Buying insurance is pretty straightforward as a customer. But for investors in their stock, insurers are among the most complex businesses you’ll find. Here are the four ratios to focus on before you buy.
1. Expense ratio
Insurance is a highly cyclical industry. Natural disasters can wreak havoc on a company’s income statement, so you have to take any one year’s financial performance with a grain of salt.
So how do you separate the well managed companies from the lemons? One figure to keep an eye on is the expense ratio. The expense ratio shows the percentage of the net earned premium (NEP) spent in the course of acquiring, writing and servicing the insurance policies.
Insurance is largely a commodity, meaning it's hard for customers to differentiate between policies. That lends itself to a more competitive industry, so the most profitable insurer is generally the one who can keep its costs low. The lower the expense ratio, the more efficient the operation.
The average expense ratio for Australian general insurers was 26.3% in the 2015 financial year. See Table 1 for how Insurance Australia Group (ASX: IAG), QBE Insurance (ASX: QBE) and Suncorp Group (ASX: SUN) compare.
|Industry 5y avg.||Industry 2015 avg.||IAG FY2015||QBE CY2014||SUN FY2015|
|*Australian general insurance operations only|
Source: KPMG General Insurance Industry Reveiw 2015
2. Loss ratio
Focusing on costs alone is pretty meaningless. Insurers usually get themselves into trouble by taking on too much risk relative to the premiums they earn.
To measure an insurer’s underwriting discipline, look at the loss ratio, which is calculated as net claims expense divided by NEP. Though the loss ratio can jump around a lot from year to year, a consistently high ratio could mean that an insurer is pricing its policies too cheaply.
The average loss ratio for Australian general insurers was 67.2% in the 2015 financial year.
3. Combined operating ratio
The combined operating ratio (or ‘combined ratio’) is arguably the most important measure of an insurer’s performance and profitability.
To calculate the combined ratio, simply add the loss ratio and the expense ratio together.
A combined ratio below 100% means an insurance company is operating at an ‘underwriting profit’ – that is, it’s making money from its insurance business, before adding the returns from investing customers’ premiums.
On the other hand, a combined ratio of more than 100% represents an ‘underwriting loss’, which means an insurer is reliant on investment income to turn a profit.
Generally, a combined ratio below 100% is a good result; a figure below 90% is exceptional. The average combined ratio for Australian general insurers was 93.5% in the 2015 financial year.
4. Insurance margin
When you pay your insurance premium, the insurer holds onto it until a claim is made. Over that time, the cash can be invested in assets, such as bonds or shares, and the investment income is retained by the insurer. Investing this 'float' sensibly is a large part of what made Warren Buffett so rich (see What's special about Warren Buffett).
By adding the investment return earned on the float to the underwriting profit, we derive the ‘insurance profit’. The insurance margin is simply the insurance profit divided by the NEP.
A high insurance margin over several years usually indicates the company is writing profitable policies and also earning good returns on its investment portfolio.
Investment income can be quite volatile, however – and, with rock bottom interest rates, has been particularly low in recent years. For all four ratios mentioned, it’s important to take several years’ results into account to see how an insurer is faring.
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