How to study an insurance company

Shareowner, Mar/Apr 2003 by John Bart, David Cusson, Tom Slee

Special Report

This timely study of Canada's large life insurance companies provides readers with the perspective and tools to find the insurers) that offer the best value over the next 3-5 years as consolidations or significant acquisitions occur.

The three articles included in this report, and the accompanying Stock Study Guides, were prepared by John Bart (editor and investment advisor), David Cusson (director of research and investment advisor) and Tom Slee (independent analyst). Editor

Thanks to demutualization, life insurance companies are among the most-widely-held stocks in Canada. The accompanying chart shows the relative popularity of insurers in the Low Cost Investing Program (LCIP). Note that AFLAC has been in the LCIP since 1996 and that American International Group is just being added. Also, Manulife and Great-West Lifeco recently launched competing take-over bids for Canada Life.

While U.S. and Canadian insurers write a lot of business in the other's country, please note that differences in national reporting requirements can be significant.

A few years ago the Canadian life insurance industry was a quiet investment backwater. As a matter of fact, most of the major insurers were mutual companies. Then suddenly, almost overnight it seemed, five of the largest life companies were demutualized and partially deregulated. This transformed the industry into a dynamic, high growth sector and it has never looked back.

Demutualization = The Impetus For Innovation

Following demutualization insurers can readily sell new debt and shares to help finance expansion. Now they can acquire other companies to diversify and, most important, compete with the banks on a more equal footing.

In fact, the major insurers have lost little time in branching out aggressively and developing new and different markets. Each has now developed a distinctive profile, somewhat different strategies, and an array of new products.

However, insurers continue to operate under government guidelines and the supervision of the Superintendent of Financial Institutions.

Capital Adequacy

In the final analysis, insurance companies sell integrity, assurance, comfort and a guarantee, all intangibles supported by a company's financial strength. Policyholders must be confident that an insurer can pay its claims.

Confidence is available when an insurer has:

1) substantial current assets (mainly: cash, equivalents and short-term securities) to meet ongoing needs; and,

2) sufficient equity to absorb substantial and unexpected losses such as those that occurred at the World Trade Center in New York.

The Federal Superintendent of Financial Institutions (SFI) instructs insurers on how to establish their minimum capital requirements that reflect four risk components: asset defaults;

mortality expectations;

pricing risks; and,

interest rate changes.

It is worth noting that while the SFI's capital guidelines are more than sufficient to protect the public, the major insurers try to maintain their capital at between 175% to 200% of the minimum requirements. Safety is the watchword.

Liquidity

Actuarial Reserves

Each year management makes provisions for future claims called "actuarial liabilities" which are based on assumptions about mortality, interest rates and so on. The details of these estimates are contained in the company's "Appointed Actuary's Report." The Appointed Actuary is a qualified professional retained by the company to run adequacy tests on the numbers reported to the shareholders. In addition, the Superintendent of Financial Institutions keeps an eye on things.

The typical Canadian insurer needs about $7 of equity to support every $100 of actuarial reserves.

Product Mix

At one time, life insurance companies focused on selling traditional policies like whole life, term or group insurance. Now they have diversified into more profitable money management and new products.

Profitability

The accompanying Chart shows the trend and average ROE during the last 10 years for the insurers covered in this Special Report.

Diversification

It's also important that an insurer is well diversified; otherwise overall earnings may fluctuate wildly. Generally, long-term investors like to see: (1) solid representation in defensive products like individual life that provide downside protection during poor stock markets; and, (2) retirement and savings products that can boost earnings in good times.

Segmented data are available in the profiles beginning on page 17.

Summary

The foregoing material describes some of the unique considerations associated with studying the investment merits of an insurance company.

Additional perspective on the investment merits of life insurance companies is available in the following article, "Trends in the Insurance Industry."

The third article in this Special Report uses the analysis available with the Stock Study Guide software to study the insurance companies included in the Low Cost Investing Program. A summary of our analysis is available in, "Discovering the Best Insurance Stocks Today" (beginning on page 15).