Professional Documents
Culture Documents
Additionally, because of the sources of some of their capital (largely individual consumers), there is strict
regulation surrounding what kind of assets FIG companies can and cannot hold on their balance sheet,
and in what quantities.
There are a multitude of additional complexities involved with FIG companies which will not be covered
here, but this should help to provide a basic understanding of how FIG companies operate and function
and how people think about them.
Lets go ahead and start with banks
1) Banks
How Do Banks Make Money?
Net Interest Income (50-75% of revenues). The interest they receive on their interest-earning assets
(loans), less the cost of: The interest they pay on their interest-bearing liabilities (deposits) The cost of
bad loans (mortgages they foreclose on)
Banks hold deposits, for which they pay little interest, and use them to make loans, for which they earn as
much interest as they can. They also have to eat the cost of loans that default, how much of which is
dependent on the quality of said loans and what collateral (if any) is associated with them.
Besides just deposits, banks can also fund their lending activities using wholesale funding from other
financial institutions, the government (i.e., the Fed), and the capital markets. Together, these comprise a
banks interest-bearing liabilities. Equity contributions are also a source of capital, though it is usually
fairly limited because of how banks deliver value to shareholders and the capital requirements associated
with how they maintain their balance sheets.
The investments banks interest-earning assets are primarily composed of loans (mortgages,
commercial financings, construction loans, etc.), but can also include investments in other sources
(securities, proprietary PE-type investments, stocks and bonds, etc.) depending on a banks capital
position.
The reason that interest expense is included above the top line (in net revenues) is because interest
expense for a bank is analogous to COGS for a widget company. The uses of the liabilities drive bank
interest expenses are fungible between being operational and being a traditional source of financing
since again, their assets are their capital.
Non-interest income (25-50% of revenues):
Mostly composed of fees, but can include other fun stuff as well.
Banks charge fees for pretty much anything they can get away with likely the best know examples are
investment banks charging advisory fees and commercial banks charging lending and deposit fees (think
ATM fees and the like).
Besides fees, other common sources of non-interest income include:
Principal Transactions for certain sources of their capital, banks are not limited solely to
fixed income able to make principal investments which are slightly more risky merchant
banking, for example.
Asset Management Detailed further below, but also a fee on the assets being managed
Credit cards Besides the loans associated with the card, banks also use them to generate
interchange fees (essentially a transaction fee the reason so many delis in the city dont
take AmEx is because their interchange fees are much higher than other issuers)
Some investment income not included in interest income (typically from principal
transactions)
Interest Income
Less: Interest Expense
= Net Interest Income
Add: Non-interest Income
= Total Revenues
Less: Non-interest Expense
= Pre-Tax, Pre-Provision Earnings
Less: Credit Loss Provisions
= EBT
Less: Taxes
= Net Income
Definitions:
Non-interest Expense Essentially SG&A. Includes compensation expense, technology and
equipment, marketing and sales, etc.
Credit Loss Provisions Banks have to assume that some portion of their loans are going to default. In
anticipation of that, they set aside a certain amount of capital each period to match what they estimate
the losses will be for the loans they originated.
This is charged against the I/S in the period during which the loan is originated i.e., not when the loans
actually default (if they default).
The capital they set aside and charge against their revenues goes to a reserve fund (a contra asset) on
the B/S called Loan Loss Reserves discussed below.
Key Profitability Ratios:
Net Interest Margin (NIM) Net Interest Income / Average Earning Assets
Higher is better
Lower is better
Higher is better
Return on Average Common Equity (ROAE) = Net Income / Avg. Common Equity
Higher is better
As mentioned above, banks set aside a provision each period based on the loans they originated in that
period. This goes to a contra asset called Loan Loss Reserves, which is basically an emergency fund
for when loans go bad and the bank has to cover the cost of default.
Where it gets tricky is that a loan can be behind on payments and not be considered a default. The
process of disposing of bad loans therefore involves the following steps:
1. Loan is made
2. Borrower stops repaying loan
3. Up until 90 days past due, the bank accrues the interest on the loan as if it will eventually be
paid back.
4. After 90 days past due, the loan goes to nonaccrual (they stop assuming they will get paid
back any interest) and is considered a Non-performing Loan (NPL)
5. The NPL is appraised (based on the value of the collateral and any money the borrower can
repay) and the expected loss from the loan is charged against the reserves (theNet Chargeoffs, or NCO)
6. After the loan is foreclosed, any collateral is sold, and any recaptured principal is added back
to the reserve as Recoveries. In the case of mortgages or real-estate loans, the collateral is
called Other Real Estate Owned (OREO) basically all the houses the bank has
repossessed that they havent been able to sell yet.
Each period, the reserve calculation is as follows:
Loan Loss Reserve, BOP
NCO
+ Recoveries
Lower is better
Lower is Better
Higher is better, but too high means a bank could have money used for reserves that could
be put to better use
To reiterate, a bank wants as many interest earning assets as possible and it wants to earn as much
interest on those assets as possible.
The problem is that, generally, loans with higher interest rates are also loans with higher risk profiles.
Since the deposit base utilized by banks is one of the foundations of the financial system, there are all
sorts of capital requirements regarding what a bank can and cannot use different types of capital for.
Taken to an extreme, if a bank took everyones deposits and lost them all betting on red, then a lot of
people would be SOL (the FDIC only covers up to $250k). Regulators dont want that to happen, so they
put in rules saying You cant bet peoples money on red, because thats too risky, but you can invest this
money in treasuries or something we think is safe.
To determine if a bank has enough capital to handle a worst-case scenario (think stress tests), banks
use a variety of capital ratios to determine how solvent they really are and how big the risk that they lose
everybodys money is. The numerator of these ratios is some definition of what a banks safe capital
(sources of funding) is, which is divided into tiers of decreasing safety thusly:
Tier I
Preferred Stock
Subordinated Debt
Tier II
While the denominator is some representation of a banks total assets (i.e., loans and other investments):
Tangible Assets (TA) Total assets less goodwill and intangibles (i.e., assets that could be reasonably
recovered in bankruptcy)
to shareholders only (in contrast to cash flows to shareholders and debt holders), as debt funding is
directly correlated to the banks assets and its profitability.
Banks tend to trade primarily based on Tangible Book Value (book value that would be available to
shareholders in bankruptcy) and Earnings (P/TBV and P/E).
1. P/E Because of the capital adequacy concerns mentioned above, banks are only able to
dividend a limited amount of their earnings each period to equity holders, since they may
have to retain some portion of their earnings in order to improve and/or maintain their capital
position. Higher multiples are driven by higher quality (i.e., consistent) earnings
2. P/TBV A representation of how many income producing assets a bank has. Higher
multiples are driven by higher ROTCE ratios.
3. DCFs While DCFs are rarely used to value banks, they can be applied to an estimation of
future dividends (assuming a constant capital ratio) though this method is heavily dependent
on cash flow and growth assumptions.
2) Insurance Companies
How Insurers Make Money?
This can be broken down into two ways again:
1)
Underwriting Income
Investment Income
Money they make by investing the cash they receive from premiums before they have to pay out claims
Most of their income typically comes from investments. Insurers can and do make money from their
insurance operations, but they usually price their products competitively so that they receive as many
premiums as possible. Sometimes this means that they break even (or even come out negative) on a
given insurance product because if they price it any more expensively then a competitor will capture that
premium.
Premiums are analogous to a banks deposit base they represent cash with almost no cost-of-capital
(or even negative cost of capital if an insurer is able to turn an operating profit) that insurers can invest for
themselves (hence why Warren Buffet loves insurance so much). They want the investment income they
can make on the cash they have lying around while its waiting to be paid out for policies.
Life vs. P&C
The insurance industry is broadly divided into two categories: Life Insurance, and Property & Casualty
(P&C) Insurance (i.e. car / house / medical insurance anything that isnt life insurance).
The reason for the distinction is because of the nature of the payout periods for life insurance vs. other
kinds life policies, by definition, last longer than any other type of insurance a consumer may purchase.
Therefore, once they sell a policy, they know with reasonable certainty that they have the capital they get
from those premiums for a fairly long amount of time, allowing them to make conservative, long-term
investments that will generate more investment income than ones with lower time horizons.
P&C insurers, on the other hand, have much shorter policies and payout periods. As such, in addition to
investment income, they tend to rely slightly more on the income they can generate from their actual
underwriting operations because theyre churning through policies.
Accounting Quirks
The total value of a given insurance policy is not static. The revenue and expenses associated with a
policy (both historical and projected) can change over multiple periods. As such, there are a lot of
accounting quirks associated with how insurers report their financials, mostly to do with how to reconcile
the timing mismatch and estimates informing their underwriting profit. There are a boatload of variables
that can affect how a policy is valued.
Example to demonstrate:
Lets say you have a 3 year renters insurance policy, which you paid entirely up front. The insurer now
has your cash in its hand, which it can use to invest, but it doesnt actually earn the money for years 2
and 3 until years 2 and 3 happen, so whats the fairest way to recognize it? And what about the
associated investment income?
Then, lets say halfway through year 2, you get robbed and they have to pay out the full value of your
claim. The recognized claim expenses associated with the policy to that point had actually been nil, but
the reported expenses had been estimated (based on actuarial statistics). Now the insurer has to take
this actual expense amount (the claim payout) and spread it out over the 3 years, including retroactively
updating the recognized year 1 expense amount.
Then on top of that it turns out the salesman who sold the claim had a clause in his contract that he
would lose his unvested bonus if a certain amount of his policy sales resulted in claims, so now the
commission expense associated with the policy also has to retroactively change for year 1 and the
estimate for commission expense may have to be lowered for year 3.
You also have the investment income / losses, which include both realized and unrealized interest
income, dividends, capital gains and losses, etc, and all the fun accounting rules that get associated with
them.
Add to all this the fact that most insurers also take out their own insurance policies (called re-insurance)
in order to hedge / manage their overall risk, so if your policy was reinsured it was likely ceded, or given
to another insurer, who is actually the one now responsible for paying you (though indirectly).
Oh, and dont forget the taxes associated with all of the above.
As a result of these complexities, a lot of understanding insurers comes down to understanding the
accounting rules associated with them.
To oversimplify, there are basically three kinds of accounting insurers use:
1. GAAP / IFRS Traditional accounting required by the SEC. This focuses on trying to what
an insurer earned in a given period so that shareholders can see that the business is
healthy
2. Statutory Accounting required by state insurance regulators (insurers are primarily
regulated at the state level). This focuses on the cash insurers actually receive from
premiums and pay out as claims so that regulators know that an insurer will have enough
cash to cover their required payouts in the future. It also informs the rules surrounding when
insurers are allowed to issue dividends to their shareholders (similar to bank capital
regulation)Associated with Statutory accounting is what is calledStatutory Capital &
Surplus (C&S) similar to shareholders equity, but with some adjustments. C&S is used by
regulators to determine the maximum amount of dividends that an insurer can pay out to
shareholders. The differences are basically that the income or earnings added to C&S each
period are closer to actual cash earnings than in GAAP. Examples of specific differences
include:
Acquisition costs (cost of new and renewal policies) are charged as incurred and not as
earned
Realized capital gains/losses resulting from changes in interest rates are deferred and
amortized over the life of the associated security
3. Embedded Value (EV) While not required disclosure, EV accounting is used by life
insurers as a way of determining the intrinsic value of all the policies on their books. If XYZ
insurance company suddenly decides to stop doing business , then their existing policies
they have would still generate premium revenue and have claims to pay for many years into
the future. EV tries to estimate what the implied value of these policies would be.
= Operating Income
Less: Interest
= Pretax Income
Less: Taxes
= Net Income
For statutory accounting purposes, net income is slightly different:
Pretax Income
Less: Increases (Decreases) in Deferred Acquisition Costs (DAC)
= Statutory Pretax Income
Less: Taxes
= Statutory Net Income
Definitions
Direct Premiums = Policies the insurance company wrote themselves
Assumed Premiums = Blocks of policies the insurer took from another insurance company (in order to
provide reinsurance)
Ceded Premiums = Blocks of policies the insurer gave to another insurance company (in order to get
them re-insured)
Interest & Investment Income Similar to interest income for banks, though there is no associated
interest expense in the top line
Losses and LAE = The claims the insurer actually had to pay out in a period, along with any associated
adjustments to previously paid out claims
Commissions = Commissions paid for the policies generated in the period
Underwriting Expenses = Expenses associated with actually implementing the policies they have
office
Deferred Acquisition Costs (DAC) = DAC is an asset on the balance sheet that represents the
expenses associated with acquiring (generating or purchasing) new policies that have been paid but not
yet been incurred (since per GAAP rules they must be spread over the life of the policy). Change in DAC
represents a non-cash item on the income statement, so Statutory Net Income adjusts for it in order to
get a picture of what actual cash earnings are
Unearned Premium Reserve (B/S Item): Similar to a banks loan loss reserves (though not a contra
asset), insurers create a reserve for premiums insurers they up front on multi-year policies. They create a
liability called an that increases when they receive upfront premium payments and decreases when over
time as they actually earn the said premiums.
Ratios
Retention Ratio = NWP / GWP
Weighted Investment Returns = Interest and Investment Income / Total Value of All Cash and
Investments
Higher is better
Lower is better
Lower is better
Lower is better
Lower is safer
Higher is safer
Risk Based Capital (RBC) Ratio = Total Adjusted Capital (TAC) / RBC
RBC is calculated in a similar way to RWA for banks, with different weightings given for their
various investments and other assets
Above 200% is good, anything below 150% is bad. Under 70% requires state regulators to
take control unless is corrected in 90 days.
Valuation
Valuing insurers is slightly different for Life vs. P&C insurers. Both generate investing income, so
valuation based on balance sheet (including ROE and ROA) is important in the same way it is for banks.
Because P&C insurers generate more of their income from underwriting, their valuation is also informed
more by their operational performance.
Ratios Both:
For P&C:
For Life:
DCFs are also possible for insurers in a similar way to banks they can be valued based on their
expected future dividends assuming constant capital requirements.
Other FIG Sub Sectors (Yes we likely missed a few here)
Exchanges
Financial Processors