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The income statements of insurance companies differ from other industrial concerns. Instead of having “revenues,” insurers use “net premiums earned.” Net premiums earned (NPE) is the actual dollar amount that an insurer receives from its policyholders. In other words, it’s the premium the insurer receives from its customers in order to compensate it for the risk undertaken. Increases in net premiums earned are based on many factors including rate increases, new business wins, and more favorable terms and conditions. Another variable (not included on the Value Line page) is net premiums written (NPW). NPW is the dollar amount of policies that an insurer underwrites (but hasn’t necessarily received). Hence, net premiums written can be viewed as a leading indicator for net premiums earned. If the NPW/NPE ratio is greater than one, it implies that the top line is in growth mode. For example, in 2006, WR Berkley (WRB) had NPW of about $4.8 billion with NPE of under $4.7 billion, which was a precursor to a solid bottom-line improvement the following year.
Another line item that is unique to insurance companies is the combined ratio. The combined ratio is the sum of the loss and expense ratios. The loss ratio is the dollar amount of losses that an insurer incurs. Specifically, it is the claims that are filed by its customers. The expense ratio reflects general operating costs (actuarial costs, office-related expenses, support staff salaries, among others) for an insurance company. The sum of these two factors (the combined ratio) measures whether the insurance company is profitable on an underwriting basis (that the funds received from customers are less than the losses and expenses related to such policies.) In general, a combined ratio of less than 100% means that the company generates underwriting income. A combined ratio of more than 100% implies that an insurer is operating at an underwriting loss. Hence, 100% can be viewed as the “breakeven” point for underwriting results. One factor that may cause the combined ratio to exceed 100% is a large dollar amount of weather-related catastrophes (hurricanes and other natural disasters). Some companies take on riskier business (prone to higher losses) in order to boost net premiums earned, and thus increase invested assets (more on this topic below). However, such a scenario can backfire if a number of significant catastrophes occurs.
Here is an example of how the combined ratio works for Hanover Insurance Group (THG). In 2005, a period marked by Hurricane Katrina and other natural disasters the company posted a loss ratio of about 79% and an expense ratio of approximately 31%. Hence the combined ratio was 110%. The underwriting margin (1-the combined ratio) is –10%. This means that the company lost $10 on every $100 that it insured based on losses and expenses. However, in 2007, a lighter catastrophe year, the loss and expense ratios were about 64% and 33% respectively. Therefore, the combined ratio was 97% and the underwriting margin was 3%. This implies that the company made $3 in underwriting profit for ever $100 that it insured.
Another piece of the income statement is investment income. The best way to view this variable is to look at float. Float is the dollar amount of funds an insurer receives minus its immediate expenses. Investment income is important for many insurers, as, in many cases, it is their only form of income. This is the case particularly during periods of heavy losses. HCC Insurance Holdings (HCC) has posted about 15% annual growth in investment income per share over the past decade. During this time, the insurer booked an underwriting profit in only eight of those years.
Insurance companies tend to be more conservative with regard to their investment holdings. Therefore, high-quality fixed-income securities and blue chip stocks are generally the norm. Also, debt-to-total capitalization ratios are generally a moderate 35% or below, in most instances. One line item that deserves special attention is reserves. This is the “buffer” that an insurer has in place for catastrophic events. In general, we think that reserves to anticipated losses over a 12-month period should be at least 2.5 to 1. For reinsurers, who undertake the risk of primary insurers, the ratio may be greater. This is how companies can withstand catastrophic losses. For example, primary insurer Hanover (noted above) was able to make it through active hurricane seasons in 2004 and 2005, thanks to its adequately reserved position.
Sometimes, insurance companies “cede” policies to a reinsurer. In other words, if they feel that the risk of insuring the policy is too great (and the cost of reinsurance is reasonable), then they will sell (cede) to the reinsurer. The amount that a primary insurer cedes can be calculated from the difference between gross and net premiums written. Another line item worth mentioning is policy retentions. This is the dollar amount of policies that stay on a company’s books from one year to the next. In general, the higher an insurer’s policy renewal rate, the lower the expense ratio.
As mentioned earlier, reserves are a key component of an insurer’s balance sheet. It also affects profits and losses. If a company takes a reserve strengthening charge, in other words, if it underestimated losses for a particular period, then this would curtail profits. On the other hand, if an insurer releases reserves, implying that reserve levels are healthy, earnings would receive a boost. One company that has recovered sharply after several reserve additions several years back is CNA Financial (CNA). During 2001 and 2003, the company booked significant losses in order to shore-up its reserve position by writing off unprofitable policies. After “clearing the decks,” the company was able to book an underwriting profit in each year from 2006-2009.