Page 87 - FINAL CFA II SLIDES JUNE 2019 DAY 5.2

LOS 17.f: Describe key ratios and other factors READING 17: ANALYSIS OF FINANCIAL INSTITUTIONS
to consider in analyzing an insurance company.

MODULE 17.6: INSURANCE COMPANIES

Insurance company revenues include premium income and income on float (i.e., income earned on premiums between their collection and the payment of claims).

Property and casualty (P&C) insurers differ from life and health (L&H) insurers in terms of variability of claims and contract duration.
• Claims for P&C insurers tend to be lumpier as compared to relatively stable and predictable claims for L&H insurers.
• Contract duration (i.e., policy period) is much higher for L&H insurers relative to that of P&C insurers. Regulatory requirements that focus on solvency of insurance
companies often result in different reporting standards compared to IFRS or U.S. GAAP.

P&C Insurance Companies
Premium income is usually the highest source of income for a P&C insurer. Keys to the profitability of an insurer are:
• prudence in underwriting,
• pricing of adequate premiums for bearing risk, and
• diversification of risk.
To diversify their risks, insurers often reinsure some risks. The policy period is often very short, with premiums received at the beginning of the period and invested
during the float period. Claim events (e.g., fire, accident, etc.) are clearly defined but may take a long time to emerge.
Property insurance covers specific assets against loss due to insured events. Casualty insurance (also called liability insurance) protects against a legal liability (often to
a third party) due to the occurrence of a covered event. Sometimes a policy, known as multiple peril policy, may cover both property and casualty losses occurring
during a covered event.

P&C Profitability

P&C margins are cyclical. During periods of heightened competition, price cutting to obtain new business leads to slim or negative margins (soft pricing
period). This soft pricing period leads to losses and a shrinking capital base for many insurers, who either leave the industry or stop underwriting new
policies. The resulting reduction in competition leads to a healthier pricing environment (hard pricing period), which in turn results in fatter margins. Higher
margins during the hard pricing period attract new competition, perpetuating the cycle.

Major expenses for P&C insurers include claims expense and the expense of obtaining new policy business. The cost of writing new policies depends on
whether the insurer uses a direct-to-customer model (in which case it would bear the fixed cost of staffing) or the agency model (in which case it would
pay variable commissions). Soft or hard pricing is driven by the industry’s combined ratio (total insurance expenses divided by net premiums earned).
When the ratio is low (high), it is a hard (soft) market.

For a single insurer, a combined ratio in excess of 100% indicates an underwriting loss. The combined ratio, per Statutory Accounting Practices, is the
sum of the underwriting loss ratio and the expense ratio.