Insurance Finance & Investments: Cash is still King!
Cash is still KING!
“You will soon find out that your biggest problem is.…What to do with all the fucking cash.” This is a line from the movie Scarface starring Al Pacino, whose boss in the film, Frank Lopez, explains the narcotics business to him.
I bet you never thought that insurance and the narcotics “business” have something so fundamental in common. Apparently they do, and share that commonality with supermarkets. In a nutshell, insurance companies work like supermarkets in that they have negative working capital requirements.
The supermarket business model entails putting products on the shelves, selling them to consumers first, and paying suppliers later. Supermarkets, like insurers, are capital-heavy in the set up stage. They first invest in real estate purchases or leases, people, and systems and then, within a short period of time, operate at a negative working capital requirement thanks to the time lag between when they sell products to consumers and when they have to pay suppliers.
Enters Mr. Buffett’s float concept, which is money that insurers borrow at little or no cost.*
Insurance companies collect premiums before paying claims. Well, they are supposed to anyway. Properly-capitalized insurers have a lot more cash than they require from day one and continue to build their cash reserves over time thanks to the time lag between premium collection and claims payment.
Insurers then face the issue of what to do with all the cash. Al Pacino’s Scarface lessons, I’m afraid, won’t be of much help here, but this blog should provide some guidance.
As cash is king, you need to collect it, manage it, and love it. To do that, starting at the top as always, you need to hire a great CFO.
What Makes a Great Insurance CFO?
The CFO’s is probably one of the toughest jobs in the industry as it requires a unique balancing act to perform superbly.
Your CFO must be equally comfortable with the routine, repetitive, mundane, and control aspects of the job as well as its more strategic demands. He or she should be able to quickly step out of control and interpretation mode, put on a deal-maker hat, and get M&A deals done.
I am going to play David Letterman here and take poetic license to give you a sample of my top sixteen attributes a CFO should possess. Please refer to the chapter 6 in The Insurance Management Playbook for the full list:
> Has a strategic mind-set and understands how to plan and model to arrive at your desired financial end state.
> Pushes the business to spend in the right way to build capabilities and market relationships at all levels of the organization.
> Is trusted by his or her functional bosses at regional and head-office levels.
> Understands trend analysis and proactively suggests options to mitigate future issues, such as aligning your operational expenses with top-line shortfall to hit the overall financial metrics.
> Has a good sense of humor. Insurance accounting and finance can be dull.
> Possesses strong leadership skills and is well-liked and -respected by his or her team and peers.
> Is a very good internal and external communicator, translating the numbers, connecting the dots, and telling a story.
> Is capable and willing to take over from the boss to run meetings, chair committees, and more.
There are three core principles to remember when thinking through insurance company investments:
> As the guardian of policyholders’ and investors’ funds, the insurance company’s overarching investment philosophy must be capital preservation to ensure having sufficient liquidity to pay claims when they arise.
> Cash flow management is vital as insurance companies’ profits come in two forms: Underwriting profits and investment income, which accounts for some 50% of the industry's profits.
> Insurers should underwrite and service claims for a living, and professional money managers should handle investments. Outsourcing the investment activity is prudent.
The Insurance Management Playbook contains illustrative tables of U.S. property and casualty (P&C) and life and health (L&H) insurance companies’ invested assets from 2010 to 2012. The main takeaway is that in a properly regulated market the invested assets’ portfolio mix looks very conservative: P&C insurers invest over 65 percent of their assets in US T-bills and other government and municipal bonds as well as highly-rated corporate debt whereas the figure for L&H insurers is closer to 75 percent in the United States.
The portfolio mix looks materially different in less regulated emerging market environments. This could be a recipe for disaster as an insurance company that is heavily invested in the stock market or real estate may see the value of its investment portfolio falling below the value of its obligations at any given time.
A devaluation of a firm’s investments will weaken its balance sheet, affect its solvency ratios, and may strain relations between its senior management and its regulators as well as its rating agencies. Most regulators mandate a certain level of solvency, which is the amount of capital an insurance company holds in excess of its short- and long-term liabilities. Highly rated companies’ solvency margins are often 50 to 100 percent higher than the regulatory requirements.
So, to practice what I preach and keep it simple, be conservative when investing insurance company assets.
Assets & Liabilities Matching
A brief word about the concept of assets and liabilities matching (ALM) to shed some light on the timing of insurers’ investments’ maturity.
An auto/motor or property short-tail insurer needs to have a lot more liquid assets on hand to meet claims obligations that will most probably arise over a period of twelve to eighteen months versus, say, a professional liability writer for notaries or obstetricians who will need the claims dollars some five, ten, or even twenty years after the policy underwriting, and premium collection, year.
The above paragraph refers to the concept of tail which is the time lag between underwriting a policy and ultimately paying out a claim.
ALM is a methodology for how and how long to invest your assets in order to have enough liquidity when the claims start coming in and you need to pay out. It is not an exact science but the approach is a lot more scientific than artistic. For a discussion on art vs. science please refer to my recent blog: Insurance Underwriting: War and Inefficiency.
Who Should Invest you Insurance Funds?
I don’t like do-it-yourselfers when it comes to investing insurance assets for most companies out there. It could be a recipe for disaster.
A company's in-house investment team will probably never out-perform an asset manager who is experienced in investing insurance companies’ monies like the giant BlackRock or boutique General Re New England Asset Management. CFOs might find this hard to swallow, but it’s true.
Even the biggest insurance and reinsurance firms outsource the majority of their investment activities. They follow the money managers’ performance closely and participate in the strategic asset allocation decisions, but the smart ones let the professional money managers get on with it.
So, pick a great asset manager, figure out what his or her insurance and overall experience and track records are, and stick with that person or company as long as they deliver.
Finance Controls & Processes
The Good News: I will spare you the torture of delving into this supremely important area of finance in detail here. However, The Playbook contains some 15 pages of guidance and tips on the topic.
The Bad News: A few areas to watch out for:
> Process mapping and segregation of tasks and functions are key to have a controlled environment, avoid slippage, and minimize the risk of fraud. Segregation is also important from a regulatory and anti-money laundering points of view. When in doubt, be obsessive about controls.
> Receivables: Just like I argued in my Why Sales must be Everybody's Business in Insurance blog, cash collection is EVERYBODY’s job in an insurance company from the CEO downwards.
> Expense Control: As technical and investment margins continue to be squeezed, more focus is being placed on expense control. Don’t overdo it and squeeze your employees and distributors but this is definitely an area to be laser-focused on. As advised in my Insurance Entertaining in a Global Economy blog, don't take a falafel burger client to a steak dinner and so on.
> Go back to the beginning of the blog and review some of the top attributes of great CFOs.
> On the investments side, your overarching investment principle should be capital preservation.
> Establish an assets and liabilities matching committee and outsource your investments to a professional asset manager with insurance business experience.
> Collect cash on time and milk the asset. Receivables and cash flow should be obsessively looked after. Cash collection is everybody’s business, from the CEO down.
> The segregation of responsibilities will increase your control over the business.
> Keep an eye on regulatory and anti-money-laundering requirements when constructing your controls and segregation-of-powers system.
> Engage audit teams proactively. Benefit from their knowledge, insight, and experience to help your run your business better. They are not there to catch you but simply to make the business stronger.
> Expense control is paramount. It can deliver operating profit and give you pricing power in the marketplace. Establish policies and communicate them clearly.