Now let’s take a look at how the balance sheet links to the income and cash flow statement.
Just like any manufacturing operations have a limited capacity, insurance operations do likewise. For example, Daimler Chrysler’s capacity is the number of car manufacturing plants it has and how many cars those plants can produce.
An insurer’s capacity is its shareholder’s equity, which is simply total assets minus total liabilities. The more policies an insurer writes, the greater its risk of losses if those policies result in claims. Because losses eat into equity, an insurer can’t write too much insurance or it’ll lose serious impairment. For example, if an insurer writes premium equal to 10 times its equity and ends up taking a 10% underwriting loss, then those losses would nearly wipe out its entire equity and render the insurer insolvent.
To prevent this from happening, insurance regulators generally don’t allow insurers to write premiums more than three times their equity, although most insurers stay well below this limit. Thus, the equity on the balance sheet determines how much capacity it has to write insurance and collect premiums.
An insurer’s balance sheet is also where it carries its investments. As mentioned earlier, an insurer uses float, debt, and equity to invest in stocks and bonds to earn investment income. Meanwhile, it must also pay interest on its debt. Putting it all together, here’s how an insurer uses its balance sheet assets and liabilities to generate revenue:
Balance Sheet Translates into
1) Investment Portfolio 1) Investment Income
2) Debt 2) Interest Payment
3) Equity 3) Underwriting Profit/ Loss
4) TOTAL 4) Pre-Tax Income
FROM BALANCE SHEET TO INCOME
Let’s use a different example this time, Markel (NYSE:MKL), a property and casualty insurer. In fiscal 2005, Markel’s balance sheet showed about $1.7 billion in equity, $4.4 billion in float, and $850 million in debt, totaling roughly $6.95 billion in financing. These sources of cash were reinvested into $6.2 billion worth of investments (the difference resulting in cash of $0.334 billion and goodwill of $0.34 billion). The simplified balance sheet looks like this:
Markel Balance Sheet in 2005 (Million of Dollars)
1) Investment = $6,200
2) Cash + Goodwill = $750
3) TOTAL ASSETS= $6,950
LIABILITIES & SHAREHOLDER’S EQUITY
1) Float = $4,400
2) Debt = $850
3) Shareholder’s equity = $1,700
4) TOTAL LIABILITIES & SHAREHOLDER’S EQUITY = $6,950
Now let’s link this to the income statement. Markel used its $1.7 billion in equity as capacity to write about $2 billion in premiums, of which it earned $1.94 billion in 2005. Of that $1.94 in premiums earned, Markel incurred about $1.95 in losses (for claims and claims expenses) and operational expenses. Thus, for every $1 in premiums, Markel estimates it will ultimately pay out about $1.01 in losses and expenses – resulting in a 1$ loss per dollar of premium written, in other words, Markel is running at an underwriting loss. Markel paid interest of $64 million on its $850 million in debt, but earned an investment income of $260 million on its $6.2 billion investment portfolio.
To demonstrates how it works:
Numbers in Millions
FROM INCOME STATEMENT TO CASH FLOW
To link the income statement to the cash flow statement is quite simple. Markel’s $148 million in net income flows directly to operating cash flow (CFO). CFO includes this $148 million, working capital adjustments, and increases or decreases in float. Because most insurers grow their float on an annual basis, CFO is often much greater than net income.
CASH FLOW IN 2005 (IN MILLIONS OF DOLLARS)
1) Cash from operations (CFO) = $551
2) Cash from investing (CFI) = ($567)
3) Cash from financing (CFF) = ($29)
As we can see, via net income, float, and working capital adjustments, Markel had $551 million of operating cash flow to work with. The insurer then puts this cash into investments, as well as some minor outlays for capital expenditures and other activities. This resulted in a $567 million outflow of cash from investment activities (the bulk of which was used to increase Markel’s investments). In CFF, insurers pay out dividends, repurchase or issue of stocks, and issue or redeem debt. In this case, Markel made some minor adjustments to its financing sources by buying back a small amount of stock and debt, resulting in a decrease of $29 million in total. Thus, CFO is usually where net income and float come in from the income statement. This CFO is put back to work in investments, which shows up on the balance sheet, and increases or decreases in debt and stock – as well as dividend payments – flows through CFF, which are subtracted or added to their respective balance sheet accounts.
Hopefully, this summary provides a better understanding of how an insurer’s financial statements link to each other. As you can see, insurers that have strong balance sheets and underwrite profitably can quickly reinvest that cash into more invested assets – and thus use its increased capacity (shareholder’s equity) to write more premiums. And that’s how disciplined insurers can easily attain double digit returns on equity.