Banks and Insurers: How Financial Companies Make Money

What you will learn

• Why EV/EBITDA and free cash flow do not work for banks.
• The four key bank metrics: net interest margin, cost/income ratio, cost of risk and CET1 ratio.
• How an insurer earns money from underwriting and from investing premiums, measured by the combined ratio.
• How to link a bank's return on equity to its price-to-book ratio.

Explanation

For an industrial company, debt is a financing choice. For a bank, borrowed money (deposits, bonds) is the raw material of the business. That is why enterprise value, EBITDA and free cash flow, covered in the stocks course, are not meaningful for banks. Analysts work with equity-based measures instead: return on equity (ROE) and price-to-book (P/B).

How a bank earns money

• Net interest income (NII) = interest received on loans and securities − interest paid on deposits and debt.
• Net interest margin (NIM) = NII ÷ average interest-earning assets.
• Fee and commission income: account fees, payments, asset management, advisory.
• Cost/income ratio = operating costs ÷ operating income. Lower means more efficient.
• Cost of risk = loan loss provisions ÷ average loans, usually in basis points (1 basis point = 0.01%). Provisions are amounts set aside for loans expected to go bad. They rise sharply in recessions, which makes banks cyclical.

Capital: the safety buffer

Regulators require banks to hold equity against their risks. Assets are converted into risk-weighted assets (RWA): a mortgage counts less than an unsecured business loan. The common equity tier 1 (CET1) ratio = CET1 capital ÷ RWA. Under the Basel III rules applied in the EU, the minimum is 4.5% plus a 2.5% capital conservation buffer, and supervisors add bank-specific requirements and further buffers. Compare the actual ratio with the bank's published requirement and target, not with the bare minimum. A CET1 ratio far above target can support dividends and buybacks; a ratio close to it limits them.

From ROE to P/B

A simple steady-state formula links profitability to valuation:

Justified P/B = (ROE − g) ÷ (cost of equity − g)

Here g is long-term growth and the cost of equity is the return shareholders require. A bank that earns less than its cost of equity "deserves" a P/B below 1.

How an insurer earns money

Property and casualty insurers collect premiums first and pay claims later. They earn twice: from underwriting (premiums higher than claims and costs) and from investment income on the money held until claims are paid.

Combined ratio = (claims + expenses) ÷ earned premiums

Below 100% means an underwriting profit. Since 2023 European insurers report under IFRS 17, using terms such as "insurance revenue" and "insurance service result", so each company defines its combined ratio slightly differently. Life insurers, with long-term guarantees, need a different analysis. Insurer solvency is regulated under Solvency II; the solvency ratio compares available capital with the required capital, and supervisors expect it to be at least 100%.

Worked example

Hypothetical example: a bank and an insurer, figures in euros, rounded. Tax rate 30%; all other effects ignored.

Bank: average interest-earning assets €50bn, average loans €40bn, interest income €2.0bn, interest expense €0.9bn, fee income €0.5bn, operating costs €0.96bn, provisions €0.12bn, equity €5bn, CET1 capital €4.2bn, RWA €30bn.

1. NII = €2.0bn − €0.9bn = €1.1bn. NIM = €1.1bn ÷ €50bn = 2.2%.
2. Operating income = €1.1bn + €0.5bn = €1.6bn. Cost/income = €0.96bn ÷ €1.6bn = 60%.
3. Cost of risk = €0.12bn ÷ €40bn = 0.30% = 30 basis points.
4. Pre-tax profit = €1.6bn − €0.96bn − €0.12bn = €0.52bn. Net profit = €0.52bn × 0.70 = €0.364bn.
5. ROE = €0.364bn ÷ €5bn ≈ 7.3%. CET1 ratio = €4.2bn ÷ €30bn = 14.0%.
6. Justified P/B with cost of equity 10% and g 2%: (7.28% − 2%) ÷ (10% − 2%) = 5.28 ÷ 8 ≈ 0.66.

Insurer: earned premiums €2,000m, claims €1,300m, expenses €600m, investment portfolio €5,000m with a 3% yield.

1. Combined ratio = (€1,300m + €600m) ÷ €2,000m = 95%. Underwriting profit = €100m.
2. Investment income = €5,000m × 3% = €150m. Result before tax ≈ €250m.
3. Stress: a storm year pushes the combined ratio to 103%. Underwriting result = −3% × €2,000m = −€60m; the result before tax falls to about €90m.

Common mistake

Practice activity

A hypothetical bank has average interest-earning assets of €20bn, average loans of €15bn, interest income €0.9bn, interest expense €0.4bn, fee income €0.2bn, operating costs €0.42bn, provisions €0.05bn, CET1 capital €1.5bn and RWA €11bn. Calculate NIM, cost/income ratio, cost of risk, pre-tax profit and CET1 ratio. Then calculate the combined ratio of an insurer with earned premiums €800m, claims €520m and expenses €248m.

Key takeaways

• Banks and insurers are analysed with equity-based measures, not EV/EBITDA or free cash flow.
• Bank profit = NII + fees − costs − provisions; cost of risk is the main cyclical swing factor.
• Compare the CET1 ratio with the bank's own requirement and target.
• Insurers earn from underwriting (combined ratio below 100%) and from investing premiums.

Next step

The next lesson covers energy and utilities: how commodity prices and regulation drive their cash flows and dividends.