Page 91 - FINAL CFA II SLIDES JUNE 2019 DAY 5.2

READING 17: ANALYSIS OF FINANCIAL INSTITUTIONS

L&H Insurance Companies
Similar to P&C insurers, L&H insurers derive their revenue primarily from premiums, while investment MODULE 17.6: INSURANCE COMPANIES
income is the secondary source. Life insurance policies can be basic term-life, whereby the insurer
makes payment if death occurs during the policy period. Other types of policies may include other
investment products attached to pure life policies. Health insurance policies vary globally by the type
of coverage provided.

Primary considerations in analysis of L&H insurers include:

1. Revenue diversification. The proportion of income generated from premiums, investments, and fees can vary over time and among insurers.
While diversification is a desirable attribute, premium income tends to be more stable over time relative to other sources.

2. Earnings characteristics. An L&H insurer’s profitability reflects a number of accounting items that require judgment and estimates. Actuarial
assumptions affect the value of the future liabilities due to policyholders. Current period claim expense includes not only actual claim payments,
but also interest on the estimated liability to policyholders. L&H insurers also capitalize the cost of acquiring new and renewal policies and
amortize it based on actual and estimated future profits from that business. Therefore, estimates influence the amount that is amortized in any
given period. Estimates also affect the value of securities and, hence, investment returns (discussed in the next section). Finally, mismatches
between the valuation approaches for assets and liabilities can distort values when the interest rate environment changes.

Apart from standard ratios such as ROA, ROE, and EBIT margins, industry-specific cost ratios include:
1. total benefits paid ÷ net premiums written and deposits.
2. commissions and expenses ÷ net premiums written and deposits.
3. Investment returns. L&H insurers have a longer float period than P&C insurers, so investment returns are a key component of the insurer’s profitability.
A large portion of the investment portfolio is often long-term debt. Duration mismatch between the insurer’s assets and liabilities is an area of concern.
Similar to P&C insurers, the total investment income ratio (investment income divided by amount of invested assets) is often used to evaluate an L&H
insurer’s investment portfolio performance. Analysts often recalculate this ratio after removing unrealized gains and losses from investment income to
remove the impact of estimated fair values for some of the investment assets.
4. Liquidity. While policy surrenders can be unpredictable, the liquidity needs of L&H insurers are generally fairly predictable. Hence, keeping excess
liquidity is not as much of a concern for L&H insurers compared to P&C insurers. Analysis of liquidity for an insurer includes analyzing the insurer’s
investment portfolio. Non-investment grade bonds and equity real estate are typically relatively illiquid as compared to investment grade debt. A
liquidity measure used by Standard and Poor’s, for example, takes a ratio of adjusted investment assets to adjusted obligations. Assets are adjusted
based on their ready convertibility into cash, while obligations are adjusted based on assumptions about withdrawals. This ratio is estimated both under
normal market conditions and under stress scenarios to assess the liquidity risk for the insurer.
5. Capitalization. Similar to P&C insurers, there are no global minimum capitalization standards. Domestic regulators often do specify risk-adjusted
minimum capital requirements. Due to duration mismatches between assets and liabilities for L&H insurers, risk-adjusted capital requirements usually
incorporate interest rate risk.