What to Know About Insurance Company Financial Status

I recently listened to an insurance company executive give a discombobulated, “woe is me” speech to a room of agents who were largely ignorant of carriers’ financial success.

To summarize his presentation:

Insurance company investment income is down to 2 percent so companies have to make an underwriting profit. Underwriting profit was good last year, but the economy is slow, and growth is slow, so insurance companies have to watch expenses and maintain higher prices.

I have heard this same speech, sometimes it is a lecture and sometimes it is a marketing rep simply repeating what he/she has been told, so many times that I can give it. The presentation is almost always the same regardless of market conditions or carrier variance. And companies get away with their sorrow tales because agents are almost as ignorant of insurance company financial success as low-level company people.

Some carrier CEOs do not understand their own financials. This is a potent statement but readers with key experience know its truth. Given the recent Wall Street Journal articles on an insurance company whose financials are clearly suspect, one has to wonder whether all insurance department analysts understand insurance company financials adequately, too.

Here are some absolute facts based on simple math and A.M. Best and Insurance Information Institute data.

Investment Income

As taught in the first 15 minutes of Finance 101, investment income = investment portfolio x yield. I don’t think I have ever heard or read of an insurance company describe investment income as a function of anything but yield. It is as if the size of their investment portfolio never changes. It is as if they think or want to portray every insurance company as having the same size of portfolio (relative to net premiums written). That is absolutely not the case because investment portfolios relative to NPW vary from one company to another by 100 percent-plus. Here’s how it works:

If the investment portfolio is $100 million and yield is 3 percent, then: $100 million x 3 percent = $3 million in investment income.

If the investment portfolio grows, which is the case for the industry (the industry has record surplus so it stands to reason investment portfolios are growing), then investment income still increases if the yield does not decrease too much: $110 million x 2.9 percent = $3.19 million in investment income.

The carrier’s investment income increased 6.3 percent although the yield decreased 3.3 percent. In these situations, I typically hear insurance companies announce that the yield decreased by 3.3 percent, another sad year for investment income. That is just plain baloney! Yield decreasing then is really only an issue for undercapitalized and/or inadequately profitable carriers (often but not always problems that go hand in hand). For well-capitalized companies especially, marginally lower yield is just a nuisance. For example, if yield is 2 percent per the speaker’s presentation (that particular company’s yield is more than 3 percent, which is 50 percent better than stated – not a small increase so even here companies are hedging the true value of their investment income), they are making more money each year because their underwriting profits are so high and they are leaving their money in the company thereby investing their profits and growing their investment portfolio and investment income.

The best companies are making so much money on their investments and their profitability is so large that investment income is huge. Consider that in 2014, many strong companies achieved combined ratios of less than 90 percent. Companies are profitable, at the industry average combined ratio of 103 percent (20-year average). Do not ever believe a story that companies are not profitable at a 103 percent or even a 104 percent, because if companies don’t make a good profit at a 103 percent over the past 20 years, the industry would be broke rather than having record surplus.

If underwriting profit is at least 13 percentage points better than normal (which it was in 2014), some companies made absolutely huge underwriting profits. Even more, some companies made as much in investment income as underwriting profits. I don’t feel sorry for them that yields are low.

If the company executive’s presentation was accurate, these results would not be possible. This combination of great underwriting results, strong investment income, and outside capital coming in is why surplus is at a record.

Haves and Have Nots

These are all facts. What is missing is the distinction between the haves and have nots. According to an A.M. Best special report (March 30, 2015), 30 percent of all carriers, by their own admission, have 0 percent excess surplus. For some companies I am not convinced their reported capital adequacy is quite as strong as their scores suggest. For example, a major source of capital for one carrier, per A.M. Best, is the capital contribution every new policyholder makes. But I have done E&O audits for agents representing this carrier and any notification the insureds get regarding this capital contribution is so buried that agents selling the product don’t often understand it, much less the insureds.

So if a capital call occurs, what happens versus a company that has cash in the bank with which to pay for a catastrophe? I am sure the regulators and rating companies have insights I do not have on these kinds of situations, including those where companies reinsure themselves. Somehow this makes sense but on the surface, it makes me wonder.

I find inadequately capitalized companies (relative to their competitors – not necessarily solvency standards) want agents and employees to believe their profitability/surplus issues are shared by all carriers. That is clearly not the case by any intelligent measure. This means that they don’t have capacity to cut rates in a soft market as much as their competition. They may not have capacity to increase writings. They may not provide the support agents need. They are at a significant competitive disadvantage and obviously, no executive wants outsiders or even most insiders to understand the disadvantage exists. That is one aspect. However, some top executives have been drinking the Kool-Aid so long they have lost track of their true financial position. I have had conversations with company executives where I have had to cite their own filings because they have been so out of touch.

Already moderately capitalized or inadequately capitalized (from a competitive perspective), they have another potential problem: when interest rates increase, the value of their investment portfolio may decrease thereby cutting their surplus and ability to write business.

Many relatively new companies that might have had reinsurance issues now reinsure themselves. Frequently some affiliated reinsurer provides 100 percent or nearly 100 percent of the primary insurer’s reinsurance but the affiliated reinsurer is dependent on the primary company for cash flow, which then provides the capital for the reinsurance policy. I have never understood how reinsuring yourself is true reinsurance especially if the reinsurer needs the insured’s profits with which to reinsure. Beyond the capital double counting issue, there does not seem to be much spread of risk. There’s only one insured so it seems concentration of risk is as high as possible.

I am not seeing agents and others making a distinction between this scenario and an insurance company purchasing reinsurance from A+ rated, completely separate reinsurance carriers either. Instead, I hear people say, “They’re (We’re) reinsured so nothing to worry about!” Being that their affiliated companies are often on islands, the phrase, “Don’t worry, be happy” comes to mind.

Reinsurance Is Not Generic

Reinsurance, much less the specific treaties, is not generic. An obvious statement clearly not understood by some important people. Maybe a large hurricane will teach this lesson but I worry about the insureds who may pay the price. If this happens, the entire industry will suffer. The call for federal regulation will escalate possibly past the tipping point. The industry has been lucky that no major hurricane has hit an insured area in 10 years, the longest period in modern history.

This industry, by companies’ own admissions and by simple review, is an industry of haves and have nots. Understanding which is which, understanding just how profitable the haves are and how marginally profitable/capitalized the have nots are creates a true competitive advantage. Knowledge truly is power and knowledge in this case involves looking far past the simple letter grades. And at the next “woe is me” carrier presentation, listen between the lines.