Analysing... Life insurers

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Just as there are special tools for analysing, say, mining and oil companies, the same is true of banks and insurance companies.

Life assurance companies, or broad-based companies that derive most of the revenue from writing life policies, need to be looked at in a particularly special way.

One reason for this is that their core product has a particularly long operating cycle. The duration of a life policy from the first premium being paid to the final termination of the cover or the death of an annuitant could be as much as 60 years.

A typical scenario is for premiums - the insurer's revenue line - to be paid regularly over a period of years, but for the true cost and profitability of the policy only to become apparent at a much later date.

Not only that, but to some degree these costs lie outside the company's control. It is not certain when a policyholder will die, triggering a claim or terminating an annuity. And, by the same token, it is uncertain when and in what way a pension will be drawn, or what a pension policy's stockmarket returns will be on the premiums and contributions that are invested in it.

The traditional way in which this conundrum is addressed is for profits to be calculated in terms of the surplus available in the life fund that can be transferred to the profit and loss account. These transfers have to be consistent with maintaining sufficient assets in the fund to meet potential future liabilities.

Potential liabilities

These potential liabilities are calculated by actuaries taking into account longevity data, mortality rates, previous claims experience and the extent to which any of these factors have recently departed from what had been statistically expected. Assumptions are also factored in about long-term investment returns. After these assumptions have been made, if there is something left over, it can be regarded as being owned by shareholders, and transferred to their account.

This is unsatisfactory in many ways - not least because small changes in assumptions can make a big difference at the bottom line. But there are alternatives.

One is to look at the company's so-called embedded value. This is calculated by looking at the market value of tangible shareholders' assets - mainly listed investments - and to add back a capitalised value of the surplus expected to emerge from the life fund in the future.

In some cases, an allowance is also made for the discounted present value of future new business. Adjustments can also be made for the commissions paid out to secure new business.

These can change reported numbers quite considerably.

As an investor, one can make of these calculations what one will and, arguably, it is one reason why investing in life assurance stocks is a game for professionals or industry insiders with an in-depth knowledge of the accounting technicalities. For the rest of us, it all looks rather opaque.

Analysts reckon that if a life company is selling at or near its embedded value and generating profitable new business, then its shares are probably cheap - as long as the numbers are regarded as trustworthy and the assumptions underlying them are reasonable.

But, according to Chris Hitchings, an analyst at financial sector specialist Keefe Bruyette & Wood: "Insurers have become adept at choosing a portfolio of assumptions that, while appearing plausible, show their embedded value in the best light."

Neither embedded value nor any of the other tools used by analysts is infallible, but one advantage of analysing insurance companies is that they are bound by law to file detailed returns with the insurance regulator to demonstrate their solvency. Insurance analysts earn their crust by regularly poring over the minutiae in these numbers.

Peter says

I should preface all of these comments by saying that in 25 years of active investing I have singularly failed to make money investing in insurance companies, simply because I find it hard to get a grip on how to value them.

A lot of life companies look objectively cheap at present, but this is probably because of market fears that they may be more exposed to dubious investments, than they have yet to admit to and have been compromised by the credit crunch. There are also question marks about profitability if interest rates stay relatively low. Some also worry about whether sales of profitable unit-linked products will be hit as a result of recent equity market turmoil.

As KBW's Hitchings observes: "The usual rule is that, in a bear market, life insurance shares underperform - however cheap they appear."