Insurance companies provide products that most of us need, and in doing so take many risks that we don’t want. Insurance companies are often regarded as large, relatively boring financial institutions, but in reality, they are engaged in the business of protecting others from financial damage and risk management.
- Until recently, most insurance companies were organized as mutual companies, owned by policyholders rather than external investors.
- Demutualization is the process of transforming these mutual companies into stock companies, which are now listed on major stock exchanges.
- When buying insurance stocks, there are fundamental differences in the business models of life and health insurance companies and property causal insurance companies.
Demutualization of the insurance industry
Historically, the structure of an insurance company is a mutual company, owned by policyholders, and operated only for the benefit of policyholders. On the other hand, joint-stock companies are owned by shareholders and seek to maximize shareholder returns. In recent years, many mutual companies have been converted into joint stock companies through a process called demutualization. Because mutual companies do not issue stocks to the public, only stock companies can invest in the stock market.
The insurance policy sold by the insurance company promises to pay benefits to the policyholder if an underwriting event occurs during the validity period of the policy. For life insurance, the event covered will be the death of the insured. Have homeowners insurance that could be fire, storm damage, or theft.
In exchange for insurance coverage, policyholders pay insurance premiums, which are used to make profits for the company until they are required to pay the claim.
Investment insurance company
Insurance companies have unique circumstances, which makes their analysis different from other financial institutions such as banks or lenders.
All insurance companies have a set of future liabilities, and if a qualifying event occurs, they are contractually obliged to pay these liabilities. Therefore, they must invest the premiums received in a conservative way so that they have a ready reserve of liquid assets to pay for these claims. Insurance company portfolio managers use asset-liability management (ALM) by matching assets and liabilities; instead of the more familiar asset management, which seeks to maximize returns while minimizing portfolio risks.
Therefore, the investment portfolio of insurance companies is mainly composed of fixed-income securities, such as high-quality bonds issued by the US government or AAA-rated bonds of large companies.
Generally speaking, there are generally two types of insurance companies outside the health field: life insurance and property insurance. Each has special considerations that investors should consider.
Life insurance company
When evaluating life insurance companies, it is important to know that government regulations require them to maintain an asset valuation reserve (AVR) to cushion the value of the investment portfolio or major losses in investment income. Therefore, compared with other types of financial institutions, these companies tend to have lower financial leverage at work. This brings up potential valuation problems because it means that insurance companies value assets at market value but liabilities at book value.
Actuarial Science has developed a mortality table, which is very good at determining the average maturity of life insurance claims after the death of a policyholder. The size of these liabilities is also known in advance, because the death benefit stipulated in the life insurance policy is not adjusted with inflation. Since the amount and expected duration of liabilities are well known, these companies seek to invest in a portfolio that matches the size and duration of these liabilities. The amount of excess income, or the amount of assets exceeding liabilities, is called surplus. Maximizing residual value and stability are the main goals of the life insurance portfolio. Since life insurance policies usually do not pay for benefits over many years, the portfolios of these companies often consist of high-quality bonds that mature for many years.
Life insurance companies must also consider disintermediation The risk when the policyholder withdraws the cash value from the perpetual policy (to borrow at that cash value), which leads to an increase in the liquidity requirement of the investment portfolio. This usually happens during periods of high interest rates. At the same time, high interest rates have led to a decline in insurance companies’ investment portfolios, because they invest mainly in bonds, and bond prices fall as interest rates rise. During periods of high interest rates, the combination of these factors may lead to increased return volatility and increased risk.
Some of the largest listed life insurance companies are: MetLife (MET), Prudential (PRU), Genworth Financial (GNW), Lincoln National (LNC), AXA (AXAHY:OTC) and Aegon (AEG).
Investment property and accident insurance company
Asset-liability management is also crucial for property and accidental injury companies, but the risk exposure of these companies is different from that of life insurance companies in many areas. Although the products offered are more diverse-households, cars, motorcycles, boats, liability insurance, umbrellas, floods, etc.-the duration of these liabilities is much shorter: usually each insurance is a single year or less. Therefore, the portfolios of these companies will tend to consist of high-quality bonds with maturities ranging from a few months to a year.
In addition, it may take a long time for the claim to be resolved and paid. The claim process can be controversial and can take years of litigation time before the claim is paid if it has already been paid.
Many non-life insurance policies also have inflation risks because they promise to completely replace the value of an item, even if the item is nominally more expensive due to inflation in the future. On the whole, the time and amount of liabilities are more uncertain than life insurance companies.
Property insurance companies also have an underwriting cycle or profit cycle, generally 3-5 years. During periods of fierce business competition, policy prices will be lowered to retain business and occupy market share (think of all advertisements claiming to lower the cost of auto insurance). Often, the prices of securities in the insurance company’s portfolio are below sustainable levels and cause losses when paying insurance policy claims. The company must then liquidate its portfolio assets to supplement cash flow, and the stock price may fall. Insurance companies were forced to increase policy prices, and profitability began to grow again, opening the door to new competition. Therefore, property insurance companies tend to invest in taxable bond portfolios during periods of loss, and they tend to invest in non-taxable bonds such as municipal bonds during periods of positive earnings.
Some of the largest property and casualty insurance companies that investors can list on the stock exchange are: Allstate (ALL), Progressive (PGR), Berkshire Hathaway (which owns Geico and many other insurance companies), Travelers (TRV), and Zurich ( ZURVY: OTC).
There are several ETFs that allow investors to have wider exposure to the insurance industry, including: SPDR S&P Insurance ETF (KIE); Invesco KBW Property and Casualty Insurance ETF (KBWP); And iShares American Insurance ETF (IAK).
Understanding the special environment in which insurance companies operate helps to assess whether listed insurance companies are a good investment and whether the economic environment is conducive to the profitability of these companies.
The high interest rate environment may be detrimental to life insurance companies because they face the risk of disintermediation. Property insurance companies are subject to the ebb and flow of the profit cycle. Being able to identify when the economy of these industries changes may send signals to buy or sell accordingly. Keeping in mind the duration and maturity of bonds in the portfolio of different types of insurance companies can help determine how changes in interest rates will affect each company.