How to evaluate life insurance companies is a question that plagues both consumers and industry professionals. Many companies love to market on ratings or a single financial metric at which they excel.
But highly rated life insurance companies are a dime a dozen and what financial attributes truly matter when it comes to crossing life insurance companies off your list. I want to spend today discussing how we evaluate life insurance companies.
We'll dive into why ratings might steer you in the wrong direction and what financial attributes we hold most important.
High Ratings…Almost Everyone's Got ‘Em
The Life Insurance industry is reputedly well capitalized and financially secure. Industry regulators demand conservative investment portfolio and proof of airtight strategies to handle economic catastrophe. As such, few life insurance companies have bad ratings. While a downgrade for a life insurance company can be a big deal, they are rare.
Additionally, keep in mind that ratings assess the counter-party risk associated with owning an insurance contract from a particular insurance company. Its a speculative measurement of how likely the insurance company can meet the obligation it has to you as well as the commitments it has to all policyholders.
So while we certainly want peace of mind regarding the chances the insurance company can keep the promise it makes to us regarding claims payment, the evaluation of such strength tells us little about other facets of a life insurer or its individual life insurance policies.
Say, for example, we want some indication that the insurance company can continue to pay a competitive dividend on its whole life insurance policies. The ratings of the company hold little if any weight on speculating future dividend payments.
Dividends being a non-guaranteed element of a life insurance contract means the life insurer holds zero obligation to pay them. While you might argue that a life insurance company with low ratings, might pay lower dividends because it struggles to keep up with the things it must do, the reality for the majority of the industry is that a small minority have trouble meeting their obligations.
If for example, one company holds an AM Best A++ rating and another A+, we have little concern about either companies' ability to meet obligations. So, trying to determine if one will pay a better dividend versus the other based on this data point alone isn't very useful.
Evaluate Life Insurance Companies with Income Statements
Our focus on life insurance companies often comes down to several income-focused numbers. Our primary belief is that insurance companies that excel as turning premiums and assets into cash flow are the one that will most likely deliver the highest amount of value to policyholders.
But life insurance accounting is slightly different from the accounting methods most of us have some level of understanding. The insurance industry has its own unique set of accounting rules that value assets differently and place particular cash flows in different places on the income statement as compared to companies that are not in the insurance business. Still, we can cut through the nuance and make assessments on the data.
The more net income a company creates, the better it is at doing whatever it exists to do. This is not necessarily the case for insurance companies.
At first, this seems strange and counter-intuitive, but consider this straightforward example that should pretty quickly highlight why net income might not be all that significant to you if you choose to buy life insurance from a specific company.
Net income represents the cash left over after the company pays everyone for every aspect of its business operation. We like net income when it comes to most corporations because it's the pot of money from which we might receive a distribution.
But for an insurance company, unless you are an owner of public shares issued by public stock companies, net income will never result in your receiving any payment.
Dividends paid to participating policyholders (e.g., participating whole life insurance) come earlier in the income statement right after the company calculates operational profits, but BEFORE it calculates tax liability. Interest paid to policyholders (e.g., for universal life insurance) come from a point even earlier in the income statement.
So higher amounts of net income reported by a life insurer mean the money wasn't paid to policyholders. There are several reasons why this number might be higher when others could argue it should have gone to policyholders–that's an incredibly complex discussion that I can't sidetrack today's blog post with–but the important take away is that it didn't go to them.
So unlike most corporations (both public and private), we don't worry so much about net income when it comes to life insurance companies. We want to see some; otherwise, the company operates at a loss, which won't work long term.
But we want to see way more money ultimately going to policyholders, so we have to dive deeper into the operational income figures reported by life insurance companies if we wish to speculate on how well an insurer can continue to deliver value to policyholders.
Life Insurance Company Investment Income
Life insurance companies collect premiums from insurance policyholders and use those premium dollars mainly to buy income-producing investments. Insurers use the income produced by those investments to pay for policy features guaranteed to each policyholder.
Income generated over guarantees creates profits that often go towards the payment of non-guaranteed elements of insurance contracts. In fact, income produced from investments usually makes up the largest source of insurance company operational profits.
Because investment income comprises such a large percentage of operational profitability, we pay close attention to it and how it changes over time for a specific life insurance company. Ideally, we want to see investment income on a continual rise over time.
This isn't always the case, and we have to identify reasons for the decline in investment income. Over the last decade, a significant driver of declining investment income stems from U.S. Monetary Policy resulting in sustained low-interest rates within the U.S. economy.
We evaluate life insurance companies' investment income primarily in two ways.
First, we look at overall yield achieved on invested assets. We hold this important because we can tie the total investment yield to the relative return targeted by the life insurer for cash value life insurance policies and determine if one is straying significantly from the other.
If, for example, the current fixed interest rate declared on a universal life insurance policy for a specific company is 5%, but the company achieves only a 3.5% yield on investments, there's a concern that the company may not be able to maintain that interest rate on the universal life insurance contract.
Second, we look at the total investment income generated by the assets held by the life insurance company. We are especially interested in how this figure compares with obligations the insurer owes policyholders. We look at the “gap” between investment income and policyholder obligations and compare across multiple life insurers by looking at these figures as a ratio or percentage of one another.
For example, if a specific life insurer generates $250 million in investment income and pays $175 million in policyholder obligations, then the liabilities total 70% of the investment income generated by the insurer. Or put another way, the insurer produces roughly 43% more investment income than it needs to pay policyholders for contract features.
If another life insurer produces $350 million in investment income and has $300 million in obligations, then this company's expenses are almost 86% of investment income or the insurer produces roughly 17% more income than it needs to cover obligations.
From this standpoint, the first company appears to be in a better position because it generates more investment income relative to expense obligations to policyholders.
Insurance Company Capital
While we place a big emphasis on income, we don't completely ignore capital when we evaluate life insurance companies. We feel that capital plays a lesser role not because it's unimportant, but because most life insurers have significant capital positions.
In much the same way ratings are less exciting because most insurers have excellent ratings, life insurers also generally all have stellar capital positions. Not all of them, but just like a lowly rated company would immediately find itself dropped from our list for consideration, a company with a weak capital position is in the same boat.
Our analysis of capital looks at trends such as the growth in admitted assets over time as well as the growth in surplus. We're mainly concerned with a surplus because it acts as a cash cushion insurers can use when cash flow isn't sufficient. This statement is especially critical for mutual life insurers because they do not have access to capital markets like publicly traded life insurance companies do.
A significant area of focus for us is regulatory calculated surplus components like the Asset Valuation Reserve (AVR). This figure is a required component of a life insurer's surplus calculated based on the perceived risk profile of the investment mix the insurance company holds.
A higher AVR indicates assumed riskier investments so the insurer must hold on to more money to hedge the potential losses.
We want to know how AVR changes over time, and we want to know how AVR looks relative to the investment yield. If a life insurance company has an abnormally high AVR and low investment yield, something is wrong. If the insurer has a relatively low AVR and higher than the average yield on investments, then we take note.
Evaluating the Trend is Very Important
We're never concerned with one-year financial data, but instead, find the trend over time the deciding factor in our opinion about a life insurer. While income figures tend to be our most significant area of focus, no single data point drives the majority of our opinion about a life insurance company. We feel that all data points play a vital role in the final decision.
The trend tells us how the insurer is managing the business over time. How it grows and adapts to ever-changing circumstances. It also helps prevent over or understating performance in an extraordinarily good or bad year respectively.
Few financial events took place out of the blue. Instead, we can usually follow a trend to find out where the event started to take shape. The trend is hard to see until we have the advantage of hindsight.
Regardless, we know that trend analysis is a powerful tool when trying to make inferences. That's why we collect a few data points over several years to evaluate life insurance companies and feel strongly that anyone who wishes to make similar evaluations needs to do with from the same sort of time series data review.