Have you ever wondered what it means when we buy an insurance policy? Is it simply about making a bet as to whether something awful might happen?
For instance, when we insure the contents of our homes, is it a wager with an insurer on whether we might be burgled? There is, perhaps, some truth in that.
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But consider this scenario. One million households voluntarily contribute $100 a year into an insurance pool every year. If something terrible should happen to any of the homes, then they would be compensated from the money collected….
…. It could be financially crippling for any one of those households to shoulder the burden of an expensive repair by itself. But it is less onerous if it should only cost a hundred bucks a year to pay for a repair that might costs thousands of dollars. So, insurance is collective risk management.
Winners and losers
Insurers are also making calculated wagers. They might bet on how long someone could live. For instance, on the day that we retire, we can swap a sum of money that we have saved in exchange for an annuity that would continue to pay us for as long as we are alive.
That is essentially a bet on how long we might live. If we should get back more money than we have handed over to the assurance company, then we have effectively “won”. If we don’t, then we have “lost”. But we are not exactly able to complain, though, because we would be dead.
Whether it is an assurer or an insurer, these businesses can amass huge sums of money that are not immediately required but will still need to be invested. This is known as the float.
Berkshire Hathaway is, for example, an insurer that has, and continues to provide Warren Buffett with the float or capital that he needs to invest. It is almost as good as an interest free loan. It has made him one of the richest people in the world because he is very good at allocating the funds available.
If we invest in insurance companies, we are relying on them to invest their floats profitably. We also need them to be conservative and disciplined when writing policies, so they don’t pay out more in claims than they collect in premiums. If it can do both things successfully, then their book values should grow steadily over time.
By the book
The rate at which insurers grow their net asset values can vary widely. But generally, they have grown them in the mid-teens. The ability to grow that book value can reflect an insurer’s ability to write profitable policies and an ability to invest the float prudently.
Some of the above-average performers include China’s Ping An Insurance (SEHK: 2318.HK), Malaysia’s Allianz Malaysia (KLSE: 1163.KL) and Sri Lanka’s People’s Insurance.
A rising book could be an important driver for the market values of these insurers, which might appeal to growth investors. Meanwhile, the rate at which dividends can grow could provide income investors with rising payouts.
The average rate of growth of dividend is around 8%, though some insurers have grown their payouts considerably faster. These include some Chinese insurers that are tapping into a growing market. According to Swiss Re, China’s share of the global insurance market could double from 11% in 2018 to 22% by the early 2030s.
The use of levers
One of the main drivers of dividend growth could come from a high return on equity. This is the amount of profit that a company can generate on every dollar invested by shareholders. Insurers don’t disappoint.
The average return on equity is 11%. Some of the highest include Prudential (SGX: K6S), which is listed on the Singapore Exchange, and Malaysia’s Syarikat Takaful (KLSE: 6139.KL). These high returns on equity stem primarily from a use of leverage.
On average, insurers have as much in liabilities as they do in assets. But those liabilities are primarily insurance and annuity payments that are paid over a long time.
A high return on equity on its own is pointless unless the insurer retains a significant portion of its profits. By and large, insurers are not the most generous of dividend payers.
The median payout ratio is just 20%, which means that they retain around 80% for use within the business. That could explain their fast dividend growth, though. A retention ratio of 80% coupled with a return on equity of 11% would imply a dividend growth rate of around 8%.
The lesson for investors is that sometimes a low dividend yield might not look attractive today. But if the dividend can grow quickly, then a 2% yield could double in eight years if the payout can grow at 9% a year. Chances are, the share price could grow at the same rate too.
A version of this article first appeared in the Business Times.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore Director David Kuo owns shares in Allianz Malaysia.