Transcript

Asim (00:13)
Hi and welcome to the What’s New at CFI podcast. I’m Asim Khan and I’m joined today by our Chief Content Officer Scott Powell. He’s also our co -founder. Scott, welcome to the podcast.

Scott (00:23)
Thanks, Asim. I’m pleased to be here.

Asim (00:26)
It’s great to have you, and recently, you’ve published a course on reading and analyzing insurance company financials. Could you tell us, I mean these are kind of complicated for most people, so why is that and how do these differ from say financials that we’ve looked at in the past, like for industrials or even for say banks?

Scott (00:48)
Yeah, it’s great. So one of the things that I’m glad you raised the banks, because we actually have a course on reading and analyzing bank financial statements. And it’s because the whole way a bank makes money is different. The bank makes money off its balance sheet and the layout of the balance sheet is very different than an industrial company. And we go right down to the very beginning and say, let’s just make sure we’re comfortable with how the balance sheet is laid out, how the income statement is laid out and so on. Now, banks are tough. I’m going to tell you, insurance companies are tougher. And so,

we’ve had learners reach out multiple times and I’ve had the privilege of working with several insurance companies over my career. And, in fact, often, I was teaching employees within the insurance companies who had difficulty reading their own financial statements. So one of the things you want to think about is that the financial statements need to reflect the reality, the operational reality of the business. So I’m going to start very high level. This is probably going to come, check out our course, I’ll explain why, but…

We don’t distinguish current and non-current assets ever on insurance company or current and non-current liabilities. It just doesn’t make sense. The other thing is that the asset side of the balance sheet is going to be dwarfed, literally dwarfed by the investments. So, typically investments make up around 85% of all assets of insurance company. And the bulk of those assets are almost always fixed income securities. And I mean, sorry, I’m going into teaching mode, but…

That’s just to begin with. But then you’re going to see things on the face of the balance sheet that you’ll never see anywhere else, like something called deferred acquisition costs and unearned premiums. And so what I wanted to do is demystify all this jargon and turn it into plain English.

Asim (02:14)
Thanks.

Scott (02:31)
Sorry, I’m stopping because I’ll let you ask questions because I could just keep going.

Asim (02:35)
No, I mean please, this is all kind of stuff I’m getting pretty much for the first time. So assets, sure, in insurance companies they take their premiums and then they buy fixed income securities and try and match assets to contingent liabilities somewhere down the road, right? But first I have to ask you, the insurance companies that we’re talking about, are these kind of…

I don’t know, is it like a all -state or is it farmers? Is it what AFLAC? What sort of insurance company is this?

Scott (03:10)
Great question. So the first thing I’m going to say is that another difference on that balance sheet is the cheapest source of funding for an insurance company is its policyholders. And so one of the things you want to think about a typical industrial company, we talked about whack and debt and equity, but Warren Buffett, I’m going to not paraphrase him correctly, but one way you can think about an insurance company,

is it’s the cheapest way to fund an asset management company. Or insurance companies are just asset management companies with a cheap source of funding, which is we pay premiums and the insurance company uses that to make returns on investments.

And we call that the float. There’s even jargon around that, which is called the float.

Asim (03:59)
Which is the spread between basically low cost premium and whatever you’re earning on the portfolio.

Scott (04:02)
Yeah, it’s basically, yeah, so you have to pay premium, you have to pay claims, right? You’re paying your premiums, but between, think about this, you get the premiums upfront, the claims you always pay later. And so what do you do with that money? Great, it’s free money. And so we have to pay the claim. So we use that money to invest. Obviously we need to invest it so we have enough money to pay the claims, but we can also earn a return for our shareholders.

Now you mentioned types of insurance. There are many types of insurance. There’s life insurance. There’s health insurance. We talked about at a high level different types of insurance, but we try to focus on what we call PNC or property and casualty insurance. In some parts of the world, we just call that general insurance. But even then, see there’s synonyms. General insurance and PNC are being the exact same thing. It just is, especially in North America, we tend to call it PNC.

In other English speaking countries like the UK, you might hear it called general insurance. But that’s things like car insurance, home insurance. And because typically those insurance policies a year, we decided to focus on those type of insurance companies because generally they’re the easiest to understand. Because between the premium and when you have to pay out, if we have a car accident and we’ve been paying premiums, we’re going to claim that as soon as possible. We’re not going to wait five years, right?

Asim (05:23)
Yeah.

Scott (05:23)
Life insurance is different because the claim could be 50 years from the time we’re paying the premium. So we focus and you ask companies, it was really important for me that people can navigate a real annual reporter 10K. So we actually look at two U .S. insurers. In fact, you named one of them by maybe by accident. We look at progressive insurance in all state and then we look at one insurer that reports under IFRS. In fact, it’s the largest PNC insurer in Canada and a large one in the UK called intact insurance.

Asim (05:44)
Mm-hmm.

Scott (05:53)
And we also show how it’s differently laid out if you’re looking under US GAAP or IFRS.

Asim (06:00)
So, okay, let’s just go back to the basic format of the income statement balance sheet, say. What’s unique in insurance company financials in that sense?

Scott (06:14)
Yeah, so the good news is there’s an accounting concept that if you’ve done our accounting fund in months, you know, and that is we have to record our revenue when we earn it, not when we receive the payment. Key thing about insurance is it’s like an airline ticket. We pay upfront, but we actually don’t get delivery of the service. We get it over time. So let’s imagine I pay you, you’re an insurance company. I’ll say, I pay you a thousand dollars for my car insurance. You can’t actually claim that as revenue.

But every month, or actually, we typically do it on a daily basis, every day that goes by, you get a bit of earned revenue because you’re delivering the service, which is, in this case, insurance coverage. So, by the end of the 12 months of coverage, that premium is entirely earned. And there’s some jargon in insurance. We call it risk and premium versus earn premium. Written premium is we wrote a policy for a thousand.

The earned premium is what we can record now. So maybe it’s two months in and we take the 1000, we divide it by 12 and multiply it by two. We would actually take that unearned premium and record it as our revenue, but we don’t call it revenue. You’ll see a line item typically called earned premium.

Asim (07:30)
Earned premium and then the balance sheet side what’s different.

Scott (07:35)
Yeah, so other thing is we have to, you know, we talk about expenses and income when we earn or incur them. The other thing that’s common insurance is insurance companies sometimes sell directly to consumers, but often they go through brokers and they have to pay brokers a commission. And that commission could be 10%. And what we have to do with that commission as well is we have to record it when we, it’s, we don’t record it when we pay it. We also have to expense it over time of the policy.

And so what that leads to is two things on the balance sheet, because you asked about the balance sheet. We have our unearned premiums that are sitting there. They’re ones we’ve written, but we haven’t earned because we haven’t provided coverage yet. But we also have something called deferred acquisition costs. And that’s a lot of jargon. That’s just basically broker commissions that we actually paid but haven’t expensed yet. So, you can think of deferred acquisition costs as a prepaid expense. In fact, that’s kind of, that’s the best way to think about it. So you,

when you see these items, you kind of go, what are they? Because they’re material. They’re actually quite large. And so we demystify that in the course.

Asim (08:40)
Okay, so, well, going back to the income statement for a sec. So, that unearned premium is pretty much synonymous with unearned revenue for an industry. Cool. Okay. And then the deferred acquisition cost, what, at the business level, what is that? Like some insurance guy hounds you and manages to sell you life insurance for some amount. He gets his commission check, not right away, but he kind of gets it.

Scott (08:51)
You got it.

Yeah.

Asim (09:10)
Over time, right?

Scott (09:10)
Close enough. No, he gets, yeah, close enough. Like, I mean, there might be 30 days, but he’s going to say, hey, I’ll state, I sold a policy on your behalf, you owe me 10%. And, you know, 30 days later, they get it. But.

Asim (09:20)
Yeah.

And then they expense it out over time? Is that what?

Scott (09:25)
Yeah, so what happens as soon as all state or progressive pay it, then it becomes a deferred acquisition cost. So I’m going to do some, we even in the course do some basic debits and credits just so you see what’s happening. So the cash goes down. So we’re crediting cash, but we have to debit something and we’re debiting a prepaid expense. Cause we paid the broker for the full year when they only actually earn one month of it. Cause there’s only one month of coverage so far and so on.

Asim (09:36)
Mm.

Mm-hmm.

Right, right. And so there’s a negative cash flow impact right away, but over the long term, I guess, Juan, I guess it’s obvious the insurance company makes so much off of that premium stream, right, that it’s able to overcome that initial cash hit.

Scott (10:03)
Yes.

You got it. Because what are you going to do with the rest of it? We’re going to pay that, let’s say it’s a thousand, we take that 10 % immediately, we’re going to throw it into investments. We don’t want it sitting in cash. We need it earning a return for us. Right? The biggest three expenses also, these aren’t going to be a surprise, but you’ll always see them on the income statement. The three biggest expenses are going to be your claims expense. Hopefully, that’s obvious. The second biggest one typically is your broker costs, which are your acquisition costs. And then there’s typically a

Asim (10:16)
Right.

Yeah.

Scott (10:34)
catch-all category called underwrite other underwriting expenses. You don’t need to set the person up on the system. You know, it’s all the things that are still related to that policy.

Asim (10:43)
Yeah, yeah, that salesman needs a desk and a phone and some office and all that kind of stuff. Are there any, and I guess we could wrap on this note, are there, you know, we have all sorts of ratios when we’re looking at industrials, for instance. Are there any metrics that are key to the measuring of performance in insurance?

Scott (10:47)
Yeah.

So you’ve just asked me my favorite question because, in fact, we go through all the unique ratios for insurance companies, and we actually create an insurance company pyramid of ratios. So, if you know the basic pyramid ratios, which is the DuPont pyramid, that won’t work for an insurance company. But we show you how you can go from return on equity right down to the ground level and figure out what’s going on with ROE and what are the drivers. And I show you, for example, with progressive how you can actually use that. We calculate the ratios

and we see ROE drop in one year and we use that pyramid and we explore what’s causing it and the pyramid helps you diagnose what’s happened either to create overperformance or underperformance. So I’m glad you asked that question. It’s one of my favorite parts of the course.

Asim (11:49)
And what can you just, for the sake of color, what are a couple of these ratios, like some of the more important ones?

Scott (11:57)
Yeah, especially for property and casualty insurance, there’s something called the combined ratio. And we just want to see how good they are at underwriting. So we basically say, what are the earned premiums? And how much did it get cost to get those premiums? You can think of claims and broker costs as like cost of goods sold. And when you net those off, you want to have a positive number, but typically it’s very close to a hundred percent. So we’re not talking about gross profit. You typically get very close to zero.

Asim (12:15)
Mm-hmm. Okay.

Scott (12:27)
The next line item after that is actually investment income. And that’s where the returns are made. Remember I keep saying, you think about an insurance company as an asset management company, you can break even on the underwriting and make your returns on the investments. So combined ratio, and then we also, because there’s a lot of preferred stock and often things like non-controlling interest,

Asim (12:27)
Hmm.

Scott (12:54)
When you calculate return on equity for an insurance company, it’s important that you do return on common equity, excluding non -non-controlling interest and preferred shares because preferred shares are so common with insurance companies. I can keep going, but there’s way too many ratios to talk about. Big one is combined ratio.

Asim (13:09)
Yeah. So I’ll just ask a geeky question then because you mentioned preferred shares. I don’t know the answer, so it’s not rhetorical. Do preferred shares common because by regulation, insurance companies are supposed to have a certain capital buffer, so they’re using these sort of mezzanine instruments to get there?

Scott (13:29)
You hit the nail on the head. So like banks, they’re regulated. Here’s the bad news. There’s not global standards for insurance company regulations, so they’re done at the national level. So one of the things that is under with banks, what’s really great is everyone’s following for the most part Basel 3. We don’t have an equivalent of Basel 3 for insurance, but they are regulated at a national level. But the regulations in the UK versus the EU versus the US.

Although similar intent are going to actually be executed differently.

Asim (14:05)
Interesting. That’s a whole different field, right? From…

Scott (14:08)
Yeah.

Asim (14:09)
It’s a thing of a thing all its own. Scott, thank you so much for your time and encourage people in the field or who want to make a change into the insurance field. I mean, it’s kind of hot right now. Warren Buffett bought a whole bunch of chub shares. So I think there are a lot of people out there looking at insurance companies. So, you know, I thought with respect to this course, I wanted, I’d like to know what intrigued Buffett? Why did he make this huge bunch of chub shares? So you can take, one can take this course,

Scott (14:14)
Yeah.

Asim (14:40)
and armed with that make these investigations. So, thank you so much, Scott.

Scott (14:43)
My pleasure.