Defensive Value Investing: A 20-week course
“First, let’s analyze why the financial crisis occurred. If I could sum up the catastrophe in one word, it would be ‘leverage.’ “Steve Eisman (reimagined as Mark Baum in The Big Short)
So far we’ve looked at a number of different ways to measure a company’s financial performance.
We’ve measured growth rate by looking at the growth of revenues, capital employed and dividends. We’ve measured growth quality by counting revenue, earnings and dividend increases, and we’ve looked at other factors such as debts (via the debt ratio) and profitability (via return on lease-adjusted capital employed and profit margins).
For the majority of companies these metrics and ratios work just fine. But for banks and insurance companies, they don’t.
So today I want to focus on why banks and insurers are different and what adjustments we need to make so that we can analyse them sensibly. Let’s get the ball rolling with banks.
Why banks are different
Most companies are trading businesses. Very simplistically, trading businesses buy in goods or materials, do something to those goods and materials to add value (perhaps turning wood into chairs, or stacking tins of beans on a convenient supermarket shelf) and then sell the end product to customers.
Most trading businesses require capital assets such as property, plant and equipment to add value to their raw materials. These assets are primarily paid for with money that belongs to shareholders, and some use of borrowed funds (although hopefully not too much) is also common.
Service businesses are similar to trading companies, except they provide services instead of products. So an accountancy business is a service business, but the accounting software is provided by a trading business because software is a product.
Service businesses are very similar to trading businesses, except there is often little or nothing in the way of ‘raw materials’. They also require capital assets, although usually less than a trading business.
capital from shareholders, perhaps top that up with a little debt, and then use those funds to buy property, plant, equipment and raw materials. They then turn those raw materials into finished goods, which they sell to customers in exchange for cash. Some businesses provide services rather than goods (e.g. accountants), but the basic idea is the same.
Banks and insurers are financial companies, and they have a different business model.
For the most part, banks generate profits by lending money to other companies or individuals. The borrow money from depositors and pay them, say, 1% interest on their deposits, and then lend that money out to borrowers at, say, 5% interest.
The difference between interest received and interest paid is called net interest, and most banks show net interest at the top of their income statement rather than revenues.
As well as having different income statements, banks also have different balance sheets. For example, most companies fund their operations with a balanced mix or equity (in the form of retained earnings of cash raised from rights issues) and debt. But banks, on the other hand, typically fund their operations almost entirely from customer deposits.
For banks, loans are assets and customer deposits are liabilities.
Financial companies, such as banks and insurers, are a special case. Instead of revenue, banks often refer to net interest income, while insurance companies use terms like net earned premium or insurance revenue. This can make things rather complicated, so instead of revenue I use book value (often called shareholders’ equity) as the top line measure of a financial company’s progress.
Here’s a short definition of book value:
Book value is a balance sheet item equal to total assets minus total liabilities.
It is also known as net asset value, shareholders’ equity or total equity. For banks, book value is (very approximately) the difference between loans (which are an asset from the bank’s point of view) and deposits (which are a liability). Banks primarily make a profit from the difference between what it costs them to borrow (the interest they pay on deposits) and what they earn from lending those deposits out (the interest they receive on loans). Generally speaking, an increase in book value means a bank is taking in more deposits and making more loans, which in turn means it has the potential to produce larger earnings and dividends. It’s similar to how an increase in revenues for non-financial companies creates the potential for more earnings and more dividends.
The same sort of story applies to insurance companies. In their case book value can be thought of (again, very approximately) as the difference between insurance premiums that have been put aside to cover the cost of future claims (which are an asset) and the expected costs of those future claims (which are liabilities). Again, generally speaking, an increase in book value means an insurance company has taken in more premiums in order to cover more insurance risk, which in turn means it has the potential to produce larger earnings and dividends.
As with growth quality for revenues, earnings and dividends, calculating the growth quality of book value for financial companies is just a case of noting down how many times their book value went up over the last ten years. From here onwards, if I mention revenues then take that to mean book value in the case of financial companies.
CHAPTER 3 (PROFITABILITY)
Profitability for financial companies
For financial companies such as banks and insurers I use return on equity (ROE) instead of net ROCE. ROE is the ratio between post-tax profits and shareholders’ equity (book value), which is equal to total assets minus total liabilities. I’ll go into the balance sheets of financial companies in more detail in the next chapter, so for now I’ll just say that ROE makes more sense than ROCE when calculating profitability for these companies.
The calculation is almost the same as before, except in this case you won’t need to find the figures for fixed assets, current assets or current liabilities. Instead you’ll need:
- Shareholders’ equity – Also known as total equity, book value or net asset value; can be found on the balance sheet.
In fact you should already have this data as shareholders’ equity (i.e. book value) is used in the calculation of both growth rate and growth quality for financial companies.
To calculate profitability for financial companies the steps are:
- Calculate ROE for each year as:
- ROE = (post-tax profit / shareholders’ equity) × 100%
- Take profitability to be the median ROE for the period, i.e. the middle value when all the results are placed in ascending order.
The rule of thumb for financial company profitability is the same as before (above 7%). However, in addition to return on equity, we will also be measuring the profitability of insurance companies with the combined ratio as well.
The combined ratio for insurance companies
To understand the combined ratio we need to look at the two ways in which insurance companies make their profits:
- Underwriting (insurance) profit – Writing insurance policies where the premium more than covers the expected cost of claims and other expenses.
- Investment profit – Between the time that premiums are collected and the time they are paid out to cover claims (which can be many years), insurance companies invest those premiums and record whatever returns the investment markets provide as a profit (or a loss if the investments do badly).
Generally an insurance company would want to make good profits on both the underwriting and investment sides of its business. However, of the two forms of profit, underwriting profit is the most important because it represents the profit from the company’s core insurance business rather than the ups and downs of the investment markets. The combined ratio is how we can measure that underwriting profit.
I’ll explain how the combined ratio works with an example.
Imagine an insurance company that receives £ 100m in car insurance premiums, but expects to have to pay out £ 105m in claims and £ 5m in expenses. Under those circumstances it would make an underwriting loss of £ 10m (£ 100m premium income minus £ 105m claims minus £ 5m expenses).
The scale of this loss can be measured with the combined ratio as the combined ratio is a combination of both the loss ratio (the ratio of claims – known as losses – to premiums) and the expense ratio (the ratio of expenses to premiums).
So in the previous example the company has a loss ratio of 105% (ratio of £ 105m of claims to £ 100m of premiums) and an expense ratio of 5% (ratio of £ 5m of expenses to £ 100m of premiums) giving a combined ratio of 110%. The company made a £ 10m underwriting loss and so, as you can see, a combined ratio which is over 100% shows that an insurance company has been losing money on its underwriting activities.
Although most of the time insurance companies will want to make profits on both sides of their businesses, this is not always the case. A good example of this would be the long stock market boom of the 1990s, where many insurance companies were able to make huge profits primarily on the investment side of their business. In fact, investment returns were so good that many were willing to offer insurance for less than the expected cost of claims (in other words to make an underwriting loss) just to get their hands on more premiums which they could then invest in the stock market.
Of course making an underwriting loss every year would be a very bad way to run a business were it not for the fact that the insurance premiums, once collected, can be invested to generate an investment return. Using the previous example, if the £ 100m of premiums were invested for an annual return of 20% then the £ 20m investment return would more than offset the £ 10m underwriting loss. The result would be a net profit. That’s basically what a lot of insurance companies were doing during the heady days of the dot-com boom. It’s a very risky way to run an insurance business because investment returns can be volatile and profits can quickly turn to losses.
Table 3.2 shows the combined ratios of several leading insurance companies at two separate points in time.
Each company that existed in 2000 was willing to write insurance at an underwriting loss, i.e. the combined ratios are all above 100%. Each ratio in 2000 is around 110%, which means each premium payment of £ 100 was expected to cost the company around £ 110 in claims and expenses. The management of each company must have believed that investment returns would more than offset those underwriting losses. Unfortunately for their shareholders, it didn’t quite work out that way.
When the stock market fell from 2000 to 2003 each company would have made heavy losses on any equity investments and there would have been no underwriting profits to fall back on.
That’s why I insist that any insurance company I invest in has a profitable underwriting business, so that it doesn’t have to be overly reliant on risky and volatile investment returns.
My rule of thumb for insurance company profitability checks that over a period of time the company has made a reasonable profit from its underwriting business:
Defensive value rule of thumb
Only invest in an insurance company if its five-year average combined ratio is less than 95%.
The combined ratio isn’t used by life insurance companies (insurance companies are usually categorised as life or non-life, as the two markets require substantially different business models), so don’t be surprised if you find a company in the life insurance sector which doesn’t quote one. However, if the company does have general (non-life) insurance operations as well, as Aviva does, then it probably will quote a figure for the combined ratio. The best approach is to just scan through the annual results to see if the ratio is there. If I can’t find a combined ratio in an insurance company’s annual results then I’ll just measure its profitability with return on equity alone.
Okay that’s enough theory; let’s work through a couple of examples using a company I have recently been invested in.
Amlin is a FTSE 250-listed reinsurance company (i.e. it provides insurance to insurance companies) that operates primarily through Lloyd’s of London, but also has operations abroad. Note that Amlin has recently been taken over and de-listed from the stock market, but that does not change the usefulness of this example. You can see the relevant figures for Amlin in Table 3.3.
Let’s go ahead and calculate Amlin’s profitability:
- Calculate ROE for each year
- As before I’ll just do this for 2005. All other years follow the same process.
- 2005 ROE = (£ 140m / £ 785m) × 100 = 17.9%
- Take profitability to be the median ROE for the period, i.e. the middle value if the results were all aligned in ascending order.
After sorting Amlin’s ROE results into ascending order the middle two values are 17.5% and 17.8%. The median is the average of those two, which is 17.6%.
Despite making a loss in 2011 (due to major earthquakes in New Zealand and Japan), Amlin’s profitability is 17.6%, which is very high and a long way clear of my 7% minimum.
As with British American Tobacco, Amlin is an above average company when it comes to long-term profitability.
Amlin’s combined ratio
I’ll use Amlin again as the example for the combined ratio so that you can see how it performs on a different measure of profitability to ROE.
This time there are almost no calculations to be done – if the company has a combined ratio then it is simply stated in the annual results. All you have to do is search for it and make a note of its value over a five-year period, which you can see for Amlin in Table 3.4.
Amlin’s average combined ratio over this period is 92.2%, so its underwriting business has been profitable enough to pass my 95% rule of thumb. This is further evidence of the company’s strong profitability.
CHAPTER 4: CONSERVATIVE FINANCES
Conservative finances for banks
The core business of a bank is to borrow money from those who have it (by taking in deposits, such as through current accounts) and lend it on to those who need it (in the form of loans and mortgages). Profits come primarily from net interest income, i.e. the difference between the interest income on money it has lent out (say a loan with 6% interest) and the interest expense on money it has borrowed (such as a current account with 3% interest). There’s a bit more to it than that of course, but that’s the basic picture.
So the entire business of a bank depends on borrowed money. The result is that normal debt ratios (including the one I’ve just described) are largely useless when analysing banks because they make banks look hopelessly over-leveraged (where leverage means the use of debt as a lever to increase returns).
In my early days as an active investor I simply ignored this problem and assumed that banks, which operate in a highly regulated industry, would always be a safe bet. However, the recent financial crisis blew that theory out of the window and so I spent some time looking for a simple ratio or measure that might separate safer banks from riskier ones. Fortunately banking regulators have come to like the idea of simple ratios and so now I use a ratio which has become a central focus of banks and bank regulators in the wake of the financial crisis.
For that ratio to make sense, I need to briefly outline some of the key ideas that relate to bank balance sheets and how they differ from non-bank balance sheets. This will not be a completely accurate representation of how banks work, but for our purposes it will be more than sufficient.
Bank balance sheets
Imagine a bank that has £ 100m of customer deposits held across many current accounts. Those are the bank’s liabilities (otherwise known as its sources of funds). The bank has loaned £ 99m of those deposits out to small businesses and homebuyers, leaving £ 1m in its vault as a daily cash float. Together the loans and the cash make up the bank’s assets (otherwise known as its uses of funds).
In that very simple example everything works fine when the loans are all repaid on time, but in the real world some loans are not repaid on time and some are not repaid at all. If £ 5m of the bank’s loans are not repaid (i.e. are defaulted on) the bank would have £ 100m in liabilities (those current accounts) but only £ 95m in assets (£ 94m in loans and £ 1m in cash). The bank would no longer have enough money to pay back its depositors and so it would be technically insolvent; shareholders would almost certainly be asked to put up additional capital through a rights issue to make the company solvent again.
To avoid this situation, banks have additional sources of funds which can absorb losses more easily than current account deposits. These include some forms of unsecured debt, but the primary buffer in this situation is shareholder equity.
Imagine the same bank as before, but this time instead of having £ 100m of deposits the bank has £ 90m. It now also has £ 10m of capital invested by shareholders, giving it the same £ 100m of funds as before. If £ 99m is lent out and if the same £ 5m of loans is not repaid, it has the same default rate as before, but this time the bank’s assets (£ 94m in loans that will be repaid and £ 1m cash in the vault) are still worth more than its customers’ deposits (£ 90m). In this scenario those current account holders can still get all their money back and so a rights issue would not be required to raise additional funds.
The difference with the second case is that rather than depositors taking a potential hit, the bank’s shareholders have now absorbed the losses. More specifically, shareholder equity has absorbed the losses by declining in value from £ 10m before those loans were defaulted on to £ 5m afterwards.
This sounds bad for shareholders, but in reality it may or may not have a material impact on shareholder wealth as the buffer of shareholder equity can be rebuilt in subsequent years, for example if future default rates are below expectations. By having a sufficient buffer of shareholder equity the bank has been able to absorb losses without having to do unpleasant things like suspend dividends or raise additional capital through a rights issue.
The common equity tier 1 ratio
To measure the ratio between a bank’s equity buffer and the amount of loans it has made, I use a ratio called the common equity tier 1 ratio (CET1 ratio). Common equity tier 1 is basically shareholder equity with a few adjustments which we don’t need to worry about. It is, according to the latest banking regulations, the “highest quality component of a bank’s capital”.
The CET1 ratio is the ratio between a bank’s common equity tier 1 capital and its risk weighted assets (RWA), where RWA is basically the value of the bank’s loans and other assets, adjusted upwards or downwards depending on how risky they are deemed to be. In practical terms, the higher the CET1 ratio the more of an equity buffer a bank has against the unexpected.
So looking back at that previous example, with its £ 10m of shareholder equity and £ 100m of loans and cash (ignoring the risk weighting of the loans for the sake of simplicity), the CET1 ratio for the bank would be £ 10m divided by £ 100m, which is 10%.
One thing I should point out is that while the CET1 ratio is found in the annual and interim results, you will struggle to find it in older results because it’s fairly new. However, its predecessor, the core equity tier 1 ratio, is very similar and for our purposes the two are interchangeable. If I refer to CET1 then take that to mean either the common or core equity tier 1 ratio, depending on what was in use at the time.
Table 4.4 shows the CET1 ratio for several leading banks, before the financial crisis and after.
TABLE OF CET1 RATIOS FOR BANKS
Table 4.4: Common equity tier 1 ratios for several leading banks before and after the financial crisis
Before the financial crisis all of the surviving banks in Table 4.4 had lower CET1 ratios than they did a few years after the crisis. It’s interesting to see that HBOS, with the lowest pre-crisis ratio, was taken over, while Standard Chartered, with the highest pre-crisis ratio, was barely hurt by the crisis at all (although there were also many other factors, not least of which was the fact that Standard Chartered’s business operates primarily in markets that were not hurt so immediately by the crisis).
Of course there is much more to calculating the risks faced by a large bank than simply looking at its CET1 ratio. However, I still think the ratio has a lot of merit to it. It’s usually easy to find the number in the annual reports, it’s used extensively by the banks themselves and it does appear to have a reasonable correlation to how well each bank withstood the stresses of the financial crisis.
As with many of the financial ratios and metrics in this book, I prefer to look at the average CET1 ratio over a number of years.
Calculating the average CET1 ratio
To calculate the average CET1 ratio you’ll need:
- Common equity tier 1 ratio (CET1 ratio) – For the most recent five years. This isn’t part of the balance sheet but it should be found fairly prominently towards the beginning of a bank’s annual results. Older results may refer to the similar core equity tier 1 ratio instead.
There is only one step to calculating this metric:
- Calculate the five-year average CET1 ratio
What is a reasonable CET1 ratio?
The latest banking regulations state that a bank must have a CET1 ratio of at least 4.5% at all times. On top of this, an additional buffer of 2.5% (taking the total to 7%) should be built up during good times so that it may, if necessary, be drawn down in bad times. Finally, there is an additional buffer for systemically important banks of up to 2.5%, taking the maximum requirement at any time to 9.5%.
That seems like a fairly reasonable minimum to me. As Table 4.4 shows, before the financial crisis most banks had a CET1 ratio of less than 9.5%. After the crisis they have all moved to ratios above 9.5%.
I want any bank that I invest in to have been slightly more cautious than the maximum caution stipulated by the regulators, so until recently my rule of thumb was to insist that the average of this ratio be 10% at least. However, problems with Standard Chartered (one of my previous holdings) have made me more cautious still and so now my required ratio is even higher (I will talk about improving and evolving the strategy based on your experiences as an investor in Chapter 14).
Defensive value rule of thumb
Only invest in a bank if its five-year average common equity tier 1 ratio is above 12%.
Given that Standard Chartered has had problems, let’s calculate its average CET1 ratio to see if it passes the new stricter rule of thumb.
Standard Chartered’s common equity tier 1 ratio
Standard Chartered is a FTSE 100-listed bank which operates primarily in Asia, Africa and the Middle East. In recent years it became popular with investors because it came through the financial crisis with barely a scratch on it, largely thanks to its small exposure to Western markets and a relatively strong balance sheet.
Like the combined ratio, the common equity tier 1 ratio doesn’t need to be calculated; it will simply be quoted in a bank’s annual results. You can see Standard Chartered’s CET1 ratios over the last five years in Table 4.5.
Table 4.5: Standard Chartered CET1 ratio for the five years to 2014
The decline in CET1 from 2013 to 2014 in Table 4.5 was primarily down to regulatory changes, where the ratio being used switched from core equity to common equity, which is calculated in a slightly different way (the common equity ratio is usually slightly lower).
Standard Chartered’s average CET1 ratio of 11.6% was, and still is, conservative relative to the ratios maintained at most other major international banks. However, many of those other banks have had enormous problems after the financial crisis and, while Standard Chartered’s recent dividend cut and rights issue have been minor in comparison, the fact that they have occurred shows that even a CET1 ratio of more than 10% is not really high enough to be considered conservative.
Standard Chartered’s own goal for CET1 beyond 2015 has been increased to the 12% to 13% range, which is why I have increased the CET1 rule of thumb to that level. However, given that new rule of thumb minimum of 12%, Standard Chartered does not make the cut. On that basis I would not describe it as having a history of conservative financing and I would not buy the company’s shares at this point in time under my new rules.
Conservative finances for insurance companies
The first thing to note with insurance companies is that, unlike banks, the debt ratio we looked at earlier is still applicable. However, insurance company borrowings must be separated into core structural borrowings and operational borrowings before the ratio can be calculated.
- Core structural borrowings – These form part of the company’s capital structure, i.e. part of the capital buffer in the same sense as the common equity buffer that banks use. They are typically unsecured, long-dated borrowings that are less risky than operational borrowings.
- Operational borrowings – These are essentially the same as borrowings in non-financial companies. It is these borrowings which we will use to calculate the debt ratio.
The difference between core structural and operational borrowings will either be obvious from the balance sheet or there will be a note to the accounts which breaks down total borrowings into the two categories, assuming the company makes use of either type of funding.
Since operational borrowings for insurance companies are effectively the same as borrowings for non-financial companies, the debt ratio is calculated in the same way. However, for insurance companies I like to go a step further and look at their capital buffer in much the same way as we did with banks, so let’s delve a little deeper into how their balance sheets are structured.
Insurance company balance sheets
Insurance companies exist to spread risk by pooling small, frequent, regular payments from lots of policyholders (known as premiums) in order to cover the costs of large, infrequent, irregular events when they occur (known as claims).
If an insurance company collects more in premiums than it eventually has to pay out in claims and other expenses it will have made a profit on the underwriting side of its business. This is the underwriting profitability we measured with the combined ratio in Chapter 3.
In terms of an insurance company’s balance sheet, its main assets are the pool of collected premiums and its main liabilities are the claims it can reasonably expect to have to pay.
As insurance companies have an obligation first and foremost to fulfil their insurance contracts and pay claims promptly, their assets must always exceed their liabilities. The surplus of assets over liabilities is also known as the premium surplus, as it is effectively the surplus of premiums received over expected claim payments. This surplus is very similar to the capital buffer that banks use and it is required for more or less the same reasons.
Here’s a quick example:
If an insurance company has £100m of pooled premiums and £99m of expected claims it would have a premium surplus of just £1m. If the value of its pooled premiums decreased by just 2% to £98m then the company would be technically insolvent.
Why would the pool of premiums decrease in value?
The reason is that premiums are often invested to some extent in volatile assets such as equities in order to boost the company’s underwriting profit with an additional investment profit. However, as we know, equities can go down as well as up. With a 2% decline in the value of its premium assets, our example insurance company would no longer have enough funds to cover its expected claims. That is not acceptable and so the premium surplus would have to be rebuilt by raising new equity or debt capital, both of which could have a negative impact on shareholder wealth.
This is more or less what happened to many insurance companies such as RSA and Aviva after the dot-com bubble burst. It was a major problem for them and their shareholders.
However, if our example company had £ 100m in premium assets and £ 90m of claim liabilities then it would have a premium surplus of £ 10m. In that case if the premium assets declined in value by 2% to £ 98m the company would still have a sufficient capital buffer and no additional capital would need to be raised. Shareholders in this company would likely be much better off than in the previous example.
There are lots of different ways to measure an insurance company’s capital buffer but I like to use a traditional measure of capital strength known as the premium to surplus ratio.
The premium to surplus ratio
As the name suggests, this is the ratio between premium income (specifically, net written premium) and the premium surplus (usually assumed to be equal to tangible shareholder equity). Here are some definitions:
Net written premium – The amount of premium a company has written during the period in question (typically the financial year) net of reinsurance premiums (where reinsurance is effectively insurance taken out by an insurance company to cover some of the risks it has insured). If, for example, a company wrote a policy for car insurance for £ 120 per year exactly one month before the end of the financial year, it would still represent £ 120 of premium written for that year.
In the premium to surplus ratio, net written premium represents the amount of risk an insurance company is taking on, much like the risk weighted assets in a bank’s common equity tier 1 ratio.
Tangible shareholder equity – This is simply shareholder equity (total assets minus total liabilities) minus any intangible assets on the balance sheet. This is effectively the capital buffer between an insurance company’s expected claims (its liabilities) and its ability to pay those claims (its assets).
However, income statements for insurance companies usually show net earned premium (also known as premium revenue) rather than net written premium, although the difference between premiums earned and written is usually relatively small. This means you’ll have to search the annual results looking explicitly for net written premium, although fortunately it is often mentioned towards the start of the document. Generally I would say it is reasonable to calculate the premium to surplus ratio using either net written or net earned premium, but I will assume you’re using the more technically correct net written premium.
Here’s a quick definition of net earned premium:
Net earned premium – Found on the income statement, but may be referred to as premium revenue. It’s the amount of premium an insurance company has earned during the period. Using the previous example of a £ 120 policy written exactly one month before the year end, the premium earned during the period would be for just that one month, i.e. £10.
Calculating the average premium to surplus ratio
To calculate the five-year average premium to surplus ratio you’ll need the following figures covering the last five years:
- Net written premium – This is not always quoted in the income statement so you’ll just have to search for it in the annual results (or use net earned premium from the income statement).
- Total equity – On the balance sheet.
- Intangible assets – Listed under non-current assets on the balance sheet.
This is a very simple calculation:
- Calculate tangible equity for each of the last five years as:
tangible equity = total equity – intangible assets
- Calculate the premium to surplus ratio for each of the last five years as:
premium to surplus ratio = net written premium / tangible equity
- Calculate a five-year average for the premium to surplus ratio
What is a prudent premium to surplus ratio?
From both research and experience I have found that a premium to surplus ratio of 2 seems to be a reasonable cut-off point for what could be considered a conservative premium surplus.
Beyond that level insurance companies may be more sensitive to negative shocks and surprises, potentially leading to dividend cuts and/ or rights issues. Companies whose ratio is consistently below that limit may be more robust when bad things happen, as they invariably will at some point.
Defensive value rule of thumb
Only invest in an insurance company if its five-year average premium to surplus ratio is less than 2.
Here is a worked example from an insurance company whose shares I have owned quite recently.
RSA Group’s premium to surplus ratio RSA (previously called Royal & Sun Alliance) is a FTSE 100-listed general insurance company, which means it primarily insures things like cars and houses. It has had a pretty rough time of it since the year 2000, with rights issues and dividend cuts on more than one occasion.
Table 4.6 shows how thick its capital buffer has been over the past five years.
Table 4.6: RSA Group’s average premium to surplus ratio for the five years to 2014
Let’s work through the steps to calculate the average premium to surplus ratio:
- Calculate tangible equity for each of the last five years (here’s the 2010 calculation):
2010 tangible equity = £3,895m - £1,209m = £2,686m
- Calculate the premium to surplus ratio for each of the last five years (again, just for 2010):
2010 premium to surplus ratio = £ 7,455m / £ 2,686 = 2.8
- Calculate a five-year average for the premium to surplus ratio:
five-year average premium to surplus ratio = (2.8 + 3.2 + 3.5 + 4.5 + 2.4) / 5 = 3.3
RSA’s average premium to surplus ratio is 3.3, which is clearly too high for my liking. To make matters worse it is above my preferred maximum of 2 in every single year.
It is perhaps no coincidence that RSA suspended its final dividend for 2013 and launched a £ 775m rights issue in 2014. If it had maintained a significantly lower premium to surplus ratio then perhaps neither of those undesirable actions would have been required.
Amlin’s premium to surplus ratio
Let’s have another look at Amlin to see if it has a substantial capital buffer to go along with the high rates of profitability we uncovered earlier. You can see Amlin’s average premium to surplus ratio in Table 4.7.
Table 4.7: Amlin’s average premium to surplus ratio for the five years to 2014 The premium to surplus ratio for Amlin is below 2 in every single year and therefore – of course – its five-year average is well below 2 as well. Perhaps this is one of the reasons why Amlin was able to maintain its dividend in 2011 even though the company made a substantial loss in that year after several major earthquakes resulted in exceptionally high levels of claims.
As with any financial measure, the premium to surplus ratio is not perfect and a high or low value does not automatically mean an insurance company will or won’t run into problems. However, on balance I think it’s a useful ratio and quite easy to calculate. It can, in many cases, separate out the riskier insurance companies from the not so risky.