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Financial services is, without a doubt, a sector that long term investors can’t afford to miss.
Compared to banks or asset management companies, insurance companies are, however, very unique and often seem to operate like an enigma – where nobody understands them other than the actuaries.
In this article, I’ll explain the business model of insurance companies as well as the metrics investors should focus on when they are analysing insurance stocks.
Hopefully, with this in mind, insurance can be made easy and long-term investors can benefit from buying into the best stocks in the space.
Insurance’s business model
The business model of insurance companies is actually quite straightforward. To a certain extent, it’s similar to banks.
Banks lend money to individuals or businesses at a higher interest rate utilising the deposits they take from their customers at a lower interest rate. Hence, they earn an interest rate spread.
For insurance companies, they receive insurance premiums from their customers (policyholders) and invest part of the premium to generate a return that can cover the future payouts to these policyholders (claims).
The time lag (i.e., receiving money in advance and making payments in the future) is what Warren Buffett calls “float” and is the very core of insurance business model.
Types of insurance companies
The duration of the time lag differs depending on different types of insurance products or contracts.
Broadly speaking, there are two main categories of insurance companies – property & casualty (P&C) insurance and life & health (L&H) insurance.
P&C includes insurance products, such as auto insurance and travel insurance, while L&H includes products such as critical illness and life insurance.
In general, you can see that the duration of the time lag for P&C is much shorter than that for L&H. As such, the way P&C invests is very different from how L&H invests.
For this article, I’ll use Chinese insurance players as examples and will not include AIA Group Ltd (SEHK: 1299) since it’s actually a Pan-Asian L&H insurer.
In Hong Kong, there is only one listed pure-play P&C insurance company – PICC Property & Casualty Co Ltd (SEHK: 2328) whereas there are two listed pure-play L&H insurance companies – China Life Insurance Co Ltd (SEHK: 2628) and New China Life Insurance Co Ltd (SEHK: 1336).
Besides that, there are three listed insurance groups – Ping An Insurance Group Co of China Ltd (SEHK: 2318), People’s Insurance Co Group of China Ltd (SEHK: 1339) and China Taiping Insurance Holdings Co Ltd (SEHK: 966). These operate both P&C and L&H insurance companies in China.
What should you focus on?
Generally, there are only two ways insurance companies can make money – underwriting and investing.
Insurance companies make an underwriting profit by pricing an insurance product higher than their expected future claims. It means the premium it receives, on average, is higher than the expected future payouts to policyholders.
Similarly, insurance companies make investment profit by earning a higher investment yield than the investment return they promise to the policyholders. Investment yield is rather self-explanatory so I will focus on underwriting profitability.
For P&C companies, to gauge the underwriting performance of an insurer, you can focus on the “combined ratio”.
If the ratio is below 100%, that means the insurer is making underwriting profit and vice versa. The lower the combined ratio, the better it is.
Ping An P&C’s combined ratio in 2019 was 96.4% whereas PICC P&C’s was 99.2%. For L&H companies, it’s a bit more difficult to gauge the underwriting profitability since the products are very long term (30-50 years) and are heavily dependent on the insurers’ own assumptions (mortality, morbidity, and discount rate).
We can look at their reported “value of new business” (VNB), which is basically the present value of all future profits from the new products sold by the insurer in one particular year. Based on this metric, we can compare insurers’ VNB growth to see who’s outperforming.
From 2017 to 2019, Ping An L&H’s VNB grew by 6% per annum (p.a.), which is the highest amongst its peers (China Life: -1% p.a., New China Life: -10% p.a., PICC L&H: 5% p.a., China Taiping L&H: -12% p.a.).
Insurance, albeit not sexy, is a product that is always in demand. With the ageing population in China, and as people’s awareness towards insurance protection increases, one can easily predict that insurance demand will further increase.
Looking at the peer analysis above, it’s quite obvious that Ping An Insurance has been outperforming its peers and, in my opinion, remains the top choice for long-term insurance investors.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Hong Kong contributor Alec Tseung doesn't own shares in any companies mentioned.