Understanding an insurer's balance sheet

Insurance companies are magical creature that, in the hands of a skilled operator, perform alchemistic feats and literally mint money. But, reading and understanding their financial statements are a little difficult, so let’s try to break this task down into bite-sized chunks. First we’ll get familiar with the terms and calculations; later on, we’ll see how the statements are linked and flow into each other.

Balance Sheet

Insurance companies are balance-sheet-driven businesses, so we’ll start here with the assets, followed by the liabilities. Let’s look at the 2005 balance sheet of the auto insurer, Progressive (NYSE: PGR).

2005 Assets (Million of Dollars)
1) Fixed Maturity Securities = $10,222
2) Preferred Stock = $1,220
3) Common Equities = 2,059
4) Short-Term Investments = $774
5) Cash =$6
6) Accrued Investment Income = $133
7) Premiums Receivable = $2,501
8) Reinsurance Recoverable = $406
9) Prepaid Reinsurance Premium = $104
10) Deferred Acquisition Cost = $445
11) Income Taxes = $138
12) Property & Equipment = $759
13) Other Assets = $133
TOTAL ASSETS = $18,899

This is way too convoluted, so let’s make some simplifications. We’ll group all investments (bonds, stocks) into “Investments” and throw cash in there as well. Then we’ll create a category called “Policyholders’ money we don’t have yet.” This will consists of:

1) Premiums receivable – future premiums to be received.
2) Reinsurance recoverable – money that the reinsurers owe.
3) Prepaid reinsurance premium – money already paid to reinsurers for future reinsurance policies
4) Deferred acquisition cost – money already paid but not yet expensed, such as agent commissions and premium taxes, to acquire policies.

Everything else we’ll group it under “Other assets.” *Important note: PLEASE – when investing in an insurer, just like in banks, always read the footnotes, here I’m simplifying for clarification purposes.

Thus, our simplified assets portion of the balance sheet shall read:

1) Investments = $14,280
2) Policyholders’ money we don’t have yet = $3,455
3) Other assets = $1,163
TOTAL ASSETS = $18,899

Now that you’ve got the hang of how I’m simplifying things, we’ll go into the liabilities and shareholder’s equity. The 2005 numbers for these two items read:

2005 Liabilities and Shareholder’s Equity (Million of Dollars)
1) Unearned premiums = 4,335
2) Loss & loss adjustment expense reserve = $5,660
3) Accounts payable, accrued expenses & other liabilities = $1,511
4) Debt = $1,285
5) SHAREHOLDER’S EQUITY = $6,108
TOTAL LIABILITIES & SHAREHOLDER’S EQUITY = $18,899

We shall simplify the liabilities portion like how we did for assets. First, we shall group it into 4 categories; 1) Policyholders’ money that we have, 2) Debt, 3) Other liabilities, and 4) Shareholder’s equity.

First, “Policyholders’ money that we have” is made up of:

1) Unearned premiums – policyholder money paid for future coverage.
2) Loss and loss adjustment expense reserve – policyholder money set aside for already incurred losses, incurred but not reported losses, and the cost of settling claims.
3) Other policyholder liabilities which in Progressive case, it does not have any.

Our simplified balance sheet will thus looks like this:

ASSETS
1) Investments = $14,280
2) Policyholders’ money we don’t have yet = $3,455
3) Other assets = $1,163
TOTAL ASSETS = $18,899

LIABILITIES & SHAREHOLDER’S EQUITY
1) Policyholders’ money we have = $9,9995
2) Debt = $1,285
3) Other liabilities = $1,511
4) Shareholder’s equity = $6,108
TOTAL LIABILITIES & SHAREHOLDER'S EQUITIES = $18,899

The first thing to note here is float. In a nutshell, float refers to the money that policyholders give to insurer in return for insurance. With our simplified balance sheet, calculating float is simple:

FLOAT = POLICYHOLDERS’ MONEY WE HAVE – POLICYHOLDERS’ MONEY WE DON’T HAVE YET

In this case, we can see Progressive has about $6.54 billion in float. We can also see “Other assets” and “Other liabilities” are about the same, so we’ll net them off and ignore these. Finally, we’ve debt and shareholder’s equity value.

Thus, we’ve three main pieces that comprise the balance sheet (ignoring other assets and liabilities, which we’ve netted out): 1) Float, 2) Debt, and 3) Shareholder’s equity.

The reason I simplified to these three points is because each of these represents the different pieces of financing: 1) Float is money provided by policyholders, 2) Debt is provided by creditors, and 3) Shareholder’s equity (estimated liquidation value) is provided by equity holders.

Now back to the basics. An insurer takes money from these three sources of funding (policyholders, creditors, and stock holders) and invests it. If we take Progressive’s float of $6.5 billion, debt of $1.3 billion, and shareholder’s equity of $6.1 billion, we get a total of funding of $13.9 billion – notice this is about equal to Progressive’s $14.3 billion in investments. In other words, an insurer takes money from policyholders (float) and creditors (debt), and pays out operating expenses, claims and claims expenses, and interest payments. The remainder is left over for the stockholders and taxes – this money is reinvested into investments and increases shareholder’s equity, which increases the value of the insurance company to stockholders. However, if the insurer is taking bad risks, it’ll end up owing a lot of claims (if the losses fall to the bottom line, this eats into shareholder’s equity).

In an insurance business, the three determinants to evaluate are 1) the amount of float the business generates, 2) its cost of the float, and the most important 3) the long term outlook for both these factors. The cost of float is determined by the underwriting result of the insurer. Usually, there’ll be a cost attached to it which leaves it running at an underwriting loss. But the business only has value if its cost of float over time is less than the cost the company would incur otherwise to obtain fund. But the business is a lemon if the cost of float is higher than the market rate. The beauty of an insurance business is if it is able to run at an underwriting profit, it means they’re getting paid for holding other people’s money.

By now it should be clear what drives an insurer’s balance sheet value: the more shareholder’s equity and float, the better. However, as in all things, a caution here is appropriate – in the short run, if an insurer under-prices its policies so that it can grow premiums and float very quickly, in the long run, losses will eat up the float and shareholder’s equity, so just like in investing, watch out for fools who rush in. Progressive’s $6.5 billion in float (at end of 2005) and $6.1 billion in estimated liquidation value (shareholder’s equity) were valued at $21 billion.