Return on equity can be a valuable measuring tool, but not for everyone.
- Kate Smith and Jeff Roberts
- December 2018
- Measuring Profitability: While analysts and investors often focus on return on equity, it is only one of a number of different metrics used for the insurance industry.
- Improved Outlook: ROE is expected to improve significantly for the property/casualty industry for 2018, with lower catastrophe losses, higher investment income and corporate tax cuts being the key drivers.
- Life Sector Focus: Life products generally produce lower return due to hefty capital requirements from regulation. For instance, Solvency II in Europe has made guaranteed products increasingly capital-intensive.
Return on equity is a key metric for analysts and shareholders. But it's not necessarily the most accurate metric for insurers.
Experts say short-term reporting is problematic for life insurers, who need to view profitability with a long-term lens. Though the metric can be more valuable for property/casualty insurers, it still has some issues.
“P&C insurers price their products to return on capital, or equity,” said A.M. Best's Greg Dickerson, senior financial analyst. “But it's not necessarily as good a metric for how the overall operating performance is going because there's some noise in it, such as realized capital gains.
“It's one of the many profitability metrics we look at in ratings. We look at post-tax profitability measures, we look at pretax profitability measures. I wouldn't say that we focus overly on ROE, but it's certainly a component.”
ROE on the Rise
ROE is expected to improve significantly for the property/casualty industry for 2018, with lower catastrophe losses, higher investment income and corporate tax cuts being the key drivers.
Experts say the industry could finish the year with an ROE in the high single digits, nearly doubling its 2017 result of 4.8%.
Through the first six months of 2018, the U.S. property/casualty industry, on a statutory basis, generated an after-tax ROE of 4.4%, according to A.M. Best.
“If the industry does something comparable in the second half of the year, a high single digit ROE wouldn't seem unreasonable,” Dickerson said.
The industry's first-half performance was a marked increase over the same period of 2017, when its ROE was 2.1%.
“You see the year-over-year improvement,” Dickerson said. “For the full year 2017, the industry ended up with a 4.8% total return for the year. Included in the second half of 2017 were large catastrophe losses—Hurricane Harvey, Hurricane Irma and Hurricane Maria. So all things being equal, you would expect 2018 to come in materially stronger than 2017.”
Although the second half of 2018 saw two major U.S. hurricanes—Florence and Michael—those storms were nowhere near the magnitude of the big cats in 2017. Insured losses from Florence have been estimated at up to $3 billion and losses from Michael up to $10 billion. By contrast, Harvey, Irma and Maria generated more than $90 billion in insured losses.
“2017 was the second-highest year for U.S. catastrophe losses in history,” Dickerson said. “In 2018, catastrophe activity has returned to more normalized levels, which will benefit underwriting results. That's a big driver of expected improved results in 2018.”
Investment income also is finally starting to show year-over-year improvement.
“New money is finally getting invested at equivalent or higher rates than the bond portfolios that are coming off the books,” Dickerson said. “So you're seeing higher year-over-year net invest income.”
Many companies also are getting a boost from the reduction of the U.S. corporate tax rate, which dropped from 35% to 21%.
Assurant CEO Alan Colberg said the tax cut has “absolutely” boosted profitability for his company.
“We were a full U.S.-rate taxpayer at 35% for our U.S. business prior to this year,” Colberg said. “We're still a full U.S.-rate taxpayer, at 21%. That's part of the reason our earnings growth this year is strong. We're growing beyond the tax cut, because we have strong growth in our businesses, but we have a significant lift in earnings in 2018 from tax reform.”
Colberg said Assurant's long-term effective tax rate now is 22%-24%, down from around 33%.
“We have a fair amount of business outside of the U.S.,” he said. “In the old model, the rest of the world was a lower tax rate than the U.S.'s 35%. That's how we got down to 33%. Now the rest of the world is a higher tax rate. We have significant Canada operations and a significant and growing Japan business. That pulls our effective tax rate up.
“So we don't get as much of a savings as you might think moving from 35% to 21% because of the mix we have outside of the U.S. But still, it's a meaning lift for us in 2018.”
Dickerson said the lower tax rate doesn't affect every company in the same way, since some weren't full taxpayers to begin with.
“But looking overall at the bottom line,” Dickerson said, “the lower tax rate will benefit more companies than it won't.”
Return on equity is particularly important for life writers. The duration of their liabilities tend to be rather long, certainly longer than property/casualty writers in general.
The Life Lens
In the life space, ROE is a key financial indicator for many public insurers. But it also presents a fundamental incongruence.
Because life insurance is a capital-intensive product that spans decades and needs to be viewed through a long-term lens, true profitability can be determined only after policy obligations have been fulfilled.
Yet ROE is a construct of quarterly return.
That dichotomy can be problematic, sometimes pitting short-term business considerations against the long term and even shareholders against policyholders.
“Sometimes it's difficult because the sacrifice may be that you will start to do things in the short term that will hurt you in the long term, or you'll make decisions in the short term that really don't enhance the economic value to the company,” said Rosemarie Mirabella, director, A.M. Best. “That's what makes this short-term GAAP reporting very problematic for the life industry.”
However, most life insurers do manage to the metric, and not just because it's a core consideration for their shareholders and for A.M. Best analysts in determining company financial and credit ratings.
ROE portends the ability to grow capital, an essential component for life companies.
“ROE is particularly important for life writers,” said Thomas Rosendale, director, A.M. Best. “The duration of their liabilities tend to be rather long, certainly longer than property/casualty writers in general.
“So the ability to demonstrate your capacity for organically growing capital over the long term is particularly important because A.M. Best is looking at the likelihood of companies being able to make good on their policyholder claims, which could be 30, 40, 50 years down the road.”
The global life and annuities industry has maintained a stable ROE of 9% to 10%, according to McKinsey and Company's annual review, Life insurance and annuities state of the industry 2018: The growth imperative.
Life products generally produce lower return due to hefty capital requirements from regulation. For instance, Solvency II in Europe has made guaranteed products increasingly capital-intensive.
Life insurers typically generate half the ROE that annuity companies do over the long term. Term life does better than other life products, and supplemental voluntary products such as accident and health offerings often produce still higher ROE.
“Companies are managing all the assumptions they put into their products, and they manage to a certain rate on return, which turns out to an ROE depending on the capital structure,” said Erik Miller, senior financial analyst, A.M. Best.
The capital-intensive nature of the life industry has driven some companies to exit core businesses in recent years or switch to capital-light products.
MetLife pointed to ROE as a major driver in spinning off its traditional U.S. life insurance and annuity businesses in 2017 into Brighthouse Financial.
In recent years, The Hartford and Voya both shed their runoff variable annuity blocks to focus on new risks, exiting the capital-intensive businesses that had brought earnings volatility and pressure, especially in the prolonged low interest rate environment.
“If you go into any of the research reports of any of the big public companies, the most common theme is how capital-intensive the product is, how much money has to be held on the books and left there earning basically nothing versus how much capital can be deployed for share buybacks and dividends,” Miller said. “What you see is a big push for lower capital-intensive products, which focuses on less diversification and more on concentration of the liability and the risk profile, which obviously makes it more risky overall for the policyholder.”
It is easier to manage the equity part of the ROE equation than the return, so insurers use capital management techniques such as those share repurchases or dividend increases to augment returns.
ROE is most effective as a financial measure when comparing companies selling similar products.
Red flags are raised when they produce different ROEs. It essentially reveals their capital structures differ when they probably should not.
“It tells you how companies are pricing their products for what kind of return,” Miller said. “If you compare company-to-company with similar products, they should have similar returns.”
But ROE can be a misleading metric on the life side unless it's viewed in the proper context and among other variables.
For instance, undercapitalized companies will have better ROEs, but that doesn't necessarily mean they're better companies, said Bill Pargeans, director, A.M. Best.
“It's really risk-adjusted returns,” Mirabella said. “Some of the more sophisticated companies are incorporating that into their analyses and part of their risk management program because it's very hard to look at a number in isolation and say anything about whether it's good or bad.
“What really ultimately matters is: Are you getting the best return for the level of risk that you're taking?”