Insurance is often described as banking without money given it engages in a risk management business model using other people’s money. In normal times, insurance companies are stodgy widow and orphan stocks returning a modest return but with a level of safety. For example, using the period of 1993-2003 (i.e. pre-bubble), the S & P Life and Health Insurance Index returned only 3.6% on an annual basis.

But, with the cheap lure of money and every CEO suddenly thinking they were high-flying traders, insurance companies got sucked into the vortex of unreasonable risk taking in the recent past. The most notable example was Manulife Financial who invested insurance premiums heavily into equities, and failed to hedge against such trading, found itself in financial trouble.

Assuming that the world gets back to normal and risk management companies actually begin to manage risk responsibly again, what should one look for when investing in insurance companies?

Insurance companies- what is its business model?

Insurance is the transfer of risk from one party to another in exchange for the payment of a premium. The premium, in turn, is invested and used to pay out future claims and to operate the insurance company.

In essence, insurance companies are engaged in two primary revenue streams: the assumption of other people’s risk in exchange for money/premiums and the management of such premiums (asset management). An insurance company makes money by making more in revenue (insurance premium sales + investment income) than expenses (premiums paid out + general operating expenses).

Here’s where things get a bit bizarre. Insurance companies are guessing (albeit with some sophisticated financial modeling) whether it will make money on each policy sold. The insurance premium could be too low (i.e. the insured is riskier than they thought), the return on the premiums invested could be under its assumptions on ROI or the insured could cancel their policies too early (which, with a return of premium rider, is bad news for the insurer).  Insurance, on some preserve level,  is like taking a stab into future events.

Thus, a critical piece of an insurance company’s operations is to ensure that it always has enough capital to manage all the risk it has assumed. Mismanage the risk and you end up with AIG.

Insurance companies- what are some key factors to look at?

Beside the traditional metrics of investing stocks, what are some things that all investors should look at?

1. Premium growth. In plain English, how many premiums is it selling? This is the life-blood of any insurer’s growth. Stop selling premiums and the company will shrink since it has expenses (premiums to pay out) without corresponding revenue other than investing income. Premium growth is so important that commissions paid are generally the largest expense after premiums paid.  Also look for sources of premium growth- ideally, an insurance company should be growth among many product lines. Most companies highlight premium growth in their discussion to the financial statements
2. Combined ratio. This tells you if the premiums are making money. This is calculated by expenses and losses/revenue from premiums. If the ratio is more than 100, the company is paying out more than it is taking in. If the ratio is less than 100, the company is making money. I noticed that most insurance companies do not disclose this ratio. It has to be calculated manually or an analysts will calculate it in a research report.
3. Investment income. In some insurance sectors, insurance premiums are close to, or are, loss leaders. Money is made mostly through investment income. There’s two factors to look at: (i) what is the total of investment income over all revenue; if it is really high, the insurance company either is not selling a lot of premiums or has become purely an asset management company addicted to trading revenue to be profitable; neither are positive developments for an investor; (ii) what is the company invested in? Hopefully, their trading strategy is prudent. Most insurance companies will disclose what they are investing in and whether they are engaging in hedging strategies.
4. Capital adequacy. Similar to a bank, an insurance company has to put aside enough money in reserves (which does not show up in earnings until the transfer of risk has expired) to pay for future claims. This is referred to as the minimum continuing capital and surplus requirements (MCCSR) by Canadian regulators. In Canada, all insurance companies should have a target ratio of 150%. This is disclosed by all insurance companies. The higher the ratio the safer the company is but too high of a ratio means either: (i) risk payout is anticipated to be quite high in the future; or (ii) the company is not expanding since it is putting so much money in reserves and not to expansion.
5. Credit rating. As a payer of policies, all insurance companies have a credit rating which reflects a third parties assessment of their ability to pay policies as they become due. The higher the credit rating the better (i.e. AAA is ideal). This is always stated by insurers.

Insurance companies- common sense factors?

Insurance companies are like banks. Who is aggressively on the street selling product? As a business dependent on attracting other people’s money, whomever has the best distribution network typically has an edge over competitors (remember how large an expense commission is in an insurance company). As a practical example, think about how many people sell Blue Cross product over Manulife/John Hancock? The latter has a much larger distribution network and a correspondingly larger market share than the former.

Real estate investment trusts (REITs) tend to elicit differing opinions in this current market environment. Many bears believe that the combination of a lack of cheap capital and falling vacancies spells trouble for REITs in the near future. Others believe that the steady stream of rental incomes from various sources should tide the industry over until the recovery.

Regardless of opinion, REITs are often recommended as both appreciation and cash flow plays in an average investor’s portfolio. What is a REIT and how does one analyze a REIT properly?

For our purposes, I will only be looking at equity REITs which purchase or develop income producing real estate. Mortgage REITs are REITs which pay out distributions from the proceeds of mortgages; in Canada, these are often organized as Mortgage Investment Corporations rather than mortgage REITs.  Hybrid REITs contain a portfolio of cash flow producing properties and mortgages.

REITs- What are they?

A REIT is actually a tax designated term for a type of tax structure/security. Depending on the jurisdiction, the trust either not taxed or taxed at a very nominal rate to allow for a greater pool of income to be distributed to the individual unit-holders, who bears the tax burden. In some jurisdictions, a very high percentage of profits has to be distributed to unit-holder. Thus, they are designed by tax laws to take in income and distribute most of it to its investors.

In order to qualify for such advantages, an equity REIT generally has to be engaged in the ownership, administration and development of real estate. The proceeds of this business (i.e. rental income) forms the pool of capital to be distributed to the individual unit-holders.

Equity REITs tend to develop, own and operate residential, commercial or industrial real estate or a combination of all three types of properties.

REITs- Why invest in a REIT?

Before the real estate bubble, REITs were considered generally to be unsexy widow and orphan stocks given their ability to pay distributions to investors from plain old rental income. Given the tax advantage of a REIT, a large distribution per unit could be paid for a relatively stable asset class.

Industry studies have also shown that REIT tend to provide asset diversification from the general equity indexes when measured over long period of times.

There is some short-term uncertainty about these two advantages which, over time, should revert to the mean.

REITs- What are important factors to consider?

There are several quantitative factors to consider when looking at any REIT. I will focus on three in particular:

1. Adjusted funds from operations. This factor speaks to the substaniability of distributions. Traditional dividend analysis of dividend payout ratios is not applicable for REITs. The reason is that GAAP tends to punish real estate stocks. For example, since depreciation is booked as an expense for accounting purposes which does not directly affect cash flow, it is difficult to determine a true sense of earnings to run a dividend payout ratio. Instead, one has to use a non-GAAP measure, adjusted funds from operations, to truly determine how safe a REITs distributions are. I have previously blogged at length about REITs and adjusted funds from operations. Most REITs publish their adjusted funds from operations in their financial statements but do remember it is a non-GAAP measure.
2. Net Asset Value (NAV). This factor speaks to a REITs valuation. Again, GAAP tends to punish real estate since a real estate company books their assets at acquisition price and not at current market value. Thus, on a preliminiary analysis of the financial statements, a real estate company with a lot of older properties may not have a very good looking balance sheet with lots of expenses required to upkeep older capital assets but assets booked at book value. Accordingly, many REITs will value their business on a net asset value basis which is simply the assessed value of the real estate portfolio minus liabilities.  NAV is typically quoted on a per unit basis which gives to the investor the equivalent of price to book valuation in non-real estate stock.  Setting aside what a true valuation of property is, the question for most investors is whether the premium or discount of NAV to the trading price is above or below industry averages. Obviously, a REIT that is trading at many times the normal industry premium of NAV may trigger some concerns about it being over-valued whereas a REIT trading below an industry premium to NAV or at a discount is either a REIT in trouble or a value play. NAV is published by most REITs in their discussion to financial statements.
3. Debt Loads/loan to value ratios. This factor generally speaks to long term prospects. The Globe and Mail ran an interesting story about how the commercial real estate market, which includes REITs with properties in this sector, maybe have a difficult future ahead. Quite simply, commercial REITs are over-leveraged and their assets are falling in valuation. When the short to medium term loans become mature, IF a REIT can obtain financing, it may not have as much capital to utilize which means it either has to: (i) divest of assets; or (ii) cut distributions. There are several things to watch out for: (i) what is the current loan to value ratio of a REITs entire portfolio of real estate (a research report will probably provide this)- the lower the ratio, the better the chances are of obtaining financing since the REIT can cross-collateralize assets to decrease lender’s risk; (ii) how much cash is on balance sheet, since increasing cost of capital may have to be paid partially through revenue and partially through cash on hand;  and (iii) how much short term debt is maturing before 2012? The less the better.

REITs- the common sense approach

I work near a commercial district that seemingly is owned entirely by Allied Properties REIT. On one particular stretch of King Street West, they own 14 properties- in other words, the entire block. All the buildings are all well-maintained and look occupied (i.e. no vacancy signs outside). Not surprisingly, analysts also like this REIT.

Real estate is a very touchable class of investment so if you are interested in investing in REITs, the simple thing to do is to find out what properties they own and visit their locations. Is the site well-maintained? Is it occupied? Are the businesses busy? Would you rent there? On a fundamental basis these types of real world observations tend to reflect upwards into the financial statements.

I’ll be looking at how to invest in insurance companies in my next post in this series.

I am honored to have been included in the annual Globe and Mail’s Best Money Blogs. Special thanks to Canadian Capitalist for nominating me. If you are a first time visitor, please feel free to check out the blog and, if you enjoy the content, please subscribe to my feed.

I am pleased to start a new series today entitled “how to invest series” which looks at how to invest in stocks in various industries. The inspiration for this series are from reader questions asking me why a certain stock in an industry performs better than their industry peers or, regardless of whether you are an active or passive investor, what all this jargon means when stock analysts talk about a stock.

I am starting with investing in banking stocks; an industry which, obviously, is under a lot of attention lately. My next post in this series will be on REITs. Let me know if you have any other suggestions. Thanks.

Banks- how does it make money?

Originally, we lend it money through deposits and they lend it to borrower. The spread between the interest payable to you and I and the interest received from borrowers is called the net interest income and a profit center.  Most banks now divide their personal banking (you and I) from their commercial or wholesale banking (loans to other banks or businesses).

Over time, banks have branched out into other business lines like investment banking (earn fees on advisory services or underwriting a business going to market), trading (using deposit and shareholder equity to trade in the market), insurance (earns money between premium paid and premium paid out) and selling product (earn management fees on mutual funds).

Banks- what are important factors to consider?

Banks are in the business of risk management. Thus, on a non-exhaustive basis, you need to look at how it manages its risk by looking at:

1. Bank’s capital base: In other words, if the banks manage their risk poorly, do they have enough assets to weather the storm? If the bank lends out a $500,000 mortgage which defaults and only recovers $300,000, the $200,000 loss has to be paid out of retained earnings or shareholder equity. Multiple this loss by hundreds of thousands of times and you understand why a bank could be in trouble if it doesn’t have a lot of cash on hand. Typically, one looks at equity (usually common shares plus retained earnings plus preference shares) over assets to determine how strong a capital base is. This is known as a tier 1 capital ratio. A tier 1 one capital ratio in the high single-digits (8-9%) is considered healthy; recently, some banks have a tier 1 capital ratio of 10.  All banks provide tier 1 capital ratios so it is easy to look up.
2. Loan loss reserve. This is a portion of money set aside to cover losses on loans due to partial or full loss. A low loan loss reserve is desirable. A high-reserve relative to competitors tells an investor: (i) bank is not good at risk management; (ii) less money can be used to make new loans, slowing the growth of the business.

Assuming the bank is managing its risk properly (the defensive side of the equation), then you shift your analysis at how effective a bank is at making money (the offensive side of the equation). In addition to the usual net revenue and earnings growth, you are looking at some bank specific metrics as well:

1. …A note on return on equity (“ROE”). This is a ratio is calculated by dividing net income over shareholders equity and shows you how much profit the bank has made with shareholders’ money. ROE in banks have been around the mid teens to mid-twenties for most of this decade but banks are already warning investors that this is unrealistic going forward giving the risk taken to achieve this type of ROE. Some banks have  already talked about ROE of high single digits when the dust settles fully on the credit crisis.
2. Efficiency ratio. In plain English, this ratio measures how efficient the bank is at running its operations by looking at operating costs/net revenue (in other words, how many cents on every dollar made goes to costs). The lower the ratio the better. A ratio in the 50’s is great (Wells Fargo’s ratio is approximately 56 as of Q2 2009; Bank of America is 49.62). Having said that, you have to be cautious about efficiency ratios. A business can decrease it quickly by laying off a lot of employees which is good for the short-term but may slow growth long-term.
3. Deposit growth. A bank’s life-line is growing its deposit base. What you are looking for is growth in total core deposits year over year (a core deposit is a deposit considered to be long-term). In a large bank, core deposit growth of 4-6%  year over year would be considered a good growth rate.
4. Net interest margin. As discussed above, this is the spread between the interest received from borrowers and interest paid to deposit-holders. A margin between 3-4 is considered ideal for investors. For example, Wells Fargo’s  net interest of margin of 4.16 in the last quarter is the highest among all the large banks.

Banks- the common sense approach

Finally, I would highly suggest investing in a bank you use or that operates in your area. You can make some sense of the bank’s future prospects by simply seeing how well the bank runs and treats you. For example, CIBC is not a name you hear much of in personal and small business banking and, from professional experience, my dealings with their front-line bankers do not exactly inspire confidence. Thus, it is not surprising that the market considers this bank to trail its peers.