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After witnessing the devastating results of American International Group (NYSE:AIG) due to the company’s excessive credit default swap portfolio, it is quite evident that major risks do come with the insurance industry. Recently, many individual investors have become skeptical of insurance companies; however, this should not be the case. The economics of the insurance business are quite simple and fairly easy to understand and evaluate. After all, several insurance companies, such as Chubb (NYSE:CB) and GEICO (owned by Berkshire Hathaway, BRK.B) have provided great returns to shareholders over the years.

With insurance companies, there is ONE essential COMMANDMENT: Thou shall maximize, maintain, and grow the company’s insurance float for long-term success! The following analogy will help you grasp the dynamics of the insurance business and the power of insurance float.

Assume for the moment that you have a credit card that charges no annual fee for membership and just interest on unpaid balances at month end. Also assume that your monthly income is $10,000 and your allotted monthly credit is $10,000. You purchase $10,000 worth of goods on your credit card each month and as long as you pay off the $10,000 at the end of the month, the credit was essentially interest free. In the meantime, you invest your $10,000 monthly income in a savings account and earn interest for the month while using your interest free credit card. Repeat this over a long-period and the resulting gains could be substantial. Essentially, your credit float is always maintained at $10,000, and if you can grow it interest-free, the higher the pay-off to you.

To compare, the dynamics of an insurance company are quite similar. The monthly credit is the insurance float and is interest free as long as underwriting breaks even or profits. As the above commandment suggests, maintaining and growing this float is essential as it provides interest-free investment income that maximizes shareholder returns.

To continue, it is important to note that most of the insurance industry is highly competitive and is generally considered a commodity business, where price competition is the means for gains in market share. However, you want to avoid the firm that engages in price competition to the point where inadequate policy prices mount to severe losses and costs to float in the future. That firm also may engage in practices of maintaining premium volume despite poor underwriting (low price) conditions. In short, you want to ask the question, “Are the insurer’s pricing policies adequate to sustain significant losses?”

Or as Warren Buffett would say, “Be sure the company gets a dollar of premium for every dollar of expense cost plus expectable loss cost”. While not engaging in price-competition may dampen short-term results, long-term profitability and market share gain can be gained. This long-term oriented firm will be able to capture significant market share when the other firms are running losses due to previous poorly written policies.

Moreover, it is essential that you select a company with a successful long-term track record (perhaps looking back at 10 years of operating results when performing your analysis). In addition, you need to compare that company to the proper sub-industry averages. For example, comparing the two Berkshire insurance subsidiaries, GEICO and General Re, would be inadequate as they are engaged in different categories of insurance and their float-to-premium durations are quite different. GEICO’s policies are written for an average of 6 months to 1 year, whereas, General Re’s policies have an average duration of 3-5 years.

In addition, some useful ratios to compute when comparing insurance companies are:

  1. The insurer’s Combined Ratio is the percentage of premiums an insurer has to pay out in claims and expenses. Generally speaking, you want to find the insurer with the lowest combined ratio. For example, a combined ratio of 100% means that the insurer broke even, below 100% means an operating profit, and above 100% means an operating loss. Watch out for excessively high ratios compared to industry standards! High combined ratios result in high costs to the insurer’s float and therefore fewer opportunities for exceptional investment income.
  2. The insurer’s expense ratio (underwriting expenses / net premiums earned), which measures cost efficiency.
  3. The insurer’s loss ratio (loss expense / net premiums earned), which measures underwriting discipline.

As always, it is important to stay within your circle of competence. If evaluating bond insurance escapes your circle of competence, perhaps try evaluating auto or property and casualty insurance companies. After selecting the right company and over the long-term, you will be quite satisfied when you add an excellent insurance operation to your portfolio. Remember, good management is often correlated with good insurance companies, so partner with them in your selection as well.

Disclosure: The author holds a long position in BRK.B

Source: Choosing the Right Insurance Stock