How do insurance companies make money? We all think that the premiums that we pay every month are how most insurance companies make money. Insurance companies make money on their investment portfolios, and the big question is, how do we measure that performance to determine a company worth our investment?
Everyone is aware of Warren Buffett and his legendary performance as an investor, and he has used Berkshire Hathaway and their insurance float as a means for his investing funds.
Unlike most insurance companies, Buffett has been investing those funds in stocks, and his prowess has earned his shareholders an immense amount of money.
My goal with this post is to help illuminate how insurance companies make money, as well as how we can measure this performance and what investments they are making.
Insurance companies won’t double in a day, but they can make value investors like us wealthy over the long haul. High-quality insurance companies can generate incredible long-term returns from a business that dates back to antiquity.
As we have seen with my articles on the insurance industry, the insurance companies have a language of their own; this article is another attempt to help demystify that language.
What Investments do Insurance Companies Make?
Insurance companies invest in many areas, but mainly they invest in bonds. Yes, you read that right; they invest in bonds. Investing in bonds makes sense because bonds are likely the safest of all investment categories.
Insurance companies, being in risk management, would logically find the lowest risk that bonds offer as very appealing. But this is not the only reason.
Insurance companies like MetLife could easily take their premiums and stick them in a savings account and call it a day. But that wouldn’t be very good idea, and there are other ways to invest that money to make more money.
Investing the premiums does do two good things: it increases the insurance company’s profits and makes it possible for the company to lower its premium amounts, making its policies more attractive to customers.
Insurance companies could invest in the stock market, and they do, but investing in the stock market alone would be too risky because it’s a cyclical market that swings from high bull market returns to considerable bear market losses.
An insurance company has to know with a high degree of certainty that overall, in any given year, they’re not going to absorb an unsustainable loss; therefore, stocks can only represent a relatively small portion of their investment portfolios.
For life insurance companies, stock market investments represent around 5 percent of total holdings. Property and casualty insurance companies usually invest around 30 percent of holdings in common stocks.
The appeal of bonds is that they provide a much more predictable future cash flow, but also investment-grade bonds return markedly less on average than the long-term return of the stock market.
In 1928, $100 invested in the stock market would have grown to more than $320,000; the same amount invested in investment-grade and Treasury bonds would have grown to $7,000.
By investing only a portion of their premiums in the riskier stock market, they still participate to some extent in its higher returns, but without assuming the full risk of the stock market’s volatility.
But there’s one more reason for insurance companies to invest in both stocks and bonds rather than bonds alone: the two investment classes are only weakly correlated. They tend to rise and fall somewhat loosely together, but not exactly. Nevertheless, there is some correlation.
An ideal third investment choice for insurance companies would be another relatively low risk that’s uncorrelated – in other words, an investment whose returns are independent.
Investment in the mortgage market, which is relatively uncorrelated, accomplishes just that. The life insurance sector of the insurance market invests about 15 percent of its premiums in mortgages and first liens. These three asset classes – bonds, stocks, and mortgage instruments – comprise about 90 percent of investments for life insurance companies and over 80 percent of investments for property and casualty insurers.
The fourth-largest asset class consists of highly liquid short-term investments and cash, totaling about 5 percent of investments for life insurers and about 10 percent for insurers in the somewhat more volatile property and casualty business.
Returning to the bond section of the investment portfolio, the U.S. insurance industry’s $400 billion exposure to the financial sector’s long-term corporate bond debt as of Dec. 31, 2011.
The three major categories within the financial sector are banking, finance, and insurance. Life insurance companies hold the majority of the U.S. insurance industry’s financial sector exposure at 75.4%, or $302 billion, followed by property/casualty (P/C) companies at 19.8%, or $79 billion.
The insurance industry held 21.8% of all corporate bonds as of 2011. As a percentage of the corporate bonds, the property & casualty had larger exposures than the life insurance companies.
Where do I Find What Investments Insurance Companies Make?
When diving into this section of our learning, we are going to look at two different documents.
We will find both of these in our sec.gov section, and the first is the 13F, and the second being our favorite 10-k.
Let’s dive into the 13F first as we haven’t discussed this one before.
According to Investopedia:
“SEC Form 13F is a quarterly report that is filed by institutional investment managers with at least $100 million in equity assets under management. It discloses their U.S. equity holdings to the Securities and Exchange Commission (SEC) and provides insights into what the smart money is doing.”
The beauty of this filing is that you can get some great insight into what the “smart” money is doing with their investments. It is a great way to discover new investment ideas as well as see which companies your gurus are buying.
This 13F filing can be used with individual investors as well, such as Warren Buffet. If you look at the SEC filings for Berkshire Hathaway, you will discover what Buffett is currently holding, as well as recent purchases.
In these filings, you will find the number of shares they have purchased, plus you can determine which price they bought their companies.
One downside to these filings is they are at least 45 days behind the most recent purchase, which means you might not be able to buy Buffett’s latest company at the same price he purchased it.
For now, that is most of the relevant information that we need to look a little deeper at a 13F filing; we will discuss this much more in-depth in the future.
Let’s dive into one of these forms for a life insurance company to determine which securities they may be buying.
First up, let’s look at MetLife (MET), a life insurance company that has a great track record and has been around for quite some time.
As we can see now, MetLife has some investments in securities, but their holdings are quite limited. If you want to determine the price that they paid for a company, we look at the value in column 4; then we divide that by the shares illustrated in column 5.
For example, Avaya Holdings:
Value = 3307 X $1000
Shares = 277,630
Avaya Holdings = 3,307,000 / 277,630
Avaya Holdings equals $11.91 per share at purchase, and if we compare this to the current price of $12.36, we see that MetLife has made some money on this purchase, about 3.37% to be precise.
That was interesting, let’s take a look at another, shall we?
How about Principal Financial Group (PFG), another life insurer.
Their 13F-HR is quite a bit more extensive I can’t fit it all on this sheet, I will show you a snippet of theirs and include a link for you to go directly there to investigate further if you wish.
You can see in their 13F they have invested in some pretty big names, such as 3M, Abbot Labs, and Abbvie.
Respective prices paid for them when purchased:
- 3M – $173.34
- Abbot Labs – $84.10
- Abbvie – $72.72
Current prices for all three are respectively, 3M is $170.09, Abbot Labs is $82.66, and Abbvie is $81.75. So except for 3M, they are doing quite well with their stock picks.
Again this can be a great source of investment ideas, but it can also tell us if they are investing in high-risk companies or companies that are very volatile, which can lead to fluctuations in profits for our insurance companies.
Now that we have an idea of which companies our insurance companies might invest inlets look at their investment portfolios as a whole and determine the profitability of these exercises.
Again we will stick with Principal for our analysis of their investment portfolio.
Diving deeper into the 10-k of Principal, we will start with their balance sheet.
In the assets section, we can see a large section of their assets comprise of investments, such as:
- Fixed maturities – i.e., bonds
- Equity securities – stocks
- Mortgage Loans
- Real Estate
- Policy loans
- And other investments
We will break down the fixed maturities and securities a little more in the next section. The assets can give you a good idea of the amount of money Principal is investing. Also, notice that their investments comprise almost a 1/3 of their assets and that bonds take up roughly 70% of their investment assets.
To say that bonds make up a large portion of their investment income would be an understatement.
Again insurance companies are doing this to help stabilize their earnings as well as protect any claims they may have to pay out in the event of any major catastrophe.
Net Investment Income
Let’s dive into net investment income a little in regards to how an insurance company invests and where this income will derive from.
To recap net investment income is income received from investment assets such as bonds, stocks, mutual funds, loans, and other investments.
In the case of Principal, it will be derived from primarily bonds, stocks, loans, and real estate. We are going to investigate bonds and stocks today.
Let’s take a look at our income statement and discover how much income we received from our investments.
As we can see, the Principal received $3629.2 million in net investment income in 2018.
The net investment income comprises 25.9% of Principals’ total revenue for 2018, with that percentage holding pretty constant over the last three years.
Looking deeper at the bond portion of this income can give us some great insights into the types of bonds they are investing in and the maturities as well.
This statement comes from the notes section of the 10-k and gives us a better breakdown of the fixed assets and their fair value. It notes four from page 110 in our 10-k.
Another interesting tidbit from this statement is that we can see of their bonds investments, over 50% is with corporate bonds, which yield a better rate than US government bonds but have a slightly higher risk flavor than the US government bonds.
The next chart shows us the maturity time horizon of our bonds, and you can see the larger majority is greater than tens of years, which will also yield higher returns and give us more stability.
The final chart comes from page 111 of note 4 in our 10-k, for ease of finding it here.
This chart gives us a complete breakdown of the major components of the Principal’s net investment income. An interesting note is that we received over 67% of our net investment income from bonds.
And if we compare that to our assets, we get a 4.12% return on our bonds for 2018.
How did I arrive at that number?
Well, I took the net investment income for fixed securities or bonds from Note 4 and divided that by the fixed securities from the balance sheet.
Bond return for 2018 = Net investment income bonds / Bonds assets from the balance sheet
Bond return for 2018 = $2479.9 / $60,108.5
Bond return for 2018 = 4.12%
Pretty neat, huh?
We could also calculate an investment income return as well, using the same filings.
If we take the total net investment income and divide that by the investment assets on the balance sheet, we can derive a percentage return that we could use to compare other insurance companies to see how well they are performing in their investment portfolios.
For Principal, our numbers will breakdown as such:
Net Investment Income = $3692.2
Total investment Assets = $84,766.6
To find our investment income return, we divide the two numbers.
Investment Income Return = Net Investment Income / Total Investment Assets
Investment Income Return = 3692.2 / 84766.6
Investment Income Return = 4.35%
For giggles, why don’t we look at a few more companies to give us an understanding of how this process works and for comparing investment portfolios.
I will abbreviate these steps for the next few companies in the interest of keeping you awake.
Next company up will be Prudential (PRU), founded in 1875 and based in Newark, New Jersey. With a market cap of $38B and with a current market price of $92.97
Prudential’s total investments = $479,245
Prudentials Net Investment Income = $16,176
Prudential Investment Income = 16176 / 479245
Prudential’s Investment Income = 3.37%
Next up, we will take a look at Lincoln National Corporation (LNC), founded in 1905 and based in Radnor, Pennsylvania. With a market cap of $11.5B and a current market price of $58.02.
Lincoln Financial’s Total Investments = $115,216
Lincoln Financial’s Net Investment Income = $5085
Lincoln Financial’s Investment Income = 5085 / 115216
Lincoln Financial’s Investment Income = 4.41%
Lastly, we will look at Chubb Limited (CB), founded in 1985 and based in Zurich, Switzerland. With a market cap of $68.2B and a current market price of $150.44.
Chubb’s Total Investments = $100,968
Chubb’s Net Investment Income = $3,305
Chubb’s Investment Income = 3305 / 100968
Chubb’s Investment Income = 3.27%
That was an interesting look into the investment performance of some of the bigger insurance companies. A few of them were better performers, such as Principal and Lincoln Financial.
Because of the new accounting rules and how to assess investment portfolios it is nearly impossible to calculate an investment return for Berkshire Hathaway, which is a shame because Warren Buffett is the ultimate maestro.
This deep dive into the investment portfolio of insurance companies is necessary to investigate an area of creation for a large portion of their income.
Particularly, with life insurance carriers, this investment portfolio will be larger factor than for property/casualty insurers.
We noticed that a large portion of their investments is in fixed securities such as bonds, and some cases real estate as well. Because of the nature of how insurance companies work, and the nature of claims and the timing of claims, the use of bonds or other very stable investments is critical.
Very few insurance companies will have large portfolios of securities in terms of dollars invested, compared to the amounts invested in bonds.
The simple formula that we discovered can be useful in determining the investment performance of our insurance companies and using that as a comparative tool, ideally all things being equal, finding the company that is generating great returns on their invested capital.
This post is part of an ongoing series to help peel back the confusion that surrounds insurance companies and how they make money. I think we have seen that once you understand how these businesses make money and the different language that is used they are not all that different from “normal” businesses.
As always thank you for taking the time to read this post, and I hope you found something useful for your investing journey.
If you have any questions or need further guidance, please don’t hesitate to reach out.