insurance_companies

Insurance Companies

Insurance companies are financial institutions that help individuals and businesses manage risk. Think of them as professional risk-takers. They collect payments, known as premiums, from a large number of clients and, in return, promise to pay for specific, unforeseen losses those clients might suffer. The core business model relies on the law of large numbers, spreading risk across a vast pool of policyholders. Insurance is broadly divided into two categories: Life & Health (L&H), which covers things like life, disability, and medical expenses, and Property & Casualty (P&C), which covers assets like cars, homes, and businesses. But the real magic, especially for investors, lies in what they do with the premiums they collect before paying out claims. This pool of money, called float, is a powerful source of investment capital, making the best insurance companies phenomenal long-term investments.

An insurer's profitability is driven by two distinct, yet interconnected, operations: the business of underwriting risk and the business of investing the proceeds.

This is the classic insurance operation. Underwriting is the disciplined process of deciding which risks to insure and at what price. A good underwriter is like a skilled poker player, carefully calculating the odds before placing a bet. Their goal is to collect more in premiums than they pay out in claims and operating expenses. The single most important metric to judge this is the combined ratio.

  • Combined Ratio = (Losses + Expenses) / Premiums

A ratio below 100% means the underwriting business is profitable—they're taking in more than they're paying out. A ratio of 95% means they make a 5% profit on their underwriting. A ratio over 100% means they've paid out more than they collected, resulting in an underwriting loss. A disciplined insurer consistently aims for a combined ratio under 100%, year after year. Anything else, and they're essentially paying to hold their customers' money.

This is where the genius of the model shines. Insurers collect premiums upfront but pay claims later—sometimes many years later. The massive pile of cash they hold in the meantime is the float. They don't just let this money sit in a vault; they invest it. This is the second engine of an insurer's profit machine. While regulators typically require them to invest a large portion of this float in safe assets like government and corporate bonds, the investment income generated can be enormous. Some legendary companies, like Warren Buffett's Berkshire Hathaway, have turned their insurance operations into a launchpad for a vast and highly profitable investment portfolio, using their float to buy stocks and entire businesses.

Many value investors, led by the example of Warren Buffett, have a special affection for well-run insurance companies. The reason is simple: the unique economic engine at their core.

Float is the ultimate financial advantage. It's like getting a massive loan from your customers that, in many cases, you don't have to pay interest on. In fact, if your combined ratio is below 100%, you are effectively being paid to hold and invest other people's money. This is what Buffett calls a “negative cost of funds.” A company that can generate a large and growing float at a low cost has access to a mountain of capital to compound over time, creating immense value for shareholders. It’s a key reason why Berkshire Hathaway grew from a struggling textile mill into a global conglomerate.

When looking at an insurance company, don't get lost in the jargon. Focus on these key indicators:

  • The Combined Ratio: Is it consistently below 100%? A track record of underwriting discipline is the number one sign of a high-quality insurer.
  • Growth in Float: Is the company growing its premium volume (and thus its float) without sacrificing underwriting discipline?
  • Book Value per Share Growth: For many financial companies, especially insurers, book value is a reasonable (though imperfect) proxy for intrinsic value. Steady, long-term growth in book value per share is often a sign of a healthy, value-creating business.
  • Investment Returns: How effectively are they investing the float? Look for a solid, consistent return on their investment portfolio.

Investing in insurers isn't a risk-free game. Their business is, by definition, about facing the unknown.

  • Catastrophe Risk: Especially for P&C insurers, a single massive event—a hurricane, an earthquake, or even a global pandemic—can lead to staggering losses that wipe out years of profit. These “fat-tail” risks are difficult to predict and model.
  • Interest Rate Risk: Because insurers hold huge portfolios of bonds, their fortunes are tied to interest rates. Falling rates can hurt the income they earn on new investments, while sharply rising rates can decrease the market value of their existing bond holdings.
  • The “Asbestos” Problem: Sometimes, new types of claims emerge that nobody foresaw decades ago (asbestos-related illness is the classic example). These “black swan” events can create massive, long-term liabilities.
  • Dumb Competition: Insurance can seem like an easy business, attracting undisciplined competitors who slash prices to gain market share. This can lead to industry-wide unprofitability until the weak players go bust.