I read a few Berkshire and Marcellus newsletters to deepen my understanding of non-life insurance. Below are the key factors that one should analyze. I have applied them to two listed private non-life Indian insurers: ICICI Lombard and Star Health
๐ญ. ๐๐น๐ผ๐ฎ๐ = investment assets accumulated over time
Insurers receive premiums upfront and pay claims later. This leaves them holding money, which Buffet call “float”. Meanwhile, insurers get to invest this float (in turn called โinvestment assetsโ on the BS) to generate interest income
IL: 40,000 Cr float; 21,000 Cr gross premium i.e. float accumulated is 2x premium
SH: 12,000 Cr float, 12,000 Cr gross premium i.e. float 1x premium
Moreover, over the last 5 years SH has partly relied on external capital to grow float
๐ฎ. ๐๐ผ๐๐ ๐ผ๐ณ ๐ณ๐น๐ผ๐ฎ๐ = underwriting loss/float
If premiums exceed expenses and eventual claim payments, insurers register an underwriting profit i.e. they get paid to acquire float. Underwriting loss on the other hand is the cost of float. Quoting Buffet โan insurance business has value if its cost of float overtime is less than the cost the company would otherwise incur to obtain funds. But the business is a lemon if its cost of float is higher than market rates for moneyโ
Pre-COVID 5 year avg IL: 2%, SH -2%
i.e. SH was paid 2% to acquire float. Since SH is almost exclusively into retail health, which has higher premiums leading to lower claims ratio (but higher expense than IL) resulting in overall higher UW profitability pre-COVID
๐ฏ. ๐ฅ๐ฒ๐๐๐ฟ๐ป ๐ผ๐ป ๐ณ๐น๐ผ๐ฎ๐ = investment yield – cost of float
The underlying profit/loss adds to the investment income produced from the float
Pre-COVID 5 year avg IL: 8.5%-2%=6.5%, SH: 7%-(-2%)=9%
Negative cost of float has yielded better return on float for SH
๐ฐ. ๐๐ป๐๐ฒ๐๐๐บ๐ฒ๐ป๐ ๐๐ฒ๐๐ฒ๐ฟ๐ฎ๐ด๐ฒ = investment assets/book equity
The investment assets or float generated per unit of equity is called leverage. Pre-COVID avg IL: 3.5x, SH: 2.2x. IL has been able to drive a higher leverage. Why?
๐ฑ. ๐ฅ๐ฒ๐๐๐ฟ๐ป ๐ผ๐ป ๐๐พ๐๐ถ๐๐ = posttax return on float * leverage
Insurers with high ROE (>> COE) over extended periods of time generate a lot of shareholder value
Pre-COVID avg IL: 17%(=6.5%*3.5* 1-tax%), SH: 15%
Remember, expenses are upfront, claim payments come over a period. Since, IL has higher claims ratio, but lower expense ratio, it has done better in retaining float for longer resulting in higher leverage and in turn slightly better ROE
IL and SH are currently trading over 6, 7x BV resp. For valuing a non-life insurance firm, one needs to project the long-term outlook of all these factors. I have valued both of them. Valuation summary in another post.
What are your thoughts on non-life insurance businesses and their valuations?ย
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