Understanding an Insurer's Balance Sheet

Source: Northeast Underwriters.

Insurance companies confound many Americans, with costly premiums that often provide no obvious benefit during good times and with difficult processes to follow when you do need to make a claim. Yet as hard as it is for consumers to understand insurance companies, investors often have a tougher job, as insurers' financial statements often look a lot different from what you'd see at companies in other industries. You'll arguably find the most important aspect of an insurance company's finances in its balance sheet, so let's take a look at what you can typically expect to see on an insurer's balance sheet so you can analyze the insurance companies you're interested in as potential investments.

Simplifying an insurer's balance sheetThe toughest part of understanding insurance companies and their finances is wrapping your head around new terminology. Things like prepaid reinsurance premiums, premiums receivable, and deferred acquisition costs seem calculated to confuse the average investor.

But when you boil down an insurance company's operations to their most basic level, the business model is relatively simple to understand. Insurance companies collect money from their customers, invest it for a period of time, and then pay it back out to policyholders in the form of claims. Any money left over is profit for the insurance company.

Image source: StockMonkeys.com.

So in looking at an insurer's balance sheet, you can create a few broad-based categories of items to simplify things. They include:

Investments. These will typically include a combination of bonds and other fixed-income securities, common and preferred stocks, and cash and short-term investments.
Money that the insurance company is due but hasn't yet received. This category includes premiums receivable from customers as well as claim proceeds from reinsurance companies with which the insurer worked to share the risk of certain losses.
The value of services that the insurance company has paid for but not yet received. This category includes money paid to reinsurance companies in premiums for future time periods, as well as what the insurer has paid out in commissions to salespeople in order to bring in new policy customers -- also known as deferred acquisition costs.
Other assets, such as property and equipment as well as income-tax allocations.

When you look at these categories, the most important is what the company invests. In order to maximize profit, insurance companies have to take the premium money they receive and earn the best return they can while still ensuring that money is available to pay claims when necessary.

Turning to the liabilities side of the balance sheetMeanwhile, balancing out the insurer's assets are its liabilities. These also include some pretty confusing terminology, but again, you can simplify them into broad categories:

Money that the insurance company currently holds but which it is already committed to pay. This includes unpaid claims, amounts owed to reinsurance companies for premiums, and amounts owed to customers on annuities and other insurance products.
Money that the insurance company collected in upfront premiums for future insurance periods. This is also known as unearned premiums.
Debt that the insurance company owes to bondholders.
Other liabilities, such as accounts payable and accrued expenses.

Here, the most important amounts are the two categories of money the insurance company holds. When you add those two categories up and then subtract out the money on the asset side of the balance sheet that the insurer hasn't yet collected from policyholders, you have float -- the key determinant of an insurance company's success, because it defines how much money the company has available to invest and generate profit-enhancing returns.

What to look forIdeally, an insurance company should have three characteristics. It should have as much float as possible. Its debt should be relatively low, or at least at manageable levels. And finally, it should have as much shareholder equity as possible, as this represents the estimated liquidation value of the business when you take out the impact of operations.

An insurer's balance sheet provides only one piece of the overall puzzle for investors. Nevertheless, it's a crucial item to understand in order to get a better sense of how healthy an insurance company is financially.

The article Understanding an Insurer's Balance Sheet originally appeared on Fool.com.

Dan Caplinger and The Motley Fool have no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.