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INDUSTRY FOCUS: Insurance Companies

Presented by Lynn OstremPresident, Crow River Investment Club

Assoc. Director, NAIC Mpls/St. Paul Chapter

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Class Summary

PART ONE: How Insurance Companies Work

PART TWO: Focus on Life & Health

PART THREE: Focus on Property & Casualty

PART FOUR: Working with Industry Ratios

PART FIVE: Finding Industry Resources

PART SIX: Insurance Study Candidates – The 1st Cut

BREAK

PART SEVEN: Paring Down our Choices

And Finally… YOU GET TO CHOOSE!

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Class Materials

All class materials can be found at:

www.bivio.com/crowriver

Club Folders | Insurance Industry Study

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PART ONE

HOW INSURANCE COMPANIES WORK

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Welcome to the Wonderful World of Insurance!

●Important part of the U.S. economy

●Affects the lives of most Americans

●Maturing and saturated industry

●Understanding future drivers is key

Population is aging

Over 65 group will grow from 12% now to 20% by the year 2030

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The Game of Risk

● The Big Insurance Bet:

You say, "I bet you $300.00 that I'll die this year." The insurance company says "I'll bet you $100,000.00 you don't." (I hope they win!)

● Spread the Risk

● If we know 1 in 2000 will die

● Risk is spread among 2000 families

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Risk Diversification

Risks are:

•sickness (health insurance)

•house fires (home owner's insurance)

•physical injury (disability insurance)

•car accidents (automobile insurance)

•medical mistakes (malpractice insurance)

•bizarre incidents (casualty other)

•and even re-insurance!

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How it works

● Insurers collect premiums

● Invest those premiums

● Some earn fees on services, too

An insurer’s prosperity depends largely on its ability to quantify the ultimate cost of claims from the risks that it assumes.

● Reserves too high – Profits appear low

● Reserves too low – Profits appear inflated

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How it works

●Premiums = S ales; #1 source of revenue

●Premium Written vs. Premiums Earned

●$1,200 for a 12 month policy (written)

●$100 for 12 months (earned)

●Investment Income; 2nd source of revenue

●Realized Investment Gains; 3rd source

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Expenses

Expense components for:

L&H Insurers P&C Insurers

Commissions Commissions

Benefits--Death, Annuity, Disability, Accident & Health, & Surrender

Claims and Claims-Related Expense

Underwriting Expenses

Underwriting Expenses

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Income Statement Comparison

Industrial Company Insurance Company

Sales Premium (written or earned)

- Cost of Goods Sold - Claims/Benefits (Loss Ratio)

- GS&A Expenses - Underwriting Expenses (Expense Ratio)

= Pre-Tax Profit = Underwriting Profit (Underwriting Margin)

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Ownership Structures

●Mutual Insurance Company

Owned by policyholders

Earnings belong policyholders

Distributed as dividends or reduced premiums

Solely exists for the benefit of its policyholders

Capital is Policyholder Surplus

Aren’t required to provide financial information

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Ownership Structures

●Stock Insurance Company

Owned by shareholders

Earnings belong shareholders

Distributed as dividends

Exists to make a profit for shareholders

Capital is Shareholder Equity

Financials are disclosed to the public

Can sell stock when they need capital

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Demutualization

Demutualization occurs when a mutual company converts to a stock company

•Up Side: Access to Capital

•Down Side: Conflict of Interest

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Two Accounting Methods

●Statutory Accounting Principles (SAP)

Requires immediate expensing of all costs

Best used to gauge financial stability

Reported to policyholders & regulators

●Generally Accepted Accounting Principles (GAAP)

Attempts to match income & expenses

Best used to determine earnings growth

Reports to everybody!

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Regulation

●Governing Body: National Assoc. of Insurance Commissioners (NAIC)

●Serves 3 primary functions:

1.Monitor financial condition & claims paying ability

2.Serve as watchdogs, watching for overcharges and discrimination

3.Ensure that essential insurance coverage is readily available for all consumers

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PART TWO

Focus on Life & Health Insurance

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Life & Health Insurance Players

Types of Insurance

●Term Life

Predetermined Period

No Benefits at the End

●Whole Life

Period - Life of the Insured

Savings Component

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Life & Health Insurance Players

●1,500 L&H Insurers in the U.S. (as of 6/2004)

●Top 10 Players –

Controlled 71% of the industry’s $880.1 billion in assets

●Top 5 Players –

Controlled 52% of the industry’s assets

●Top 2 Players –

TIAA/CREF & Hartford Life controlled 37% of the industry’s assets

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PART THREE

Focus on Property & Casualty Insurance

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How the P&C Industry Works

Lines of Coverage (Per A.M. Best):

●Misc. Other 24%●Personal Auto Liability 22%●Personal Auto Physical Damage 15%●Homeowners Insurance 11%●Workers’ Comp 10%●Commercial Multi-Peril 7%●Commercial Auto 5%●Reinsurance 4%●Accident & Health 4%

100%

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How the P&C Industry Works

Catastrophic Loss– defined as an event or series of events that produce $2.5 million or more in insured losses.

●2003 – 9 catastrophes, $529 million●2002 – 25 catastrophes, $5.9 billion●2001 – 20 catastrophes, $28.1 billion

($9 billion for 9/11)

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How the P&C Industry Works

•10 largest write 28% of the premiums

•5 largest write 20%

•2 largest State Farm and Allstate write 14%

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How the P&C Industry Works

Based on A.M. Best, total assets of the P&C industry were estimated at $1.1 trillion:

●Bonds accounted for 67%●Common stocks 16%●Mortgage loans & real estate 9%●Cash and equivalents 7%●Preferred stocks 1%

100%

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PART FOUR

Working with Industry Ratios

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Ratios

•Three primary factors are important to consider when analyzing a life insurer:

•Profitability (its ability to make money),

•Liquidity (its ability to convert assets into cash to pay policyholder obligations), and

•Leverage (the extent to which the insurer uses its capital to produce business).

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Profitability

Return on Assets (ROA)

● Net Income / Avg. Total Assets

● Average for L&H is 0.4%-0.9%P&C .5%-2%

Return on Equity (ROE)

● Net Income / Avg. Shareholders’ Equity

● Average for most L&H is 9%-15%P&C 8%-18%

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Profitability

Net Investment Yield

● Net Investment Income / Average Invested Assets

● Average L&H is 4%-10%Average P&C is 4%-12%

Return on Revenues (ROR) (L&H Only)

● Net Income / Total Revenues

● Average for L&H is 2%-5%

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Profitability

Combined Ratio (P&C Only)

● Loss Ratio—Loss/Loss Adj. Expenses / Earned Premiums (+)

● Expense Ratio—Other Underwriting Expenses / Written Premiums (+)

● Dividend Ratio—Policyholders’ dividends / Earned Premiums (=) Combined Ratio!

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Profitability

Combined Ratio (P&C Only)

● 100% is break-even

● <100% - indicates a profit

● >100% - indicates a loss

1952 to 1998 – industry earned a profit in 15 out of 47 years!

1H 2003 was 99.8% (first time since 1978)

1H 2002 was 105.1%

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Liquidity

Positive Cash Flow

Current Ratio

● Total Liabilities / Total Assets

Financial Strength

● See Value Line’s Financial Strength Rating (bottom right corner)

● See S&P Stock Report Investability Quotient Percentile

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Leverage

Surplus

Minimum

Reserve Account

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Drilling Down

Other Considerations for All Insurers:

● The Profitability of Underwriting

The Rate of Premium Growth

Reinsurance

Allocation Strategy

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PART FIVE

Finding Industry Resources

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Finding Industry Information Resources

● S&P Industry Surveys/Reference Section

● Mergent’s Industry Reports

● Value Line’s Industry Page

● S&P Stock Report Sub-Industry Page

● Google Search

● Company Annual Reports/10K

● Searching NAIC Website

● Crow River Website/Research Section

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Finding Stocks for your Industry Study

● Primary—

S&P Industry Surveys

Value Line

Toolkit’s OPS Industry Feature

● Secondary--

Yahoo, MSN, Quicken, etc.

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Deciding on the Data for your Study

● Primary—

Company Financial Statements

S&P Stock Report

S&P Compustat Data Files (OPS)

Value Line Survey Page

Combination

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PART SIX

Insurance Stock Candidates

The 1st Cut

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S&P Industry Surveys

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AFL AMH DFG

MET PL LNC

L&H

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PRU SFG TMK

UCI UNM

L&H

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AFC AFG AIG

HIG HCC HMN

Multi Line

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LTR UTR

Multi Line

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ACE ALL ABK

BER CB CINF

P&C

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FNF FAF LFG

MBI OCAS ORI

P&C

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PHLY PGR RLI

SAFC SIGI STC

P&C

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XL ZNT

P&C

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RE AOC BRO

AJG HRH MMC

Reinsurance

Brokers

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AFL MET

PL SFG

That leaves us with these L&H stocks…

TMK

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Only Multi-Line stock…

AIG

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ABK

PHLY

MBI

ORI

These P&C stocks…

RLI

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BRO AJG

And, these Broker stocks…

HRH MMC

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BREAK TIME!

Please be back in your seat in

15 minutes

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PART SEVEN

Paring Down our Choices

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Our Check List:

1.Create Industry Ratio Worksheet (SCG) for side by side comparison of peers.

2.Review SSGs for quality and growth

3.Replace Assets for Sales & review long-term growth rate, R2, and Section 2B (ROA%Sales)

4.Create summary of past growth and future estimates and use it to complete the SSGs

5.Complete Stock Comparison Guides

6.Choose best candidate(s)

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Wrapping Up

Remember, your judgments are PRELIMINARY!

Next step…Order an Investor’s Packet on your stock of choice

Now the REAL work begins!

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QUESTIONS?

All Information in this seminar is available at:

www.bivio.com/crowriver

Club Folders – Insurance Industry Study

Reach Lynn at: garbagecop@foxinternet.net