Updated 4/21/2023
Continuing our discussion on investment portfolios for companies like Amazon, Microsoft, Prudential, and Apple. Today’s post covers the line item from the income statement reading as “net investment income.”
For many companies, this line item is insignificant in the grand scheme of things, but for others, such as Prudential, it can make up a substantial portion of their income. Investment portfolios from such companies as insurance giants like Prudential, Progressive, Allstate, and Berkshire Hathaway generate large sums of income for these companies. They also make up large portions of the assets held by these companies.
Did you know that almost half of Microsoft’s assets are in investments? Microsoft holds almost 45% of its assets as short-term investments, such as bonds, to generate income for the company while it waits for its next big project.
Net investment income is one of those portfolio benefits, depending on how the company has structured the investments. And depending on that structure, the income earned from the investments will filter directly to the company’s income statement and earnings.
In today’s post, we will learn:
- What is net investment income?
- What are the components of net investment income?
- Impacts on Financial Companies
- Investor Takeaways
Okay, let’s dive in and learn more about net investment income.
What is Net Investment Income?
Net investment income, according to the Motley Fool:
“Net investment income refers to the realized profits made on investment assets, including stocks, bonds, and funds, to name a few, before accounting for taxes. This includes capital gains, dividends, interest income, and subtracts any administrative fees paid, and can be calculated for both companies and individuals.”
So, the net investment income is the amount left over after subtracting managing the assets from the total investment income.
Net Investment Income = Investment Profits – Fees
When a company sells any investment assets, the proceeds from the sale result in either a realized gain or loss; depending on the investment’s nature, the realized gains could result in capital gains from selling a stock or bond.
Other results from income generated from the assets might be:
Interest income from fixed income such as bonds |
Dividends from a stock |
Rental income from property |
Annuity payments |
Royalties |
The bottom line is any income from any company investment to either the income statement as net investment income or comprehensive income or the line item on the balance sheet as other comprehensive income.
The net investment income is the difference between any realized gains and any fees associated with the assets’ management. Net investment income can be negative, depending on the assets sold for a capital gain or loss.
Okay, let’s explore some of the components of net investment income.
What are the Components of Net Investment Income
Net investment income comprises two main components, such as:
- Investment Returns
- Investment Expenses
Let’s explore the investment returns first.
The chart above is from Markel’s (MKL) latest 10-K dated February 17, 2023. We can see many different components making up the net investment income, such as:
- Interest
- Dividends on equity securities
- Income (loss) from equity method investments
- Investment expenses
Capital gains
Capital gains occur when any gain from a sale of investments, such as stocks, bonds, or other assets. In broader terms, this means that the company gains or loses on a sale of an investment, such as selling Microsoft shares for more than you purchased them. For example, if you bought Microsft at $200 and sold it for $210, you have capital gains of $10.
In Markel’s case, we can see that the company earned an income of $446.7 million in net investment income for 2022.
Interest
In Markel’s case, interest earned from the treasury, corporate, and municipal bonds totaled $356.8 million for the quarter.
Interest earned from bonds is similar to dividends paid from equities such as Microsoft. The interest earned from bonds is paid quarterly or semi-annually, depending on the bond. Remember that bonds are debt that a company uses to fund many different projects, and the interest it pays to Markel is a way to entice Markel to buy its bonds.
In Markel’s case, a large portion of its interest income comes from municipal bonds, which is debt from local governments such as cities.
In most insurance companies and banks, most of the companies’ net investment income will come from interest income. Many insurance companies invest in bonds or other fixed-income securities to generate income. For example, Prudential carries a large investment portfolio tied up in bonds, which throws off interest income in coupon payments.
Insurance companies invest in bonds to match the length of insurance premiums they write; they try to match the duration of those premiums.
For example, Allstate, an auto insurer, writes shorter-term premiums and invests in short-term bonds, whereas a life insurer like Met Life invests in longer-term bonds to match the long-term premiums of life insurance.
The insurance biz refers to these as short-tail or long-tail insurers, a little inside baseball for you.
Dividends
Dividends are cash or stocks paid to the shares’ owners and work the same for individual investors as for corporations. In Markel’s case, the company earned $107.2 million in dividends.
For example, Berkshire Hathaway made $6,039 million in dividends from its equity portfolio in 2022.
Other investment income
The other investment income is a catch-all category containing all sorts of investment income—such as royalty payments, rents from properties, and annuity payments.
For Markel, this line item is small and insignificant for the company, as they focus more on a fixed income and equity securities. But companies such as Prudential carry far more assets in these asset classes.
From Prudential 10-q from September 30, 2020, we can see that the company earns a fair amount from its other assets.
And looking at the balance sheet, we can see look at the breakdown of the investment portfolio by asset class:
Total Investments | $417,441 | Percentage of Portfolio |
Fixed Maturities | $314,966 | 75.5% |
Equities | $7,510 | 1.80% |
Mortgages | $56,745 | 13.5% |
Policy Loans | $10,046 | 2.4% |
Other investments | $21,099 | 5.1% |
Short-term investments | $4,591 | 1.1% |
This helps illustrate how the company invests in “float,” or the difference in premiums earned and premiums paid to customers. The difference between the premiums which insurance companies use to generate additional income, such as Warren Buffett with Geico and General Re.
Investment Expenses
- Transaction fees – any fees related to managing the investments, such as brokerage fees, mutual fund load charges, and charges for annuity withdrawals because the company itself can’t manage its investments directly. They use different brokerages to handle the management, which requires fees.
- Margin interest – any interest charges on margin accounts. Margin accounts use leverage or borrowing to increase the returns on an account, but using this leverage requires fees on the loans or interest payments. As with a mortgage, the lender charges a fee to use the loan to leverage an investment’s returns.
As an aside, never use margin accounts to increase your returns; this is how you lose everything when an investment goes bad.
- Ongoing fees – these fees include investment advisor fees, registered account fees, and annual investment fund admin charges. Mutual funds and ETFs charge fees for managing their funds, and they pass those fees along to the investors.
- Other – included in these fees are financial advisor fees, tax filing fees, and any other fees directly correlated to the investments.
As we see above, many moving parts comprise a company’s net investment income. It is important to understand the components to understand the assets’ impact on the company’s income.
After all, the assets help drive any company’s income, whether Microsoft, Wells Fargo, or Apple.
Now that we understand how the net investment income components work let’s look at the impact on financials, such as insurance companies or banks.
Impacts on Financial Companies
Financials such as insurance companies, banks, and investment companies make money from their investments, some more than others. Insurance companies often earn quite a bit of their earnings from their investments.
That is why we need to understand the company’s investment assets’ full breakdown and how they relate to the income statement and balance sheet. Some companies, such as Berkshire Hathaway and Markel, earn far more from their equity portfolios than the fixed income portion. As equities or stocks always outperform bonds in the long run, most insurers use fixed income as a more stable way to make money.
Because of how insurers take in premiums or insurance payments, they have to invest in more conservative investments to ensure they have adequate funds to pay out any claims that might occur. Similar to banks holding reserves to ensure they have funds to pay account holders in the case of withdrawals.
We can use a ratio to determine the effectiveness of its net investment income in relation to its earned premiums. The ratio allows us to compare the income it brings from its investments versus its operations.
Insurance companies have two main sources of income:
Premiums from underwriting
Returns on investment income
As with the combined ratio, we use earned premiums as our denominator because using written premiums means the calculation still uses premiums that insurers consider a liability.
The formula for the investment income ratio is as follows:
Investment Income Ratio = Net Investment Income / Earned Premiums
As luck would have it, both line items are available on the income statement. Let’s look at several companies to understand how this works. First, up will be Markel (MKL).
Markel Investment Income Ratio = $446,755 / $7,587,792 = 5.88%
Easy, huh?
Let’s create a chart to look at the previous quarter and nine months.
2022 | 2021 | 2020 | Avg |
$446,755 | $367,417 | $375,826 | $396,666 |
$7,587,792 | $6,503,029 | $5,612,205 | $6,567,675 |
5.88% | 5.64% | 6.69% | 6.04% |
Interesting chart, and by doing snapshots like the above, we can see how a company performs over time. Even better is to look at the company over a longer period to assess its performance.
Taking that process and looking at the net investment income ratio over ten years for Markel, we see:
2021 | 5.64% |
2020 | 6.64% |
2019 | 0.19% |
2018 | 40.69% |
2017 | 0.19% |
2016 | 8.31% |
2015 | 9.62% |
2014 | 8.08% |
2013 | 9.32% |
2013 | 9.68% |
2012 | 12.50% |
As we can see from the above chart, the company earned higher returns earlier in the decade, then leveled off, and then spiked up in recent years.
There may be several reasons for these changes. One could be that the company sold portions of its equity portfolio to purchase other businesses or fund other projects.
It also might be that the low-interest-rate environment reduced the returns available for the fixed-income portfolio.
The bottom line, using charts and ratios like the above helps lay out the performance of a company over longer periods, which allows for additional analysis of trends; when analyzing any company, asking questions while you asses are the key to finding the answers.
Let’s look at one more for giggles; Prudential is up next.
Going back to the same chart as above, I will look at Prudential’s ratios over the four periods listed on the income statement.
2022 | 2021 | 2020 |
$16,037 | $18,287 | $17,410 |
$38,019 | $34,827 | $31,140 |
42.1% | 52.5% | 55.9% |
As we can see from the above chart, Prudential carries a much higher ratio than Markel. If we look closer, we can see that Prudential has a much higher percentage of net investment income of total revenues than Markel.
- Prudential = $16,037 / $60,050 = 26.7% of revenues
- Markel = $446.7 / $11,675 = 3.82% of revenues
And if I compare those ratios to the overall insurance market of 2019, we see:
Investment income ratio = $55,065 / $629,671 = 8.74%
The numbers above were from the NAIC website, which compiles data for the insurance industry and is a great resource. All the above numbers from the NAIC were in millions. On another side note, the fixed-income portfolios for the insurance industry for 2019 earned 3.20%.
Investor Takeaways
Net investment income is an important line item to understand in the analysis of financials, especially insurance companies. Along with insurers, it impacts others such as Amazon, Apple, and Microsoft, as these companies all have sizeable investment portfolios.
Many portfolios contain large amounts of fixed-income securities such as corporate, treasury, and municipal bonds. Many investors aren’t aware that the bond market dwarfs the equity market by a factor of two. Therefore, understanding how fixed-income investments affect any company’s bottom line and shareholders’ equity is a great way to understand its goals.
For example, Berkshire Hathaway has a monstrous equity portfolio invested in the stock market. But because Buffett never sells, mostly, he doesn’t gain much on the net investment income front, except in the form of dividends from Coke, for example.
But Buffett also drives tremendous value by increasing shareholder equity by changing those investments’ fair value. As they grow in value, it flows to Berkshire’s shareholder equity, thus increasing its value.
Even though he is not profiting directly from selling any of his investments, he is growing the value of Berkshire.
But it is not just Berkshire that gains from these investments. It is also a company like Prudential with a large fixed-income portfolio that accumulates large interest payments from the bonds, driving almost a third of Prudential’s revenues.
With that, we will wrap up our discussion on net investment income.
As always, thank you for taking the time to read this post, and I hope you find something of value on your investing journey.
If I can further assist, please don’t hesitate to reach out.
Until next time, take care and be safe out there,
Dave
