Investing in insurance stocks is entirely different from investing in normal corporate stocks. You cannot just go for P/E and decide whether you should invest or not. The insurance industry follows an entirely different financial system in which cash flows in as premiums, and payouts happen much later. To create a portfolio, you need to focus on certain sector-specific ratios. Here’s the list of 10 key things you must consider prior to purchasing insurance stocks.
1. Embedded Value (EV)
For life insurance companies, Embedded Value represents the present net worth of the business plus the future profits from the sold policies.
The conventional book value does not reflect the actual value of the insurance company. Smart investors always consider EV when evaluating market valuation. For instance, any investor analysing the HDFC Life share price should consider its Price to EV ratio rather than the traditional P to E ratio to determine whether the stock is undervalued or overvalued.
2. Value of New Business (VNB) Margin
VNB margin shows the profit margin earned from newly issued policies in the year. Higher VNB Margin implies that the business has sold profitable products such as term plans rather than unprofitable products like savings plans. Choose insurers that have maintained or increased their VNB margins every year.
3. Solvency Ratio
This metric indicates whether there is sufficient capital buffer with the insurance company to meet sudden and huge surges in claims. In India, the regulator IRDAI requires the solvency ratio to be at least 150%. The top private players generally keep the buffer up to 180% to 200%.
4. Combined Ratio (For general & health insurers)
For general and health insurance companies, this is the best measure of underwriting efficiency. It takes the sum of incurred claims and operating expenses and divides them by the sum of earned premiums. A combined ratio less than 100% implies that the firm is making profits strictly through policy sales.
5. Persistency Ratio
Persistency Ratio indicates the number of customers who are renewing their policies through regular renewal premiums. Keep a sharp eye on the persistency ratios for the 13th and 61st months. High Persistency Ratios indicate customer satisfaction; hence, the firm earns predictable, recurring cash flows without having to incur additional marketing costs.
6. Distribution network and Bancassurance Moat
The companies which have a great exclusive relationship with the major banks (bancassurance) can easily sell the policy to millions of people through the banking channel at an extremely low cost. Diversification through multiple channels including banks, direct sales, and online digital channels is a great strategic strength.
7. Product mix and business diversification
Don’t overlook what kinds of products the insurer is promoting. Is their emphasis on ULIPS, or do they have a balanced mix of profit-oriented pure protection term plans, health insurance, and annuity plans? The proper product mix protects you during a bearish market scenario.
8. Quality of investment float
Insurers retain substantial funds in the form of collected premiums prior to any claims being made, which is referred to as the float. The float helps earn additional money through interest for the firm. Look at the balance sheet and determine whether the float is invested in good government bonds or corporate bonds instead of high-risk stocks.
9. Claim Settlement Ratio (CSR)
A good record of high CSR establishes trust for the brand among consumers.
Though marketing can bring in new customers, customers stay loyal to businesses that have hassle-free claims settlement procedures without any legal issues involved. Good CSR has a direct link to customer retention and market share gain.
10. Regulatory changes and tax policies
Indian insurance companies are highly regulated. The slightest change in the rules and regulations laid down by IRDAI or a reduction in taxes proposed in the budget can affect the bottom line of the company. Watch out for any changes in policies and commission structure caps before you invest in the stock market.
Conclusion
Evaluating an insurance company becomes easier if you concentrate on important ratios used in the industry, such as VNB margin and persistency. Investing in well-managed insurance companies that have good underwriting policies protects your investment from unexpected losses while ensuring consistent growth in the long term.
