Insurance is all about promises. Policyholders promise to pay their premiums and insurance companies promise to pay claims in a timely manner. On the surface, it’s a straightforward proposition, unless the insurance company can’t afford to pay all its claims.
Policyholders are not alone in that fear. For many investors, particularly casual investors, the insurance business is just too uncertain to merit investment. Insecurity about insurance companies tends to center on the idea that the amount that can be paid in claims is uncertain.
Investors who are used to considering businesses that operate in the tangible world of products and services are used to looking at business models that have fixed costs. Investors can look at a manufacturer’s cost of materials, labor, and distribution and easily understand that mark-up gets added and a price is set. The same is true for services delivered by people that come with a predictable cost.
But insurance only appears to have a fixed cost on one side of the equation — policyholder premiums. The other side of the insurance business — the payment of claims — is much more open-ended, with individual claims ranging from a few hundred to millions of dollars.
Insurance Company Cash Flow
On the surface, insurance is a business for serious gamblers only. That’s because most people only think of insurance company cash flow as having a couple of components.
Premiums are calculated based on the risk of a claim, and that risk is spread out over large groups of people. The premise is that if an insurance company writes policies for lower-risk individuals who are unlikely to make a claim, their premiums can subsidize the few higher-risk policyholders.
The entire process operates based on the accuracy and reliability of some very serious math. The result is an equation that looks like this:
Premiums – expenses and claims = profit
In reality, insurance company cash flow has another component that changes the equation dramatically, potentially turning a risky proposition with limited returns into a potential cash cow with enormous profits.
Insurance companies operate along the same lines as banks, where customers’ deposits are used to fund other people’s loans, which pay a higher interest rate than the bank pays the depositor. In the insurance industry, money that has been paid in premiums before it is used to pay claims is called the ‘float’ — which quite literally keeps an insurance company afloat.
The float is a strange bird to some investors who see it on a company’s balance sheet as a liability. However, in practical terms the float, as Warren Buffett explained in a Berkshire Hathaway newsletter, “has cost us nothing, and in fact has made us money.”
For insurance companies, the float is virtually free money that they can use to invest in things like stocks and bonds, with the best part being that they get to keep the profits. So a more accurate equation representing an insurance company would look like this:
Premiums – expenses and claims + earnings on the float = profit
It’s All About the Float
The value of an insurance company’s float for investment purposes depends on how long the insurance company has control of the capital. The longer they can keep it earning money, the greater their profit becomes.
The insurance industry uses the terms “long tail” and “short tail” to describe the amount of time they have between collecting premiums and paying claims with those funds. Since long tails are preferable, an insurance company’s underwriters and actuaries are important players in identifying risk and setting premiums.
Smart investors don’t look at the value of an insurance company’s float on its own as a means of determining its potential value to the company. The float must be considered in conjunction with the company’s claims or loss ratio. Loss ratios are expressed as a percentage, with lower percentages being preferable. The loss/claims ratio looks like this:
Claims (losses) / earned premiums* = loss ratio
Loss ratios on their own are a measure of how well an insurance company assesses risk. The lower the number, the better the company’s risk management policies are. A ratio below 100% indicates that the company took in more in premiums than it paid out in claims, and a ratio that is over 100% means they paid out more in claims than they earned in premiums.
* Earned premiums: This is the amount of premium that is left after a policy’s effective life has passed. For example, if $1,000 is collected for a year’s worth of auto insurance and no claims are made within that year, the $1,000 is considered earned premium.
The expense ratio measures an insurance company’s cost to acquire new business. It takes into account management costs, including underwriting, commissions, and other operating expenses. The expense ratio looks like this:
Underwriting and administrative expenses / net premiums*
* Net premiums: This is the amount of premium that is left after an insurance company pays for reinsurance (paying another insurance company to assume part of the risk). For example, if $1,000 is collected for a year’s worth of auto insurance and the insurance company uses $500 to purchase reinsurance, the net premium amount is considered $500.
The combined ratio is exactly what its name implies — the combined total of the loss ratio and expense ratio:
Loss ratio + expense ratio = combined ratio
The line between making a profit on premiums and not making a profit on premiums is 100%. That’s because a combined ratio of 100% means that every premium dollar received has been spent on paying claims and covering expenses.
It’s important to understand that a combined ratio of greater than 100% doesn’t mean the insurance company didn’t make a profit. It just means that it did not earn enough premiums to cover expenses. A company can still earn a profit thanks to earnings generated by investing the float.
The Strength Is in the Mix
When evaluating an insurance company, looking at how it invests its float is more important than looking at the total number of policies it has in force or the total premiums collected. An insurance company’s profitability is most closely tied to the strength of its investment mix.
The first measure of how an insurer’s investment mix will perform in the future is to look at how it has performed in the past. Among the questions to consider are:
- Has the portfolio manager changed?
- Has the company’s mix of investments changed? If so, does it adequately reflect changes in the market?
- Does the asset mix have enough liquidity to meet a sudden, unanticipated catastrophe such as a major hurricane without risking substantial losses due to poor timing?
In a nutshell, look at an insurance company’s investment portfolio with the same critical eye you would use for a mutual fund.
Different Strokes for Different Folks
While diversity is important when looking at an insurance company’s investment portfolio, it is not something you should see in terms of the type of insurance the company sells.
If history is any measure of what works and what doesn’t, you will look to invest in insurance companies that have a very narrow focus on the kind of insurance they sell. Most insurance investors will agree that a company that sells life insurance should not be selling health insurance, and a company that sells property and casualty should not be in the financial planning business.
The reason product diversity is frowned upon by investors is because insurance is not all the same. Auto and homeowners policies are underwritten much differently than health insurance. The differences are so wide that property and casualty insurers like AIG and Allstate spun off their life insurance operations into separate companies.
There are notable exceptions, such as MetLife, which operates in both the life and property and casualty markets successfully. However, it can do this because it has built a very solid wall of separation between their life and property divisions.
Don’t Get Spooked
If you’ve done your due diligence and found an insurance stock that you believe is sound and meets your criteria, don’t let the prospect of a disaster dissuade you from taking the plunge.
Catastrophic disasters like Superstorm Sandy in the Northeast or the BP oil spill in the Gulf of Mexico are both tragic and very rare. Investing or not investing based on the chances of lightning striking a particular tree is not a sound strategy. These events are so rare, and the premiums collected and surplus funds that are required by industry regulations are so great, that the chances of a single insurer being bankrupted by a single event are minuscule.
Not as Exciting as a Dot-Com
The insurance industry is many things to many people, but it has never been accused of being exciting.
Insurance stocks seldom offer the potential for a large windfall generated by a meteoric rise in price, like a shiny new tech IPO. What they do offer is steady, plodding growth and, in many cases, regular dividends.
To paraphrase Abraham Lincoln, insurance stocks are right for all of the people some of the time and some of the people all of the time, but they are almost never right for all of the people all of the time.