In the Life Insurance array, Total Income is analogous to the sales or revenues of a standard industrial company. Total Income is the sum of an insurer’s Premium Income, Investment Income, and Other Income, all of which are also shown on the Value Line page of a life insurer.
When we talk about premium income, what we mean is premium income earned net of reinsurance fees. Insurers frequently buy reinsurance to protect themselves for losses above a certain threshold. For instance, if I were to contract for a life insurance policy this morning and then get hit by a bus this afternoon, the insurer would be responsible to pay the entire policy to my beneficiaries without having received any premium payments. Reinsurance helps to limit some of this risk, by shouldering some of the burden of an unprofitable contract in return for policy fees from the original underwriter. While this practice may reduce the profitability of contracts that reach maturity, it is an important part of the hedging process for those that do not.
Premium Income becomes earned when an insurer has been exposed to a loss. For example, MetLife (MET) operates on a calendar year reporting cycle. If the company wrote a 30-year term-life policy on January 1, 2011, one-thirtieth of the value of the contract would be reported as earned for each year of the policy.
Investment Income is the return that a life insurer receives from its investment portfolio. In order to calculate the rate of return an insurer is achieving on its portfolio, an investor can divide the Investment Income listed on the Value Line page for a given year and divide it by the total investments figure shown on the company’s balance sheet for the same year. The return a company receives on its investments is often highly correlated to stock market returns and the availability of attractive yields on fixed-rate securities, such as bonds.
The composition of the investment portfolio is also an important indicator of how consistent portfolio returns will be. A company that is highly invested in fixed maturities may return a lower rate on its investments than a company that has a lot of money tied up in equities, mortgages, real estate, and other investments, but the standard deviation on that portfolio will be lower. Some insurers are more risk-tolerant than others, and the investment portfolio is something investors should evaluate before making a commitment.
Other Income is any revenue that a life insurer derives from operations other than policies that it underwrites or earns from its investment portfolio.
Benefits & Reserves are capital that the life insurer has set aside to meet future obligations to its policyholders. Generally, amounts are payable over an extended period of time and related liabilities are calculated as the present value of future expected benefits to be paid reduced by the present value of future expected premiums. Benefits & Reserves is analogous to the cost of goods sold in an industrial company.
To calculate the operating expenses for a life insurer, Benefits & Reserves are combined with interest expenses, policyholder dividends, and other expenses. Operating income is then calculated based on the difference between Total Income and these operating expenses. When income taxes are deducted from operating income, we arrive at the Net Profit figure shown on the Value Line page.
The next figure shown in the array is Insurance in Force, which is the total value of all policies written by the company. Obviously, the larger this figure, the more insurance the company has issued.
Another important metric to look at when analyzing a life insurer is the Price to Book Value. Book Value is analogous to Shareholder Equity and is calculated by subtracting total assets by total liabilities.
Historically, life insurers have traded at a premium to their book value. However, many insurers have been trading at a discount to book value since the recent recession. The market has lost confidence in the balance sheets reported by many companies, since a large proportion of assets were written off during the financial crisis. Essentially, the likelihood of book value being reduced, due to assets being overvalued in relation to their market price, is reflected in the valuation of the stock if it is trading at a Price to Book ratio of less than 100%. A return to historical Price to Book Value ratios would signal greater investor confidence in the investment portfolios of life insurance companies.
With a greater understanding of key terminology shown in the Value Line life insurance array, and of how life insurers are valued, investors should be able to make an a educated decision as to which, if any, of these issues is a good fit for their portfolio.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.