As a business, insurance does involve a lot of risks. It is a business where risk is transferred from many individuals or entities to an insurance company for a certain premium while the insurance company pools the risk from individual payers and redistributes it across a larger portfolio. The best part of the business is that, insurance companies receive premium in advance and pay out claims as needed at some future date resulting in huge float, which is used to generate investment income.
It's a lot like how a bank collects deposits, invests that money (through loans to other people or companies), and then repay your money at some future date when you eventually make a withdrawal. Commenting on investments in insurance stocks, Hemang Kapasi, Portfolio Manager, Equity, Sanctum Wealth Management said,
“The biggest success story in the insurance space is Berkshire Hathway where Warren Buffet used the insurance float to his advantage to invest in companies and created great value for its shareholders over years.”
Financial experts opine that, today there are four essential aspects that one needs to focus on, if one wants to taste success. These include, leveraging on strong brand strength, cost effective distribution network, innovative product launches and leverage efficient technology. Hence, investors should look for businesses possessing all the above features while investing in insurance stocks. Understanding a few key insurance ratios below would help investors to take sound decision while buying insurance stocks.
Investors should also focus on trends in persistency ratio, which indicates ratio of policies continuing to remain in force out of policies in the previous year. The persistency ratio indicates the stickiness of customers and thus revenue flows. A healthy mix of bancassurance and agent network is also a positive.
Embedded Value or EV is disclosed by companies at the end of the quarter. EV is the sum of the adjusted net worth and the discounted value of profits from enforce policies. EV will help determine if the company is richly or cheaply valued, this is just like how banks are valued in terms of price to book. Market experts say that, price to embedded value below three is considered fair valuation and anything above is rich valuation.
In case of general insurance companies, the combined ratio (claims + expenses / premiums) is the key metric reflecting the company’s underwriting performance. A combined ratio of an over 100 per cent means the cash outflows are more than the earnings. Which means lower the ratio better the returns or profitability.
While evaluating a life insurance company one should primarily focus on the growth and margins in new business premium i.e., Value of New Business (VNB) margins, which indicates how profitably new business is acquired. From the insurer business perspective, it is calculated as present value (PV) of all future profits to shareholders measured at the point of sale. Here the discount rate is based on the shareholders’ return expectation on capital.
The loss ratio of the company also measures the nature of risk undertaken, which is essential to judge the net claims on the premiums earned and the expense ratio judges the efficiency of such companies. There are other profitability ratios such as return on equity (ROE), return on net worth (RONW) and profit after tax (PAT) margin, other liquidity ratios and solvency parameters, which are also equally important.