insurers can easily attain double-digit returns on equity.

To read up some more on insurance:

• Understanding an Insurer's Balance Sheet
• Insurance Industry Basics: Premiums
• Insurance Industry Basics: Float
• Rounding the Second Curve- Part 2

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Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates comments, concerns, and complaints. The Motley Fool has a disclosure policy.