It is my second time trying to valuate an insurance company. As this blogs relates my expedition in value investment, I’ll try to write down my thoughts in valuating an insurance company. This valuation is directed at Assurant.
Assurant is an insurance company with multiple segments. I like to evaluate risks and revenues by segment in any business so I’ll try to value Assurant this way.
This business segment provides debt protection administration, credit-related insurance, warranties and service contracts, and pre-funded funeral insurance.
Assurant Specialty Property
This business segment can further be split in lender-placed homeowners insurance and manufactured housing homeowners insurance and most recently speciality home insurance like flood insurance.
It provides individual health and small employer group health insurance.
Assurant Employee Benefits
Primarily provides group dental insurance, group disability insurance, and group life insurance.
Regarding insurance financials, we need to read the financial statements in a different way a normal industrial business financials would be read. You got the « premium » section and then you’ve got the « Benefit, losses and expenses » section. It looks like the « revenue » and « cost of revenue » of an industrial business but it is not really the same thing.
In the premium section of the financials, you got all the premium revenues received from insured persons or institutions. You also have the interest earned from these premiums (you pay your insurance before the accidental event occurs, example death). In the case of Assurant, they also provide services related to their insurance like loan portfolio monitoring or claim management. This revenue is also included in this section.
Benefit, losses and expenses
This relates to the actual policy holders claims in the current year, the depreciation regarding insurance portfolio or business acquisition. These two expenses are mostly uncontrollable by the insurance business expect by better managing insurers evaluation. Then comes the Underwriting expenses. These are related to commissions, fees, linked to obtaining the insurance contract. At Assurant, the commissions are calculated on net revenue from premium so they are closely linked to the net income. If the net income goes down, those fees will surely fall too. That is an interesting point.
I’m not usually a big fan of ratios but I try to value an insurance business and it seems to me that 3 ratios really are crucial in insurance company valuation.
Loss ratio : total Benefits given to insurance owners divided by the premiums paid.
This ratio should give plenty of room for expenses and should be consistent through the years if the insurance premiums charged are fairly valued.
Expense ratio : total premiums earned divided by Underwriting expense.
This ratio covers commissions and other fees for acquiring premiums compared to the premiums received. If you’ve got cost flexibility, this one should stay fairly stable over time but if you have no flexibility (vendor salary, cars, rents, etc.) this one will vary wildly through the years. I, personally, would prefer a stable ratio in valuating an insurance company.
Coverage ratio : total net premium divided by total benefit, losses and expenses.
This one gives us the profitability of the overall insurance operation. A total ratio under 100% results in a profitable business segment. Otherwise, you need other incomes to compensate the losses. In good years, it should be under 100%, in bad it can go over 100% resulting in interest covering higher expenses instead of generating profit. Do not forget that the coverage ratio does not include full revenues (related services and net interest income are not part of the regular coverage ratio) but only premiums. In Assurant financials, they utilise full revenue in the coverage ratio. I’ll remove those values from the ratio to get a clear view of the financials through the years.
As we can see, AIZ coverage of premiums is not so great. It evolves around 105 and 110 for the last 2 years. I assume Assurant priced their related services in the coverage calculation because they integrate their systems to the customer system and charge “management” prices depending on the business segment (ex: warranty claim management on products, lender-placed insurance coverage for bank loans, etc.) It lowers the coverage ratio to the 100% range.
Regarding total coverage, I think there is a major discrepancy between business segments. So I analysed the profit margin by business segment (total coverage inversed).
This clearly points out the Speciality Property as the main pretax margin driver.
Let’s analyse this segment in particular to ensure this revenue will stay stable through the following years. This segment is split in 2 major different type of insurance: Lender-placed and Owner placed.
In the financials there are lots of notes regarding pursuits and business challenge in the lender-placed segment. California state passed a law that will reduce premiums for lender-placed insurance by 30% starting October 2012. New York is considering applying the same regulation and other states are considering this regulation too. Lender placed insurance is the biggest portion of this segment (70%) and will be declining in the short future.
This segment covers special event like flood. This one is increasing slowly through the last years. It inscreases less than 5% a year but it proves it should not drop shortly.
We got to restate financials for the next years because we must assume 75% of the lender-placed speciality property will disappear linked to the regulations. So at the current share count, the TTM eps comes at 7.15. If we removes 75% of lender placed we drop down to 4.66.
At the current price, we can calculate a 14% return yearly or a P/E of 7.3. But in the previous years, AIZ purchased their own shares. They purchased deeply! Around 10% per year. If we include those purchases, here is the future profit (purchase 10% per year).
What more can we say?
I’ll get in deeper on Assurant valuation, but at these levels I think we can fairly evaluate a great margin of safety on the current share count and a HUGE one if the share purchase continues.
Disclosure : Author is long AIZ.