For rational investors, it’s important to find industries that never go out of style in order to achieve stable and consistent high returns. Insurance, on the other hand, is one such industry.
As the second oldest industry in the history of the world, insurance has always been favored by many investment legends. Warren Buffett made his first investment profit (in 1951) in insurance stocks, and subsequently published an article “My Favorite Stocks” expressing his love for insurance stocks. Insurance stocks also became the code for Buffett’s lifetime wealth.
The Davis family, second only to Warren Buffett and second in the history of the investment world, has achieved 18,000 times the investment return in 45 years, also relying most on investment in insurance stocks.
So, how should one invest in such an industry that has achieved so many investment legends?
How to measure the fundamentals of insurance?
Insurance is an industry that specializes in risk, a special institutional arrangement that provides risk insurance to customers. According to the classification of insurance, it can be divided into personal insurance, which takes “people” as the main body of protection, and property insurance, which takes “property” as the main body of protection. Currently, life insurance accounts for 74% of the premium income, and life insurance is the main type of life insurance. In order to simplify the analysis, life insurance will be the main object of study later in this paper.
Overall, the characteristics of insurance with multiple attributes such as risk protection, consumer goods and asset allocation support the logic of long-term development of the insurance industry.
From the demand side of the current insurance market, three major factors support the long-term development of insurance.
First, the demand for protection brought by aging, in the future, as a supplement to the basic pension of commercial pension insurance and medical insurance, nursing insurance, demand space is vast.
Second, the demand for insurance consumption brought by the increase of per capita disposable income. After meeting the basic physiological needs, residents’ consumption will be extended to a higher level in Maslow’s demand theory, and security needs will become the main demand. The proportion of protection insurance mainly for pension and health care will increase significantly and become one of the most important consumption for the middle class people.
Third, the asset allocation demand brought by the change of wealth management. At present, residents’ wealth allocation is still dominated by real estate, but in the future, it will be overloaded with diversified financial products. Insurance products, as long-term stable and anti-inflationary financial products, will also benefit from the dividends of diversification of residents’ asset allocation.
Where does the value of insurance companies come from?
As a special kind of financial business, the insurance industry is subject to very strict regulation. But it is also the franchise system that allows insurance companies to accumulate a huge scale of floating deposits (i.e. premiums). In addition to enjoying the proceeds from the remainder after deducting the payout amount, insurance companies are also able to invest the premiums to earn more income, and it is this nature of insurance companies that Warren Buffett has used to achieve a lifetime of investment legends.
For the life insurance business, there are three main sources of profit, which are often referred to as the three differences in the industry: death difference, interest difference, and fee difference.
Deadweight spread is the gain or loss arising from the difference between the actual and expected benefit amounts at the maturity of the insurance contract; fee spread is the difference between the actual and expected operating and administrative expenses of the insurance company; and profit spread is the difference between the actual and expected investment income of the insurance company, which constitutes the most important profit driver of the insurance company. At the same time, premiums, especially long-term premiums, are the basis for the spread.
However, it is clear that the “three spreads” as a profit model do not explain specifically where the value of an insurance company comes from from a business perspective. For this reason, it is necessary to introduce the concept of Embedded Value (EV), which is unique to the insurance industry.
EV is a valuation value that reflects the characteristics of insurance operations, which is essentially a combination of discounted free cash flow and insurance actuarial calculations, by applying the concept of “economic value” and improving actuarial methods.
As the core of insurance company value, EVA is the most important source of endogenous growth for insurance companies. However, EV has many hidden actuarial assumptions and is often a “black box”. So we need to find the most important factors structurally affecting EV growth.
Valuation value (AV) of an insurance company = EV + new business value for the next X years (depending on market estimates)
EV = Adjusted Net Assets + Value of In-Force Business
Value of In-Force Business (VIFB) = Value of New Business (NBV) + Value of Inventory Business
NBV = new premiums x new business value ratio
Adjusted net assets” is mainly influenced by investment income and “value of in-force business” is influenced by NBV.
So, in summary, we can simply conclude that the growth of endogenous value of an insurance company comes from EV, which can be approximately understood as being influenced by the investment capacity of the insurance company (affecting investment income) and new premiums.
In other words, the new premiums and the investment income of the insurance company constitute the most important factors affecting the value of the insurance company.
If we further decompose, we can find the secret of the rapid growth of the head insurers.
New policy premium = number of agents x number of policies per capita x average premium per piece
With little difference in average piece premium, the number of agents and the number of policies per capita determine the size of new policy premiums, which in turn affects the growth of EV. Thus, we can see that both Guoshou and Ping An, which have the highest market share in China, have millions of agents.
How to value an insurance company?
After clarifying the value composition of an insurance company, we also need to give a valuation to the insurance company, which is the first step in making an investment decision. A good financial investment decision is to find those assets that are “priced below value”. In other words, investment should be “buy low, sell high”.
From a global perspective, financial institutions rarely use price-to-earnings (PE) ratios for valuation, mainly because the profits of financial institutions are highly cyclical and volatile, and PE can hardly reflect the real business situation. Net Price Ratio (PB) is a relatively more appropriate method, but lacks a measure of NBV and can undervalue insurance companies, and is also not fully applicable to insurance company valuations.
Neither PE nor PB valuation methods are applicable to life insurance companies. In order to make up for the shortcomings of both frameworks, PE and PB, in practice, have prompted the emergence of insurance company-specific valuation methods in the industry.
The first one is the PEV valuation method.
The so-called PEV model is to divide the share price per share (Price) by the EV per share, similar to the PB concept, professionally called as the embedded value multiple. Similar to PB or PE metrics, leading insurers enjoy a higher valuation premium.
However, the PEV valuation method has its limitations. For pure life insurance companies, the PEV valuation method is appropriate, but for integrated insurance groups and integrated financial groups, the lower the proportion of life insurance business, using the PEV method will undervalue the insurance company.
Therefore, for financial groups, a split valuation can be performed, such as valuing each section of its life insurance and property and casualty insurance separately for summation.
The second one is the NBV valuation method.
The NBV valuation model, also called net book value, refers to the value of new business in the coming year. For insurance companies, especially life insurance companies, the essence of this concept is to measure the growth rate of the business, which can be approximated as the PEG we introduced in the article “Late Bull Market, a more important indicator than PE”.
But unlike the PEG indicator, the higher the NBV, the better. And because of the delayed release of policy profits, NBV often becomes a leading indicator of profits: if NBV grows rapidly, it often signals a slow blooming of insurance performance; if NBV growth becomes slower, it also means that insurance performance growth slows down. This is often interpreted by the capital market as the expected growth rate of performance, and reacts to the rise or fall of the share price.
Of course, either method has its limitations, and there is never a one-size-fits-all indicator in investment.
As mentioned at the beginning of this article, “For rational investors, it is important to find sectors that never go out of style in order to achieve consistently high returns”. But it is also important to buy when the industry is expected to be undervalued or ignored by the public in order to achieve ultimate success.