Demystifying Insurance Sector – PART 1

As an investor, we all have heard about how Warren Buffett created wealth by investing in GEICO (General Insurance Company). But insurance unlike other sectors is different in terms of business model and key parameters used to analyse business.

Insurance in simple terms protects against risk. We generally take insurance against those events, if occurred can lead to huge cash outflow. We take health insurance against Health-related expenses, Life insurance against death, Motor insurance against car accidents etc. If insurance is in the business of acquiring risk, how does it make money out of it?

Insurance companies have two major sources of revenue – Premium income and Investment Income

Premium income includes premium paid by customers today to safeguard against future event and Investment income includes interest earned on premium invested. To understand better, let me quote Warren Buffett

In 2002, Berkshire Hathaway Shareholder letter, Warren Buffett explains

“To begin with, the float is money we hold but don’t own. In an insurance operation, float arises because premiums are received before losses are paid, an interval that sometimes extends over many years. During that time, the insurer invests the money. This pleasant activity typically carries with it a downside: The premiums that an insurer takes in usually do not cover the losses and expenses it eventually must pay.

That leaves it running an “underwriting loss,” which is the cost of float. An insurance business has value if its cost of float over time is less than the cost the company would otherwise incur to obtain funds. But the business is a lemon if its cost of float is higher than market rates for money.”

So now we have an idea about the business model of Insurance companies. We will move ahead with how insurance companies can be divided into two segments

  1. Life Insurance
  2. General Insurance

Life insurers offer life and related products like Term plans, participating, Non-participating, ULIP Etc. These are long-term policies ranging from years to decades. People pay premium in the initial years and there is a gap between a premium paid and when the claim is settled

General Insurers offer products like motor insurance, Fire insurance, health insurance etc. These policies are generally short-term in nature having a duration of 1 year

Going Forward, we will be discussing Life insurance in detail. Given, it is long-term in nature and has unique concepts to be understood to analyse its business

First, let me introduce different Life insurance products typically an insurer sells

  1. Term Plan/Protection – The purest form of insurance where the policyholder gets the coverage in the event of death. Premium payable compared to other products is less and has highest sum assured.  It is also a high-margin product for insurance companies
  2. Participating Products – This product is designed in such a way that Policyholder gets investment as well as protection benefits. Policyholder gets lower sum assured, but insurer shares extra return generated on its float with policyholder in the form of bonus and dividend
  3. Non-participating Products – This product also provides investment and protection benefits, however, investment return earned by the policyholder is guaranteed and also has higher sum assured compared to participating products
  4. Unit Linked Products – This product combines mutual funds and insurance in one product. This product has lowest sum assured and your premium paid is invested in units of Mutual funds. Return earned apart from the sum assured is dependent on the performance of the underlying instrument.

After understanding product portfolio, let us get acquainted with certain terms which will be required to analyse any Life insurance busines

  • Gross written premium

Insurance companies generate revenue from premium earned against policies issued during the year. Gross written premium includes –

New business premium – First-year premium or Lump sum premium and

Renewal premium – premium that is due in subsequent years

  • Annualised Premium Equivalent (APE)

As gross written premium includes single premium which a policyholder pays for a policy which may last for many years. We use APE to figure out premium of current year. It is calculated as follows

APE = sum of regular annual payments + 10% of single premium

  • Value of New Business (VNB)

There is a gap between premium received and payout made to policyholders, which can range for years. So, to get a broad picture of profitability of policies issued during the year we calculate value of new business. It is present value of profits of insurance contacts written in current year

  • Value of New Business Margin (VNB Margin)

This is a profitability metric for a life insurance business and can be perceived as net profit margin for a manufacturing business. It is calculated by multiplying value of new business and APE. Higher VNB Margins can be function of – product mix (having portfolio tilted towards high-margin products like term insurance), tenure, channel mix (towards those channels which have lower operating costs), persistency ratio etc

  • Persistency Ratio

Persistency ratio tells how many policyholders are still paying premium to the insurance company after starting the policy. For Example: – If 100 people started LIC and after two years the persistency ratio is 80% that means 80 people are still paying the premium and sticking with the company while the other 20 have stopped paying the premium. higher the number of years the policy continues, the higher the profitability.

So to summarize we understood about insurance business model and why it is different and interesting from other sectors. Then we deep-dived into life insurance products and understood terminologies specific to the industry. In next part, we will cover how to understand financial statements and valuation metrics used to value Life insurance companies. Stay connected.

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