Inside the general insurance business

The world of insurance can seem mystifying to some. Unlike typical businesses that get paid after providing goods or services, insurance companies receive premiums upfront while claims occur over time. Broadly, there are two forms of insurance: life insurance, which protects your family's future, and general insurance, which protects your present - everything from health emergencies to property damage.

This article focuses on the unique business dynamics of general insurance, which operates quite differently, even from life insurance. Just like with banks, general insurers' financial statements reveal distinct elements that require a closer look to truly understand their performance. But before delving into the numbers, let's first unpack how this industry works.

A unique business and float

We know that insurance companies receive premium payments upfront from policyholders in return for a promise to cover potential future losses. This advance payment is known as float - a pool of capital that insurance companies hold until claims are settled.

One distinct advantage of float is that it provides insurers with the opportunity to invest a portion of the funds in stocks, bonds, and other instruments before claims need to be paid, thereby generating income through interest, dividends, and capital appreciation. This gives insurance companies two income streams: premiums earned and investment returns.

However, not all float can be invested; insurers must carefully set aside a portion of float to cover potential future claims. Insurance companies use complex statistical models to estimate how much money they'll need for claims, when those claims might occur, and how much they can safely invest. Successful insurers know exactly how much to invest and for how long, keeping enough cash ready to pay claims when needed.

Unlike life insurance, which covers long-term risks, general insurance typically involves short-term policies that cover risks related to health, automobiles, property, and businesses, often renewed annually. The unpredictable nature and frequency of claims in general insurance make assessing potential payouts and managing investments more challenging.

Profitable underwriting

While float makes insurance look attractive on paper, its long-term success depends on something more fundamental, profitable underwriting. Underwriting in insurance is the process of assessing potential policyholders' risks-evaluating factors like age, health, and driving history to set appropriate premiums.

Profitable underwriting means pricing risks accurately and only insuring what makes financial sense. Warren Buffett, a long-time admirer of auto insurer GEICO, emphasised this in his 1972 letter to Berkshire Hathaway shareholders: "Underwriting profitability is the yardstick of success and that operations can only be expanded significantly when it is clear that we are doing the right job in the underwriting area."

Smart risk assessment is crucial in insurance. Unfortunately, in the insurance industry, successful periods often attract competition, offering artificially cheaper policies to grab customers and gain market share. This strategy could backfire because these companies may fail to properly assess their risks or keep enough money aside for claims. That's why good insurers focus on disciplined underwriting rather than policy volumes, even if it means growing slowly.

There are three key metrics that reveal an insurer's underwriting health:

• Loss ratio: It measures the proportion of premiums paid out in claims. Lower loss ratios indicate more profitable underwriting.
  
• Expense ratio: This is the proportion of operating expenses relative to earned premiums. A lower expense ratio indicates cost efficiency and streamlined operations.
  
• Combined ratio: The sum of loss and expense ratios; a combined ratio below 100 per cent signifies profitable underwriting - making money purely from insurance activities. A consistently low ratio demonstrates disciplined underwriting.

The Indian challenge
Achieving profitable underwriting in India is challenging, particularly because of intense price competition in the general insurance market. Bhargav Das Gupta, former CEO of ICICI Lombard (India's largest private general insurer), highlighted in an interview that while private players entered the market in 2000-01, premium pricing remained regulated until 2008. Following the de-tariffication, prices dropped by nearly 30-40 per cent, a trend that persisted for nearly a decade.

India's non-life insurance penetration stands at only 1 per cent, compared to around 9 per cent in the United States (as per GoDigit's IPO prospectus), indicating considerable growth potential. However, companies often compete on price to gain market share, which can lead to low-quality underwriting and increased losses. To offset this, insurers in India are focusing on boosting profitability through diversified product offerings, digital initiatives, and investment returns, along with expanding distribution networks.

Regulatory landscape and solvency requirements

The insurance industry is highly regulated to protect policyholders' interests and ensure stability. A key regulation for insurers is the solvency margin, which ensures that their assets exceed liabilities, allowing them to cover claims in adverse situations. Maintaining adequate solvency margins is vital in markets with frequent or unexpected claims, as it safeguards the insurer's ability to meet policyholder obligations. Additionally, insurers must exercise caution in their investment portfolios, balancing risk and return to avoid excessive exposure to market volatility.

Investors' takeaway

General insurance companies play a critical role in the financial landscape, providing a safety net for individuals and businesses while managing the unique dynamics of float, underwriting, and investments. For value-oriented investors, understanding these dynamics is essential to assess which insurers can sustainably grow their profits. Key indicators to monitor include combined ratio, return on equity (ROE), and book value growth - these metrics reveal an insurer's operational efficiency and long-term value creation.

As the general insurance industry in India continues to evolve, profitable growth will hinge on disciplined underwriting, judicious float management, and strategic adaptation to regulatory and competitive changes. For investors with a long-term view, insurers with a proven track record of profitable underwriting, prudent capital management, and effective investment strategies represent the most promising opportunities.

In upcoming articles, we'll dive deeper into the financial metrics that drive long-term value for general insurance companies. Stay tuned.

Also read: How to read the balance sheets of banks and NBFCs

This article was originally published on October 31, 2024.