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Life Insurance

The economic characteristics of the life insurance industry don't get our blood racing. From time to time, the very best life insurance companies might provide good investment value, but in general, the investment opportunities in the sector are rarely compelling. To explain why, we look into how the industry works.

The challenging economics of the life insurance business are reflected in the industry's stock performance. Over the IO years ending August 31, 2003 , the S&P Life and Health insurance index has returned 3.6 percent on an annual basis, versus 10.1 percent annually for the S&P JOO index.

Life insurance companies offer products that allow people to protect themselves or their loved ones from catastrophic events such as death or dis­ability or to provide greater financial protection and flexibility for situations such as retirement. A life insurer pools the individual risks of many policy-holders. The life insurer then strives to earn a profit by taking in and/or earn­ing more money than it is required to eventually pay out to its policyholders.

Life Insurance Accounting

The life insurance business is chronically blighted by the complexity of its products and financial statements. A bizarre fact of the industry is that when an insurer sells a policy, it doesn't really know how to effectively price that policy because it doesn't really know how much it will eventually cost.

Despite the best efforts of a life insurer's actuaries to estimate variables such as future investment returns, policy persistency rates (the length of time that customers keep their policies), and life expectancy, it can take years before the insurance company knows whether it made money on the policy.

Financial statements for life insurers are very different from the statements of other businesses. Although the topic of how to read a life insurer's financial statements could fill its own book, for the sake of brevity (and the reader's sanity) let's stick to a conceptual overview.

On the asset side of the balance sheet are two major items: investments (the accumulated premiums and fees that an insurer builds up before having to pay out benefits to its policyholders) and deferred acquisition costs, which is the capitalized value of selling insurance or annuities policies. For firms that sell variable annuities, separate account assets, which represent the funds that variable annuity owners have invested, constitute a third important asset type. Because variable annuity owners manage their own investments, these assets are segregated and the separate account assets are offset by an equivalent amount of separate account liabilities on the opposite side of the balance sheet.

A life insurer's other liabilities basically consist of the actuarially estimated future benefits that need to be paid to the insurer's policyholders. The two main sources of revenue are (i) recurring premiums and fees and (2) any earned investment income. The two main expenses are (1) benefits and dividends paid to policyholders and (2) amortization of the deferred acquisition costs. Given how few revenue and expense lines there are, It is vital to keep track of their growth trends.

Key Drivers of Life Insurance Companies

Life insurance is a mature, slow-growth business that offers commodity products, "which are easily substituted. Beyond certain regulatory and capital re­quirements, the barriers to entry are modest. But once a firm has entered the life insurance business, it can be difficult to exit. The firm owes life insurance benefits to its customers, who may still have many years to live.

Only a few of the very largest life insurers, such as MetLife, Prudential, and John Hancock, have economic moats because of their well-recognized brands, extensive distribution systems, diverse product offerings, and established relationships with numerous corporate consumers, but these are still tenuous competitive advantages. Otherwise, this is a classic no-moat business.

Given the commodity-like products of the life insurance industry, it is next to impossible for one insurer to successfully grow—without acquisitions—above the industry's long-term annual revenue growth rate (which is little more than the nominal growth in GDP). The concept of reversion to the mean is incredibly important to such a slow-growing business. For ex­ample, the net income of a life insurer might be above or below the trend in one period, thanks to some short-term event, such as outstanding investment returns. But over time, the investment returns—hence, net income— will likely return to the mean.

Examining the mix of insurance products a company offers is critical for getting a handle on what revenue and profit growth, as "well as the risk level, is likely to be. It is especially important to be aware of how much and what types of annuity businesses a life insurer has. Annuities produce greater exposure to the equity markets, which means that life insurers "with big annuity business are riskier investments.

Life insurers operate on a thin margin between their cost of equity and their return on equity. Look for firms that consistently generate ROEs above their costs of capital. We estimate that most life insurers have costs of equity of about 10 percent to n percent, whereas the average ROE has his­torically been around 12 percent. The strongest performing company in the industry—specialty firm AFLAC—has generated a long-term ROE of about 15 percent.

Tangible book value is the other key metric in U.S. life insurer valuation, though you'll need to adjust it by excluding marked-to-market gains or losses on available-for-sale securities from shareholders' equity. This adjustment is pretty straightforward. In the IO-K, a life insurer should have a footnote that details the amount of unrealized gain or loss on its available-for-sale securities portfolio, which is included in other comprehensive income. All you need to do is subtract the gain or add the loss to shareholders' equity to arrive at a measure of tangible book value.

Tangible book value is the safest and most practical way to think about valuation for life insurers for two fundamental reasons. First, there is very little detail available on life insurers' fundamental actuarial assumptions, and it's impossible to predict the insurers' future investment returns. Second, many major life insurers have only recently become publicly traded firms, which means there is minimal historical financial data on these companies.

Hallmarks of Success for Life Insurance Companies

Life insurers can occasionally make good investments, but it's important to avoid buying into trouble. Here's what we recommend looking for:

•  Prudent premium growth rates: Generally, the best life insurers exhibit pre­
mium growth that isn't significantly above the industry average. Accord­
ing to the American Council of Life Insurers, between 1991 and 2OOI, the
average annual increase in life insurers' premium receipts was 6.1 percent.
Underpricing risk to win sales in insurance is a dangerous game.

•  ROE consistently above the cost of equity: Given the high degree of finan­
cial leverage used in life insurance, a reliably positive spread between
ROE and cost of capital is the crucial determinant of firm success in the
long run. ROE for life insurers has historically been around 10 percent
to 11 percent.

•  High credit rating: Most first-rate insurers sport AA ratings. Understand­
ably, consumers want to buy policies from firms that they expect to be
around when it comes time to collect. High-quality life insurers also have
risk-based capital levels that are generally around twice the minimum level
set by the insurer's state regulator.

•  A diverse investment portfolio and a proven risk management culture: About
90 percent of U.S. life insurance industry assets are invested in fixed in­
come securities such as corporate bonds, private placements, and mort­
gage securities. The composition and quality of the fixed income portfolio
is crucial in determining the financial strength and future earnings
prospects of a life insurer. The best insurers control their exposure to
riskier asset classes, such as below investment grade (i.e., junk) bonds.
Compare an insurer's exposure to junk bonds to that of its competitors by
looking at a ratio such as junk bonds to tangible equity or junk bonds to
total assets.

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