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Net Investment Income: Its Significance for Many Financial Companies

Continuing our discussion on investment portfolios relating to companies such as Amazon, Microsoft, Prudential, and Apple… In today’s post, we cover 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? It’s true, 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 portfolios’ side 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 of income left over after subtracting the management of 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

Bottom line, any income from any investment from a company makes its way 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 difference between any realized gains and any fees associated with the assets’ management is the net investment income. 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 of two main components, such as:

  1. Investment Returns
  2. Investment Expenses

Let’s explore the investment returns first.

C:\Users\davea\Downloads\mkl nii.png

Looking at the chart above from Markel’s (MKL) latest 10-q dated September 30, 2020, we can see many different components making up the net investment income, such as:

  • Capital gains
  • Interest
  • Dividends on equity securities
  • Income (loss) from equity method investments
  • Investment expenses

Capital gains

Capital gains occur when there is 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 Microsoft 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 $2,483 thousand from the sale of equities, but we can see for the year that Markel has had losses of $(11,849) thousand on year to date for 2020.

Interest

Interest earned from treasury bonds, corporate bonds, and municipal bonds in Markel’s case totaled $71,831 thousand 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.

Notice that a large portion of its interest income comes from municipal bonds in Markel’s case, which is debt from local governments such as cities.

In most insurance companies and banks, the majority of the companies’ net investment income will come from interest income. A large portion of 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, where 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 out to the shares’ owners; it works the same for individual investors as for corporations. In Markel’s case, we can see the company took in $20,282 thousand in dividends for the quarter.

For example, Berkshire Hathaway made $1,024 million in dividends from its equity portfolio in the third quarter of 2020.

Other investment income

The other investment income is a catch-all category that contains all sorts of investment income—items such as royalty payments, rents from properties, and annuity payments.

For Markel, this line item is quite small and not significant 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.

C:\Users\davea\Downloads\pru nii.png

We can see from Prudential’s 10-q from September 30, 2020, that the company earns a fair amount from its other assets.

C:\Users\davea\Downloads\pru assets.png

And looking at the balance sheet, we can see look at the breakdown of the investment portfolio by asset class:

Total Investments

$541,053

Percentage of Portfolio

Fixed Maturities

$407,088

75.2%

Contractual obligations

$23,961

4.4%

Mortgages

$64,541

11.9%

Policy Loans

$11,502

2.1%

Other investments

$16,921

3.1%

Short-term investments

$10,015

1.8%

All of this helps illustrate how the company invests in “float,” or the difference in premiums earned and premiums paid out to customers. This is 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, or 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, ever, 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 can see from above, many different 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 overall income.

After all, the assets help drive any company’s income, whether Microsoft, Wells Fargo or Apple.

Okay, now that we understand how the net investment income components work, let’s look next 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. In many cases, the insurance companies 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 both 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. Equities or stocks have always outperformed bonds in the long-run, however most insurers use fixed income as a more stable way to make money.

Because of the nature 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. This is 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 is still using 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 get an idea of how this works. First, up will be Markel (MKL).

C:\Users\davea\Downloads\mkl ratio.png

Markel Investment Income Ratio = $90,384 / $1,394,428 = 6.48%

Easy, huh?

Let’s put together a chart to look at the previous quarter and nine months.

Q2020

Q2019

Nine months 2020

Nine months 2019

$90,384

$113,382

$274,242

$339,395

$1,394,428

$1,300,032

$4,085,311

$3,703,470

6.48%

8.72%

6.71%

9.16%

Interesting chart, and by doing snapshots like the above, we can see how a company is performing over periods. 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:

TTM

19.09%

2019

40.69%

2018

0.19%

2017

8.31%

2016

9.62%

2015

8.08%

2014

9.32%

2013

9.68%

2012

12.50%

2011

12.27%

2010

15.02%

As we can see from the above chart, the company earned higher returns earlier in the decade and 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 above helps layout the performance of a company over longer periods, which allows for additional analysis of trends. When analyzing any company, asking questions while you assess the business are the key to finding the answers.

Let’s look at one more for giggles; Prudential is up next.

C:\Users\davea\Downloads\pru ratio.png

Going back to the same chart as above, I will look at Prudential’s ratios over the four periods listed on the income statement.

Q2020

Q2019

Nine months 2020

Nine months 2019

$4,446

$4,438

$12,834

$13,044

$7,482

$6,937

$22,830

$22,972

59.4%

63.97%

56.21%

56.78%

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 = $4,446 / $14,425 = 30.82% of revenues
  • Markel = $90,384 / $2,911,735 = 3.10% 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 of those portfolios contain large amounts of fixed income securities such as corporate bonds, treasury bonds, and municipal bonds. Many investors aren’t aware that the bond market dwarfs the equity market by a factor of two. Therefore, understanding how the fixed income investments affect the bottom line and shareholders’ equity of any company 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 through changes in those investments’ fair value. As they grow in value, it flows to Berkshire’s shareholder equity, thus growing the value of the company.

Even though he is not profiting directly from the sale of 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, which has 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 be of any further assistance, please don’t hesitate to reach out.

Until next time, take care and be safe out there,

Dave