This article provides an overview of the financial strategies and analysis that are a part of the insurance industry. The article provides an introduction to the financial management of insurance companies, including the definition of an insurance company, the most common types of insurers and the unique financial considerations for insurance companies. In addition, this article also provides a financial analysis of insurance companies. This analysis includes explanations of the components of insurance company income, common insurance company dividend policies and the modern development of dynamic financial analysis. Further, the investment strategies of insurance companies are described, such as the variables that are involved in investment strategies, risk management techniques and the various investment portfolios held by insurance companies. Finally, this article explains some of the most important financial considerations facing insurance companies, such as the identification of loss exposures, contractual risk control measures and the identification of security risks.
Keywords Claim; Conditions; Damages; Liability; Premium; Reinsurance; Risk; Underwriting
Actuarial Science: Financial Strategies
The central objective of insurance companies is the to eliminate certain financial risks for businesses and individuals by transferring liability for the risk from businesses and individuals to the insurance company. To limit the scope of their liability, insurance companies specify the activities and events that they will insure, and may even specify activities or events that they will not insure. Thus, insurance functions as a means by which certain known, probable or potential risks are converted from an individual or business risk to an individual or business expense in the form of insurance premiums. The premiums, or payments, that the insurance companies charge insureds and the income received from investments held by the insurance company compose the reserves from which insurance companies pay benefits to insureds who suffer losses covered by a valid insurance policy.
In addition to underwriting insurance policies, insurance companies also act as financial intermediaries in other ways. Insurance company agents now market and sell various financial products such as mutual funds, IRAs, annuities, money market funds, investment securities and tax shelters. Insurance companies also manage large sums of money in the form of employee benefit, pension, retirement and profit-sharing plans. Thus, insurance companies play an important role in today's financial world, and as a result, must be carefully managed for proper growth and profitability. The following sections provide an overview of the financial strategies and analyses that play a central role in the insurance industry.
Financial Management of Insurance Companies
Financial management involves implementing the techniques, research and analysis necessary to provide a company's management team with sufficient information to make sound financial decisions on behalf of the company. At least three kinds of financial management decisions are essential in the development of successful insurance companies: Investment decisions, financing decisions and dividend decisions.
- Investment decisions involve the most efficient use and replacement of current and fixed assets and take into account the time value of money, cash flows and the risks and returns of various investment and insurance underwriting options. Investment decisions are also referred to as capital budgeting.
- Financing decisions deal with identifying and selecting the sources of funds that will operate the insurance company and implement its various goals and projects. Financing decisions involve current liabilities, long-term debt and equity.
- Dividend decisions refer to the percentage of earnings to be paid as dividends to stockholders. These decisions are closely related to financing decisions, but are also concerned with the stability of dividends over time and the impact of periodic dividend payments on the company's net worth.
The combination of these decisions allows a company's management team to put in place the necessary changes to achieve the financial goals of the insurance company and its owners, which are often different than owners of a typical for-profit corporation. Many insurance companies are known as mutual insurance companies and are owned by policyholders, not stockholders. Regardless of the owners, a company's management team most likely has as its goal to create profit or economic surplus while sustaining a healthy level of growth and productivity for the organization. Like stock companies, insurance companies must grow at least as rapidly as inflation to maintain their profitability and service to policyholders. However, the insurance industry is governed by certain regulatory guidelines that establish certain financial requirements for insurance companies. Thus, for any type of insurance company, the goal of financial management is to maximize the surplus of policyholders while complying with regulatory guidelines.
The following sections provide a more detailed explanation of the financial management of insurance companies, including a definition of insurance companies, the most common types of insurers and unique considerations for insurance companies.
Definition of Insurance Company
Insurance companies provide a medium through which individuals and businesses may transfer an element of risk in exchange for payments, called premiums. However, to actually form and maintain an insurance company, an organization must comply with special state statutes, regulations and common-law principles that govern insurance companies and insurance law. The insurance industry is largely regulated by state laws. Each state has a state insurance department that is charged with the power to oversee and regulate insurers. These insurance departments, among other things, certify that newly formed insurers comply with special statutes governing business organization and formation; license out-of-state insurers who satisfy certain requirements to operate in the state; require the filing of detailed annual statements showing the insurer's assets, liabilities, income, losses and expenses; and supervise the general conduct of insurers. To support the administrative and regulatory costs of maintaining insurance departments, states levy premium taxes on insurers. At the federal level, Internal Revenue Service ("IRS") regulations mandate that to be taxed as an insurer, the majority of a company's business must be issuing insurance. Key elements in the definition of an insurance company are the transfer of risk and the distribution of losses.
Transfer of Risk
An insurance policy transfers some risk from the insured to the insurer. To effectuate a legally cognizable transfer of risk, there must be a binding contract between two or more parties that states the terms of the risks that are transferred between or among the parties and the consideration that supports the risk transfer. If these elements are not met, an activity that purports a transfer of risk may not fall within the scope of the definition of insurance. For instance, deposits that are made into a fund administered by another party would not constitute insurance if the insured entity was essentially paying toward its own losses because this arrangement does not involve a transfer of risk.
Distribution of Losses
The IRS also defines insurance as involving the pooling of exposure and the proportional sharing of losses. Traditional insurance companies distribute the costs of losses among a group of insureds exposed to such losses. Certain distribution arrangements are often made, however, to adjust the premiums paid by the insureds to reflect the individual losses. These arrangements are generally subject to maximum and minimum limits. Otherwise insurance companies would be acting as a type of financial organization in distributing and redistributing the flow of cash flows among insureds, and this activity would fall within the realm of banking rather than insurance. Thus, financial managers must pay careful attention to the activities of insurance companies to ensure that they continue to operate within the prescribed activities of insurers, or the companies may risk losing their tax status as insurance companies.
Types of Insurers
The legal form of organization of a company acting as an insurer is also an important factor in the financial management of insurance companies. The major types of insurers are stock companies, mutual companies and reciprocal exchanges.
Stock insurers are corporations engaged in the insurance business and owned by stockholders, who are not necessarily policyholders. The stockholders elect the board of directors, which appoints the executive officers, who in turn hire the remaining managers and personnel. The stockholders share the gains or losses from operations through stock dividends established by the board of directors as well as through ups and downs in the market value of their shares of stock.
Stock insurers write almost three-fourths of the property and liability insurance premiums written by United States private insurers. Stock property and liability insurers range from small insurers writing only one line of insurance to large insurers writing practically all kinds of insurance.
Mutual insurers are corporations owned by their policyholders. They elect the board of directors. The board of directors appoints the executive officers, who then hire the other employees. There are two types of mutual insurers: Assessment mutuals and advance premium mutuals.
Assessment mutuals operate by taking a cash deposit, or premium, from members in exchange for insurance protection. If the company's losses and expenses exceed these deposits, the company can assess members for additional monies to cover losses. On the other hand, advance premium mutuals have no legal right to assess their policyholders. Some advance premium mutuals pay dividends at the discretion of the board of directors. Most of these insurers charge more than they expect they will need and thus return some of the excess premium as dividends on a regular basis. Others pay policyholder dividends only under certain specified circumstances. Instead they set a price that is close to their expected needs and the "dividend" takes the form of a lower initial premium. Advance premium mutuals write a significant portion of the life insurance and property and liability insurance policies in force today. Many of the nation's largest insurers are advance premium mutuals.
Unlike mutual insurers, reciprocal exchanges are not corporations but are unincorporated associations that involve individuals writing insurance as individuals, not as an organized business affiliation or as joint owners. Each subscriber agrees to insure individually all of the other subscribers in the exchange and is in turn insured by each of the other subscribers. Thus, there is a "reciprocal exchange" of insurance promises. Instead of writing a separate contract for each promise, the reciprocal exchange issues one contract to each subscriber that states the nature of the association and its business protections and operations.
Reciprocal exchanges write only a small fraction of the property and liability premiums today and they seldom write life insurance policies. Many reciprocal exchanges specialize in one type of insurance, such as auto insurance, although a few do offer multiple lines of insurance. Some reciprocal exchanges are affiliated with trade associations and write insurance only for members of the association.
Unique Financial Considerations for Insurance Companies
The financial statements prepared by insurance companies differ from those prepared by other corporations for audits or tax purposes. Insurance companies have relatively few fixed assets, and most of these do not appear on the balance sheet as admitted assets. In addition, on the liabilities side of a financial statement, insurance companies utilize minimal debt, so their liabilities generally consist primarily of reserves. The equity of insurance companies is generally identified as policyholders’ surplus or, in the case of stock companies, capital and surplus.
The preparation of financial statements for insurance companies follows statutory accounting principles. These principles differ in several ways from the generally accepted accounting principles ("GAAP") used by other business entities. Most of the deviations from GAAP are due to requirements imposed by state insurance regulatory authorities or are accounting adaptations that have been created to accommodate the special characteristics of the insurance business. These special accounting principles tend to be much more conservative than GAAP.
In order to focus on a company's solvency, insurance accounting procedures apply special rules for the valuation of assets. While GAAP recognize all assets, statutory accounting principles only recognize what are called admitted assets, or assets that are readily convertible to cash. Furniture and fixtures, automobiles, premiums due over 90 days and other assets of an insurance company, which are referred to as nonadmitted assets, do not appear on the balance sheet. Unrealized capital gains or losses are recognized under the statutory system but not under GAAP.
Financial Analysis of Insurance Companies
Earning income is a major objective of all businesses that seek to attract and retain capital. This applies to all forms of insurance companies as well-stock, mutual or reciprocal. Even though these organizations do not vie for funds in capital markets in the same manner as other businesses, their ability to increase insurance operations is dependent on their earning capacity.
Thus, insurance company managers face the same decisions as stock company managers and executives. They must set growth objectives and determine how desired growth will be financed. Even if an insurance company does not increase the number of policies it underwrites, it has to expand its insuring capacity simply to provide coverage to existing policyholders as their insured assets increase in value. The following sections explain the financial analysis performed by insurance companies in pursuit of their growth and profitability objectives.
Components of Insurance Company Income
Income determination rules have a wide influence of the financial and...
Relative Valuation of U.S. Insurance Companies
57 PagesPosted: 7 Jan 2012
Date Written: December 1, 2011
This study examines the accuracy of relative valuation methods in the U.S. insurance industry, using price as a proxy for intrinsic value. The approaches differ in terms of the fundamentals used, the adjustments made to the fundamentals, the use of conditioning variables, and the selection of comparables. The primary findings are as follows: Unlike for non-financial firms, book value multiples perform relatively well in valuing insurance companies and are not dominated by earnings multiples. In fact, over the last decade book value multiples have performed significantly better than earnings multiples. That is, estimated values calculated as the product of book value and the average price-to-book ratio of comparable insurers are generally closer to price than are similarly-calculated earnings-based value estimates; Inconsistent with the practice of many insurance analysts, excluding Accumulated Other Comprehensive Income (AOCI) from book value worsens rather than improves valuation accuracy; As expected, using income before special items instead of reported income improves valuation accuracy, but, surprisingly, excluding realized investment gains and losses does not. An exception to this latter result occurred during the financial crisis, likely due to an increase in “gains trading” activities; Conditioning the price-to-book ratio on ROE significantly improves the valuation accuracy of book value multiples. In contrast, incorporating proxies for growth, earnings quality and risk does not consistently improve out-of-sample predictions, although these determinants of the price-to-book ratio generally have the expected effects and are significant; Limiting peers to the same sub-industry (as opposed to all insurance companies) improves valuation accuracy; Adjusting with respect to potentially dilutive shares improves earnings-based valuations but not book value-based valuations; As expected, valuations based on analysts’ earnings forecasts outperform those based on reported earnings or book value. However, the gap between the valuation performance of forecasted EPS and the conditional price-to-book approach was relatively small during the last decade.
Keywords: insurance, valuation, accounting
JEL Classification: G22, G12, M41, G30
Suggested Citation:Suggested Citation
Nissim, Doron, Relative Valuation of U.S. Insurance Companies (December 1, 2011). Review of Accounting Studies, Forthcoming; Columbia Business School Research Paper No. 12-3. Available at SSRN: https://ssrn.com/abstract=1980417
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