Insurance is often described as banking without money given it engages in a risk management business model using other peoples money. In normal times, insurance companies are stodgy widow and orphan stocks returning a modest return but with a level of safety. For example, using the period of 1993-2003 (i.e. pre-bubble), the S & P Life and Health Insurance Index returned only 3.6% on an annual basis.

But, with the cheap lure of money and every CEO suddenly thinking they were high-flying traders, insurance companies got sucked into the vortex of unreasonable risk taking in the recent past. The most notable example was Manulife Financial who invested insurance premiums heavily into equities, and failed to hedge against such trading, found itself in financial trouble.

Assuming that the world gets back to normal and risk management companies actually begin to manage risk responsibly again, what should one look for when investing in insurance companies?

Insurance companies- what is its business model?

Insurance is the transfer of risk from one party to another in exchange for the payment of a premium. The premium, in turn, is invested and used to pay out future claims and to operate the insurance company.

In essence, insurance companies are engaged in two primary revenue streams: the assumption of other peoples risk in exchange for money/premiums and the management of such premiums (asset management). An insurance company makes money by making more in revenue (insurance premium sales + investment income) than expenses (premiums paid out + general operating expenses).

Heres where things get a bit bizarre. Insurance companies are guessing (albeit with some sophisticated financial modeling) whether it will make money on each policy sold. The insurance premium could be too low (i.e. the insured is riskier than they thought), the return on the premiums invested could be under its assumptions on ROI or the insured could cancel their policies too early (which, with a return of premium rider, is bad news for the insurer).  Insurance, on some preserve level,  is like taking a stab into future events.

Thus, a critical piece of an insurance companys operations is to ensure that it always has enough capital to manage all the risk it has assumed. Mismanage the risk and you end up with AIG.

Insurance companies- what are some key factors to look at?

Beside the traditional metrics of investing stocks, what are some things that all investors should look at?

1. Premium growth. In plain English, how many premiums is it selling? This is the life-blood of any insurers growth. Stop selling premiums and the company will shrink since it has expenses (premiums to pay out) without corresponding revenue other than investing income. Premium growth is so important that commissions paid are generally the largest expense after premiums paid.  Also look for sources of premium growth- ideally, an insurance company should be growth among many product lines. Most companies highlight premium growth in their discussion to the financial statements
2. Combined ratio. This tells you if the premiums are making money. This is calculated by expenses and losses/revenue from premiums. If the ratio is more than 100, the company is paying out more than it is taking in. If the ratio is less than 100, the company is making money. I noticed that most insurance companies do not disclose this ratio. It has to be calculated manually or an analysts will calculate it in a research report.
3. Investment income. In some insurance sectors, insurance premiums are close to, or are, loss leaders. Money is made mostly through investment income. Theres two factors to look at: (i) what is the total of investment income over all revenue; if it is really high, the insurance company either is not selling a lot of premiums or has become purely an asset management company addicted to trading revenue to be profitable; neither are positive developments for an investor; (ii) what is the company invested in? Hopefully, their trading strategy is prudent. Most insurance companies will disclose what they are investing in and whether they are engaging in hedging strategies.
4. Capital adequacy. Similar to a bank, an insurance company has to put aside enough money in reserves (which does not show up in earnings until the transfer of risk has expired) to pay for future claims. This is referred to as the minimum continuing capital and surplus requirements (MCCSR) by Canadian regulators. In Canada, all insurance companies should have a target ratio of 150%. This is disclosed by all insurance companies. The higher the ratio the safer the company is but too high of a ratio means either: (i) risk payout is anticipated to be quite high in the future; or (ii) the company is not expanding since it is putting so much money in reserves and not to expansion.
5. Credit rating. As a payer of policies, all insurance companies have a credit rating which reflects a third parties assessment of their ability to pay policies as they become due. The higher the credit rating the better (i.e. AAA is ideal). This is always stated by insurers.

Insurance companies- common sense factors?

Insurance companies are like banks. Who is aggressively on the street selling product? As a business dependent on attracting other peoples money, whomever has the best distribution network typically has an edge over competitors (remember how large an expense commission is in an insurance company). As a practical example, think about how many people sell Blue Cross product over Manulife/John Hancock? The latter has a much larger distribution network and a correspondingly larger market share than the former.

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