Insurance businesses are notoriously difficult to analyse, but it’s important to understand what you’re invested in. The contracts come in all shapes and sizes, financial results are littered with jargon, and there’s a load of different performance metrics management teams want investors to watch for. But that’s where we come in.
New accounting rules called IFRS17 were recently introduced, and some of the biggest UK insurers have just released their first set of half-year results since the new measures.
Now’s a good time to look at what’s changed and discuss some key metrics we’ll be looking out for when analysing an insurance company. You might have seen some before, but others might be new.
This article isn’t personal advice. If you’re not sure an investment is right for you, seek advice. Investments and any income from them will rise and fall in value, so you could get back less than you invest. Ratios shouldn’t be looked at on their own.
New business
In traditional businesses, calculating the value of sales or revenue is just what’s been sold and at what price. However, insurance contracts are a little more complicated.
Most forms of insurance require the buyer pay premiums either upfront or over time in exchange for a payout if certain things happen – whether that’s a crashed car or annuity payments on retirement.
IFRS17 introduced a new metric to better reflect the value of new business generated over the year – insurance revenue. It’s the first thing you’ll see on the new consolidated income statements, where you’d typically see a revenue figure for traditional businesses.
The underlying calculation has a whole range of moving parts, but in practice, it reflects the value of service provided in the year.
Some insurers will still provide details on the annual premium equivalent or present value of new business premiums. These important additional metrics reflect the total value of new insurance contracts written over the period and can give us an insight into current levels of demand.
Profit
This is where the real changes start to take hold.
Operating profit is still a key metric, but the changes start to kick in when we delve into where those profits come from.
The key change is in the recognition of profit from longer-term insurance contracts (one of the reasons life insurers will see the biggest impact). Rules from before the change allowed profits to be recognised upfront, even though the premiums earned, or expenses incurred, might be paid long down the line.
Under the new regime, expected profits are stored in the balance sheet, called the Contractual Service Margin (CSM). They’re then released through the income statement over time as the benefits and services of contracts are fulfilled.
There will also be a risk adjustment set up, a buffer in case assumptions about future profit levels don’t play out. This buffer can also be released into profit if conditions are as expected.
In theory, tracking movement in the CSM + risk adjustment should be an indication of growing/falling future profits.
For general insurance, contracts are usually a year or less (think car insurance), so these changes don’t have as much of an impact. Traditional measures like the combined ratio, which measures costs versus premiums, are a quick way to see if insurance was profitable over the year (lower = more profitable).
Capital levels
With any business, it’s important to understand balance sheet strength – the most basic question being, is there enough capital to cover what the business owes?
For regulated financial companies, there are often regulatory minimum capital levels. So one of the first things to look for is how much capital the business has compared to the required level.
The solvency II coverage ratio (sometimes just called solvency ratio) is a key measure to look out for. It’ll be given as a percentage where 100% would mean capital levels are equal to the levels required by the regulator. Those required levels are minimum standards, so we’d like to see a very healthy buffer here.
Insurers generate profit through a mix of premiums and investment returns and then have to factor in insurance liabilities. That means we tend to look at being able to generate capital instead of traditional cash flow metrics. Ultimately, capital covers liabilities, pays dividends, and, in some cases, can be used for share buy-backs. As always, never assume returns are guaranteed.
Investors have some new numbers to get to grips with, but the most important takeaway is these are accounting changes only. The underlying economics of insurance business won’t change.
How to stay on top of your investments
These are some of the more accounting-heavy businesses to analyse. If you’d rather let our experts dig into some of the numbers for you, we’ve got you covered.
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