Intangible factors in valuing insurance company stocks
Beginner Stock Market Investing, Stock Market Investing Advice, Stock Valuation
There are a number of people who believe that because of the perceived complexity of the insurance business, they should stay away from investing in insurance stocks. This is a real pity because the process of valuing insurance company stocks it’s not as complicated as you may believe and they can often be highly attractive investments. It does not take knowledge of rocket science to carry out this valuation and all you need is some plain common sense.
In the valuation of insurance stocks, it is as important to clearly understand the intangible factors as it is to do the number crunching… You should realize that the business of insurance consists of setting protection against risk and putting a value on this protection. Because of the inherent uncertainty of risk, when you look at an insurer’s financial statements, you are actually looking at a best calculation guess on the part of management and an educated estimation. Whenever you deal with estimates, you have to trust the person providing the estimate in order to rely on them.
The first thing that you should be doing in valuing an insurance company is to judge the quality and the integrity of the management. Inefficient or untrustworthy management can leave you with a stock that is worth nothing. Judging the quality of management can be a tricky and misleading process and plenty of intelligent and educated people have been taken to the cleaners by insurance companies that went bust. In this process of evaluating management, there are several tools that you should look for.
The first is the ownership pattern of the insurance company to help you to decide what possible objectives of management could have. If the management has a sizable interest in the stock of the company by way of investment or options, they are likely to have a sizable stake in the sustained profitability and prosperity of the company. This is also true if they have founded the company and treat it much like their own baby. This is a plus point when it comes to investment. If the management has no real interest in building up shareholder value, you will need to exercise caution.
A closely related factor is the compensation package for employees and its composition. Does management get penalized by forfeiting bonuses in the event of below average performance? Does the company provide overly generous stock options schemes that dilute the interests of average shareholders without any tangible rewards for them? Check the track record of acquisitions because managements have been known to indulge in this activity, not because it is in the long-term interest but because it gives them a bigger paycheck.
You also need to determine whether compensation is based on business volumes or business profitability. There are a large number of instances not only in insurance market and in businesses such as investment banking where volume-based incentives have led to deteriorating risk standards in the quest for short-term compensation. A good management is also forthright in its disclosures and aims to educate and improve the understanding of their shareholders.
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