General Insurance and ICICI Lombard

Insurance provides economic protection from identified risks occurring or discovered within a specified period. Insurance is a unique product in that the ultimate cost is often unknown until long after the coverage period, while the revenue—premium payments by policyholders—are received before or during the coverage period.

Insurance contracts are classified as either property and casualty (PC) or life and health (LH) policies:

PC insurance – 

Contracts providing protection against (a) damage to or loss of property caused by various perils, such as fire, damage or theft, (b) legal liability resulting from injuries to other persons or damage to their property, (c) losses resulting from various sources of business interruption, or (d) losses due to accident or illness. India has $30.30 billion market of insurance.

PC insurers offer insurance products in many different lines; the primary ones are:

Automobile – 

Coverage for personal injury (Personal Injury Protection or PIP, un/under-insured motorist bodily injury), automobile damage sustained by the insured (collision, comprehensive, un/under-insured motorist property damage), and liability to third parties for losses caused by the insured (bodily injury liability, property damage liability).

Workers’ compensation – 

Coverage for benefit payments to employees for work-related injuries, deaths and diseases, regardless of fault.

Commercial multiple peril – 

Package coverage including most property and liability coverage except workers’ compensation, automobile insurance, and surety bonds.

Professional liability – 

Covers physicians, surgeons, dentists, hospitals, engineers, architects, accountants, attorneys, directors, and other professionals from liability arising from error or misconduct in providing or failing to provide professional service.

Fire and allied lines – 

Coverage for fire, windstorm, hail, and water damage (but not floods).

Inland marine – 

Coverage for property that may be transported from one place to another, as well as bridges, tunnels and other instrumentalities of transportation.

Ocean marine – 

Coverage for ships, cargos, and freight.

Accident and health – 

Covers loss by sickness or accidental bodily injury, including disability income insurance and accidental death and dismemberment insurance.

Fidelity insurance – 

Protects employers for loss due to embezzlement or misappropriation of funds by an employee.

Surety insurance – 

A three-party agreement in which the insurer agrees to pay a second party or make complete an obligation in response to the default, acts, or omissions of an insured.

LH insurance – 

Contracts that pay off in lump sums or annuities upon the insured’s death, disability, or retirement. (More detail on it in the following blog).

How it works ?

The activities of insurance companies include underwriting insurance policies (including determining the acceptability of risks, the coverage terms, and the premium), billing and collecting premiums, and investigating and settling claims made under policies. Other activities include investing the accumulated funds and managing the portfolio. Investing activities are particularly important for LH insurers; for many LH insurers, the spread between the return on investments and the interest cost of insurance liabilities is the primary source of income. Investment income is also significant for PC insurers. PC insurers accumulate substantial funds due to the time gap between the receipt of premiums and payment of claims, and they invest and manage these funds to generate investment income. This income contributes to earnings and so affects the pricing of insurance policies.

The time gap between the receipt of premiums and payment of claims, creates the float, consists of four components. The first is the time interval between the receipt of premium and the occurrence of insured events. In most cases this component is relatively small, because the duration of PC policies is usually short, six-months to a year. This component of the float is reflected in the financial statements in the balance of the unearned premium liability.

The other three components, which vary in importance across PC lines, relate to the gap between the occurrence of insured events and the subsequent payments. Some insured losses are discovered many years after the event (e.g., exposure to asbestos), and in many cases the claim settlement process extends over several years (e.g., medical malpractice litigation). Also, in some cases insurance payments are made over extended periods of time (e.g., workers’ compensation).

These three components of the float are reflected in the financial statements in the balance of the reserve for losses and loss adjustment expenses, which insurers are required to accrue when insured events occur. Accordingly, the analysis of the float often focuses on unearned premium (first source of float) and, primarily, the loss reserve (other three sources of float).

Difference between LH and P&C - 

PC contracts involve greater uncertainty than LH contracts because both the frequency and magnitude of PC claims are more volatile than LH claims. PC losses are highly sensitive to catastrophic events such as hurricanes, earthquakes and terrorism acts, events which typically have limited effect on LH claims. In addition, the required payment for PC insurance claims depends on the insured’s loss (subject to limits), while for LH insurance it is often the face value of the policy.

Competition in the LH sub-industry is intense although, compared to PC insurance, LH products are generally less homogenous and there are fewer LH insurance companies. Unlike PC insurers, which compete primarily within the industry, LH insurers also compete with banks and other financial institutions. This is especially true for variable annuities, investment products, and asset management.

While the net income margin is comparable across the five sub-industries, the revenue and expense compositions are quite different. For LH insurers, investment income constitutes a substantially higher percentage of total revenue than for other insurers. This difference reflects the banking-like feature of LH insurance. LH insurers generate much of their income from a spread business: they obtain funds from policy and contract holders on which they pay relatively low interest rates and invest those funds in higher yield instruments. This spread, even when relatively small, is a primary source of LH insurers’ earnings due to their high leverage ratios. LH insurers also generate significantly more fee income than PC insurers. This is due to in part to fees on insurance policies, but also to income from non-insurance activities such as managing AUM.

Compared to PC insurers, LH insurers have significantly higher “benefits and claims” expense ratios, but this is offset by smaller amortization and “other operating expenses.”

Key Terms:

Cost efficiency measures the insurer’s success in minimizing costs by comparing the costs that would be incurred by a fully efficient firm to the costs actually incurred by the firm. Cost efficiency can be decomposed into technical efficiency and allocative efficiency.

Technical efficiency measures the firm’s success in using its inputs to produce outputs.

Allocative efficiency measures the firm’s success in choosing the cost minimizing combination of inputs conditional on output quantities and input prices. To be fully cost efficient, a firm must operate with full technical and allocative efficiency.

Revenue efficiency measures the firm’s success in maximizing revenues by comparing the firm’s actual revenues to the revenues of a fully efficient firm with the same quantity of inputs. Primary factors that affect revenue efficiency include product-line diversification and geographic diversification.

Underwriting cycle

The underwriting cycle is the tendency of PC insurance premiums, profits, and availability of coverage to rise and fall with some regularity over time. A cycle begins when insurers tighten their underwriting standards and sharply raise premiums after a period of severe underwriting losses or other negative shocks to capital (e.g., investment losses). Stricter standards and higher premium rates lead to an increase in profits and accumulation of capital. The increase in underwriting capacity increases competition, which in turn drives premium rates down and relaxes underwriting standards, thereby causing underwriting losses and setting the stage for the cycle to begin again.

Interest Rates - Depending upon asset and liability maturity structure, capital market access, and reinsurance availability, insurers will be differently affected by changing interest rates. The average market response to changing interest rates roughly tracks market clearing prices. These “cyclical” effects are enhanced for firms with mismatched assets and liabilities and more costly access to new capital and reinsurance.

Distribution Channels

Two distinct classes of insurance distribution systems are used: direct writing and agency (independent) writing. Direct writing arrangements include companies that sell through employees (direct marketers), companies that use exclusive or captive agents (i.e. agents constrained to represent the products of only one insurer), and companies that sell through the internet, telephone or mail. Under direct writing arrangements, the insurer owns the customer list and thus benefit from any residual profits that arise from the insurance transaction.

In contrast, under independent agency, the agent or broker may represent the competing products of several insurers and generally has ownership rights to the customer list.

Underwriting Risks

Underwriting risk is the risk that the premiums collected will not be sufficient to cover the cost of coverage. Insurance prices are established based on estimates of expected claim costs and the costs to issue and administer the policy. The estimates and assumptions used to develop policy pricing may prove to ultimately be inaccurate.

Market Risks

Market risks represent potential economic losses arising from adverse changes in the fair value of financial instruments and other economic assets and liabilities due to changes in financial variables such as interest rates and stock prices. PC insurers’ exposures to market risks relate primarily to the investment portfolio, which is exposed to interest rate risk, prepayment risk, credit risk, liquidity risk, and equity price risk. LH insurers have significant exposures to market risks due to their reserve liabilities and asset management income in addition to exposures in the investment portfolio.

Regulatory Risks

Insurers face several sources of risk related to regulation, including rate intervention, participation in involuntary markets, assessment risk, limits on underwriting, reinsurance requirements, and restriction on dividends.

Insurance Reserves

Insurance reserves include the liability for future policy benefits (LH insurance) and claim reserves (PC and LH). These reserves relate to both direct insurance and assumed reinsurance.

Claim Reserves

Claim reserves represent estimated future payments to settle claims related to insured events that have occurred by the balance sheet date. PC insurers typically refer to this liability as the loss reserve, while LH insurers refer to it as the liability for policy and contract claims. In both cases, the liability includes estimates of claim expense in addition to expected claim payments.

Combined ratio

The combined ratio reflects both the cost of protection and the cost of generating and maintaining the business. When the combined ratio is under 100%, underwriting results are considered profitable; when the combined ratio is over 100%, underwriting results are considered unprofitable.

Combined Ratio = Loss Ratio + Loss Expense Ratio + Underwriting Expense Ratio + Policyholder Dividend Ratio

Loss Ratio = Losses / Net premiums earned

Loss Expense ratio = Loss expenses / Net premiums earned

Underwriting Expense Ratio = Underwriting expenses / New premiums earned

The loss and loss expense ratio indicate the average cost of insurance protection per each dollar of net premiums earned during the period. Losses and loss expenses reflect not just the cost of protection provided during the year but also the adjustment to the previous year balance of the loss reserve.

The combined ratio and its components measure the underwriting profitability of PC insurance companies. The policyholder dividend ratio is insignificant for the PC insurance industry overall, constituting less than one percentage point in recent years.

Valuation Model

When valuing financial service firms such as insurance companies, analysts often value the equity directly and focus on book values. The book values of major assets and liabilities of insurers are often close to fair values. Accordingly, balance sheet amounts can be used to value those assets and liabilities, or at least serve as a reasonable starting point for valuation.

Risk management = Underwriting + Reinsurance + Investments + Reserving

Warren and Insurance Business

Property/Causality Insurance

P/C business was the industry’s business model: P/C insurers receive premiums upfront and pay claims later. In extreme cases, such as claims arising from exposure to asbestos, or severe workplace accidents, payments can stretch over many decades. This collect-now, pay-later model leaves P/C companies holding large sums – money we call “float” – that will eventually go to others. Meanwhile, insurers get to invest this float for their own benefit. Though individual policies and claims come and go, the amount of float an insurer holds usually remains fairly stable in relation to premium volume.

For the P/C industry as a whole, the financial value of float is now far less than it was for many years. That’s because the standard investment strategy for almost all P/C companies is heavily – and properly – skewed toward high-grade bonds. Changes in interest rates therefore matter enormously to these companies, and during the last decade the bond market has offered pathetically low rates.

The wish of all insurers to achieve great result creates intense competition, so vigorous indeed that it sometimes causes the P/C industry as a whole to operate at a significant underwriting loss. This loss, in effect, is what the industry pays to hold its float. Competitive dynamics almost guarantee that the insurance industry, despite the float income all its companies enjoy, will continue its dismal record of earning subnormal returns on tangible net worth as compared to other businesses.

Management’s role – Underwriting is the major role which the management has disciplined risk evaluation should be the daily focus of  insurance managers, who knows that the rewards of float can be drowned by poor underwriting results. All insurers give that message lip service but only a few could walk the talk.

ICICI Lombard -

ICICI Lombard General Insurance Co. Ltd is one of the leading and established private sector general insurance companies in India. It offers a well-diversified range of products and risk management solutions through multiple distribution channels. The company is a part of ICICI Bank Ltd which is the 2nd largest private bank in India. It offers a diversified range of products and services to retail, SME and corporate customers.

As on 31st March 2022, the company holds ~8.1% share of the general insurance industry. The Co. is the largest private-sector non-life insurer in the country. It is the 2nd largest player in the general insurance sector.

The company's GWP (Gross Written Premium) is ~18,500 crores. It includes Motor - Own damage (22% of GWP), followed by Motor - third party (22%), Health, Travel and Personal Accident (22%), Fire (17%), Marine (3%), Crop (5%) and others (9%).

It was established in 2001 as a JV between ICICI Bank and Fairfax Financial Holdings Ltd. ICICI held 64% stake and the rest was held by JV partner. Fairfax Financial exited in 2019 by selling its remaining 5% stake in the company for ~2,600 crores.

In 2021, the company acquired the general insurance business of Bharti AXA General Insurance Company^[which had 1.4% shares. It issued ~3.5 crore equity shares to the promoters of Bharti AXA General Insurance as per the scheme of arrangement.

Some numbers:

Market share Q12023 (GDPI basis): 9.9%

Individual Agents - 94,559

Solvency ratio - 2.61x

Market cap – 55000 Cr

Book Value – Rs. 205

Sales Growth – 17.74% CAGR (Since 2011)

FCF (10yr) – 10,738 Cr

EPS – 32.68

PAT – 1605 Cr (TTM)

PAT Growth – 16.35% CAGR (Since 2011)

P/E – 34x

Investment portfolio mix for Q12023 : Corporate bonds 32.3%, G-Sec 48.5% and equity 12.0%

Unrealized loss of ₹ 5.82 billion as on June 30, 2022 and Unrealized gain on equity portfolio at ₹ 1.03 billion vs.  Unrealized loss on other than equity portfolio at ₹ 6.85 billion.

Investment income was at ₹ 6.55 billion in Q1 FY2023 as against ₹ 8.89 billion in Q1 FY2022.

Combined ratio was 104.1% in Q1 FY2023 as against 123.5% in Q1 FY2022

Beyond numbers

Motor Insurance

For Motor, the Company grew in line with the industry with a market share of 11.3%. The Company increased its proportion of CV mix to 24.6%. The Electric Vehicle segment continues to be a focus area for the Company. Estimated market share of 14% in private cars and 64% in two-wheelers.

The business mix in terms of new and renewal is about 40:60, 40% of the business is new, 60% of the business is renewal.

Telematics based premiums

Authority permitted general insurance companies to introduce the following tech-enabled concepts for the Motor Own Damage (OD) as an “add on” to basic policy:

1. Pay as You Drive

2. Pay How You Drive

3. Floater policy for vehicles belonging to the same individual owner for two wheelers and private cars

The exposure on people who drive less, and those are the customers who end up buying the telematics driven product could be disinflationary, but what it does is basically price the risk better, and logically for the rest of the book the pricing should go up.

OD and TP – Tussle for pricing!

Company does not see any significant increase in the average claim size. Overall in terms of the pricing, the industry has also corrected the pricing a little bit on the OD side. On the TP side the rate increase is not in line with the inflation.

Due to regulatory capping too much of an increase in TP is not possible and so the underwriting discipline and risk management is more stringent in OD segment. When you look at each segment of risk, each risk should be appropriately priced that’s the ultimate principle. But the larger issue is that if more capital comes into a sector, there will always be aggressive behavior by some players. And unfortunately, a lot of investors mistakenly believe that the valuation of a company is a price to GWP multiple, which actually makes no sense. TP loss ratios must be looked on annual basis and not on quarterly basis, because there could be quarters based on the actuarial model, there could be releases for this quarter, and in another quarter they may not be any releases.

Staggered Performance

Bulk of the corporates have their renewals coming through in Q1 where relatively because the size of the risk is bigger, you tend to have an element of reinsurance driving the expenses higher, denting retention ratio a bit. It’s more towards quarter three and quarter four where bulk of the retail business particularly motor and health largely gets driven and booked.

Crop Insurance

Maharashtra changed the scheme from the original insurance scheme as per PMFBY to a scheme where the loss range is capped. It’s a 80:110 scheme, where if the loss ratio is below 80 as an insurance company we will refund that premium to the state. At the same time if the loss ratio is more than 110 the state will pay for that claim. It’s a fixed range product which is a replacement of the traditional PMFBY. Which inturn reduces the reinsurance cost for crop insurance segment.

Health Insurance

The loss ratios are  spread between corporate and retail indemnity book, the corporate loss ratios stands at about 91% and on the retail indemnity book the loss ratio of about 78%.

Retail vs Corporate Book - The corporate, employer-employee book, tends to operate at a loss ratio, which could be ranging anywhere between 95% -100%, and in so far as relatively small and mid corporate book is concerned, they generally tend to operate on again the employer employee part at anywhere between 90% - 95%, which is why on a blended basis, one generally gets to see the loss ratios which are relatively around those mid-nineties threshold. However, the cost of acquisition with respect to these businesses, particularly the large corporates tends to be more direct and hence to that extent on aggregate basis on a combined ratio book, it becomes viable to underwrite. Insofar as the renewal of the portfolio is concerned, a price increase in the range of 15% - 20%.

Remuneration

The growth in revenues in top line has grown by about 28%-29%. The management expense growth has been at about 27.8%. To defend the increased expenditure, management clarified that’s the way look at the numbers, whether it is commissions or whether it is operating expenses, all of them go into cost of doing the business.

Disruptions coming up !

Looking at the scope for disruption, there are both in terms of insure-tech, the way people source policies, the way people service policies, the way they service claims, there is a tremendous scope for disruption again using digital tools that are now available. Similarly there is also some amount of disruption that is possible in the distribution side now.

ICICI Lombard - launched the renewal and the cross sell, upsell module through their app.

Antithesis

Majority of the business dependent on auto sales (almost 50%) – secular vs. cyclical bet.

More investment in short term assets, leading to average to poor returns. (Management pointed out  7% annual return on investments)

Regulator caps the TP motor insurance – frequent changes seen in last 5 years

Thesis

Growth pointers – Underpenetrated market but tussle to gain market share.

Operating leverage as investment returns can offset the cyclical element.

Fair valuation

Disclaimer – This is not any investment advice but only for educational purposes.