Insurance

Accounting and
Finance
Lecture#3
By
Dr. Muhammad Usman
How to Rank Insurance Companies?

There are a number of ways to rank the size of insurance companies. Companies can be
measured by their market capitalization (the value of the company on a stock exchange) or by
using sales figures, such as net premiums written in a year or how many policies were sold.

Key Points

 Insurance companies are important players in the global financial economy, although
they may not be as flashy as investment banks or hedge funds.
 Insurance companies come in many sizes and specialize in different policy lines, from
health to life to property & casualty.

Market Capitalization

What is Market Capitalization?

Market capitalization refers to the total dollar market value of a company's outstanding shares of
stock. Commonly referred to as "market cap," it is calculated by multiplying the total number of
a company's outstanding shares by the current market price of one share. As an example, a
company with 10 million shares selling for $100 each would have a market cap of $1 billion. The
investment community uses this figure to determine a company's size, as opposed to using sales
or total asset figures.

Using market capitalization to show the size of a company is important because company size is
a basic determinant of various characteristics in which investors are interested, including risk. It
is also easy to calculate. A company with 20 million shares selling at $100 a share would have a
market cap of $2 billion.
Understanding Market Capitalization

Given its simplicity and effectiveness for risk assessment, market cap can be a helpful metric in
determining which stocks you are interested in, and how to diversify your portfolio with
companies of different sizes.

Key Points:

 Market capitalization refers to how much a company is worth as determined by the stock
market. It is defined as the total market value of all outstanding shares.
 To calculate a company's market cap, multiply the number of outstanding shares by the
current market value of one share.
 Companies are typically divided according to market capitalization: large-cap ($10
billion or more), mid-cap ($2 billion to $10 billion), and small-cap ($300 million to $2
billion).

Large-cap companies typically have a market capitalization of $10 billion or more. These large
companies have usually been around for a long time, and they are major players in well-
established industries. Investing in large-cap companies does not necessarily bring in huge
returns in a short period of time, but over the long run, these companies generally reward
investors with a consistent increase in share value and dividend payments. An example of a
large-cap company is International Business Machines Corp.

Mid-cap companies generally have a market capitalization of between $2 billion and $10
billion. Mid-cap companies are established companies that operate in an industry expected to
experience rapid growth. Mid-cap companies are in the process of expanding. They carry
inherently higher risk than large-cap companies because they are not as established, but they are
attractive for their growth potential. An example of a mid-cap company is Eagle Materials Inc.

Companies that have a market capitalization of between $300 million to $2 billion are generally
classified as small-cap companies. These small companies could be young in age and/or they
could serve niche markets and new industries. These companies are considered higher risk
investments due to their age, the markets they serve, and their size. Smaller companies with
fewer resources are more sensitive to economic slowdowns.
In order to make an investment decision, you may need to factor in the market cap of some
investments. For more information on market capitalization, read Understanding Small- and Big-
Cap Stocks.

Misconceptions about Market Caps

Although it is used often to describe a company, market cap does not measure the equity value of
a company. Only a thorough analysis of a company's fundamentals can do that. It is inadequate
to value a company because the market price on which it is based does not necessarily reflects
how much a piece of the business is worth. Shares are often over- or undervalued by the market,
meaning the market price determines only how much the market is willing to pay for its shares.

Although it measures the cost of buying all of a company's shares, the market cap does not
determine the amount the company would cost to acquire in a merger transaction. A better
method of calculating the price of acquiring a business outright is the enterprise value.

Changes in Market Cap

Two main factors can alter company's market cap: significant changes in the price of a stock or
when a company issues or repurchases shares. An investor who exercises a large number of
warrants can also increase the amount of shares on the market and negatively affect shareholders
in a process known as dilution.

Market Capitalization vs. Market Value: An Overview

In many areas of the financial sector, including economics, accounting, and investing, accurately
assessing the value of a company can be of utmost importance. However, numerous ways exist
to measure company size and value, and there is often confusion concerning similar-sounding
terms. Two such misleading terms are market capitalization and market value. While each is a
measure of corporate assets, the two are vastly different in their calculation and precision.
Market capitalization is basically the number of a company's shares outstanding multiplied by
the current price of a single share. Market value is more amorphous and more complicated,
assessed using numerous metrics and multiples, such as price-to-earnings, price-to-sales, and
return-on-equity.
Key Points

 While market capitalization and market value are both measures of corporate assets, the
two are vastly different in their calculation and precision.
 Market capitalization is calculated by multiplying the number of shares outstanding by
the current price of a single share.
 Market value is assessed using numerous metrics and multiples including price-to-
earnings, price-to-sales, and return-on-equity.
 Confusion often arises because, when referring to a company, market capitalization is
often used synonymously with market value—though technically, it means the market
value of its equity, not its market value overall.

Net Vs. Gross Premium Insurance

Net premiums and gross premiums are terms used to describe the income an insurance company
receives in exchange for the risks it assumes under insurance contracts. Premiums are the
amounts policyholders pay for insurance coverage to protect them against financial loss.
However, there are differences between gross premiums and net premiums.

Gross Premiums

Gross premiums are the amounts an insurance company expects to receive over the life of a
policy term. This affects the amount the policyholder will pay for coverage under the insurance
contract. For example, if a policyholder pays $1,000 for a six-month automobile insurance
policy, the gross premiums for that period are $1,000.

Net Premiums

Net premiums refer to the income an insurance company will receive for assuming risk under an
insurance contract, minus expenses associated with providing coverage under a policy. Insurance
companies commonly purchase reinsurance, which pays for claims above a certain monetary
amount. This helps protect the insurance company from having to pay for large, catastrophic
losses. The amount paid for reinsuring a policy is deducted from gross premiums.

Earned Premiums

Insurance policies that are paid under installment plans can also affect net premiums. In an
installment plan, a policyholder does not pay for the entire policy period at inception or renewal.
Instead, the policyholder makes installment payments, usually monthly or bimonthly. Net
premiums earned reflect the portion of the premiums the policyholder has already paid and for
which the insurance company has already afforded coverage.
Importance

Gross premiums and net premiums are important for the calculation of taxes owed by the
insurance company. State insurance departments typically impose taxes on income received by
insurance companies. Tax laws, however, may make allowances for gross premium reduced by
expenses or unearned premiums. For example, the Pennsylvania Department of Revenue
imposes a tax on gross premiums written by Pennsylvania insurance companies, but the tax does
not apply to amounts deducted for reinsurance. It also does not apply to gross premiums not
earned because the insurance company or policyholder canceled a policy before the expiration of
the policy term.

How to Calculate Unearned Premium

When you purchase insurance coverage paid with an annual premium, your protection is in force
for the next 12 months. The insurance company is, however, accepting payment for coverage it
has not yet earned. If you cancel your policy, you would receive this unused portion of your
premium back. From a balance sheet perspective, unearned premium revenue is, at the time of
payment, both a cash asset and a current liability. As the coverage period progresses, the
unearned premium amount reduces until, at the end of the policy, all premiums are earned.

Step 1

Collect the information needed to perform the calculations. You will need the amount of the
premium, the length of the policy and the periods of unearned premiums remaining. For an
example, use a $1,200 premium over a 12-month term, with five months remaining on the
policy.

Step 2

Divide the premium by the total number of periods in the term. Using the example, the $1,200
premium is divided by 12, giving a monthly amount of $100.

Step 3

Multiply the monthly amount by the periods remaining in the policy. In this example, $100 is
multiplied by the five months remaining, for an unearned premium amount of $500.
What Is the Main Business Model for Insurance Companies?

Insurance companies base their business models around assuming and diversifying risk. The
essential insurance model involves pooling risk from individual payers and redistributing it
across a larger portfolio. Most insurance companies generate revenue in two ways: Charging
premiums in exchange for insurance coverage, then reinvesting those premiums into other
interest-generating assets. Like all private businesses, insurance companies try to market
effectively and minimize administrative costs.

Pricing and Assuming Risk

Revenue model specifics vary among health insurance companies, property insurance
companies, and financial guarantors. The first task of any insurer, however, is to price risk and
charge a premium for assuming it.

Suppose the insurance company is offering a policy with a $100,000 conditional payout. It needs
to assess how likely a prospective buyer is to trigger the conditional payment and extend that risk
based on the length of the policy.

This is where insurance underwriting is critical. Without good underwriting, the insurance
company would charge some customers too much and others too little for assuming risk. This
could price out the least risky customers, eventually causing rates to increase even further. If a
company prices its risk effectively, it should bring in more revenue in premiums than it spends
on conditional payouts.

In a sense, an insurer's real product is insurance claims. When a customer files a claim, the
company must process it, check it for accuracy, and submit payment. This adjusting process is
necessary to filter out fraudulent claims and minimize the risk of loss to the company.
Interest Earnings and Revenue

Suppose the insurance company receives $1 million in premiums for its policies. It could hold
onto the money in cash or place it into a savings account, but that is not very efficient: At the
very least, those savings are going to be exposed to inflation risk. Instead, the company can find
safe, short-term assets to invest its funds. This generates additional interest revenue for the
company while it waits for possible payouts. Common instruments of this type include Treasury
bonds, high-grade corporate bonds, and interest-bearing cash equivalents.

Reinsurance

Some companies engage in reinsurance to reduce risk. Reinsurance is insurance that insurance
companies buy to protect themselves from excessive losses due to high exposure. Reinsurance is
an integral component of insurance companies' efforts to keep themselves solvent and to avoid
default due to payouts, and regulators mandate it for companies of a certain size and type.

For example, an insurance company may write too much hurricane insurance, based on models
that show low chances of a hurricane inflicting a geographic area. If the inconceivable did
happen with a hurricane hitting that region, considerable losses for the insurance company could
ensue. Without reinsurance taking some of the risks off the table, insurance companies could go
out of business whenever a natural disaster hits.

Regulators mandate that an insurance company must only issue a policy with a cap of 10% of its
value unless it is reinsured. Thus, reinsurance allows insurance companies to be more aggressive
in winning market share, as they can transfer risks. Additionally, reinsurance smooths out the
natural fluctuations of insurance companies, which can see significant deviations in profits and
losses.

For many insurance companies, it is like arbitrage. They charge a higher rate for insurance to
individual consumers, and then they get cheaper rates reinsuring these policies on a bulk scale.
Evaluating Insurers

By smoothing out the fluctuations of the business, reinsurance makes the entire insurance sector
more appropriate for investors.

Insurance sector companies, like any other non-financial service, are evaluated based on their
profitability, expected growth, payout, and risk. But there are also issues specific to the sector.
Since, insurance companies do not make investments in fixed assets, little depreciation and very
small capital expenditures are recorded. Also, calculating the insurer's working capital is a
challenging exercise since there are no typical working capital accounts. Analysts do not use
metrics involving firm and enterprise values; instead, they focus on equity metrics, such as price-
to-earnings (P/E) and price-to-book (P/B) ratios. Analysts perform ratio analysis by calculating
insurance-specific ratios to evaluate the companies.