Insurance Operations

Insurance operations are the engine room of any insurance company. It's the core business activity of accepting risks from individuals and businesses in exchange for a fee, known as a `premium`. Think of it as a two-part process. The first part is `underwriting`, which is the careful art and science of evaluating potential risks, deciding which ones to insure, and calculating the right price to charge. The second, and for value investors, more magical part, involves managing the pool of money collected from premiums. This pool, called `float`, is money the insurer holds before it has to pay out any claims. The insurer can invest this float for its own benefit, generating investment income. A well-run insurance operation not only makes a profit from its underwriting activities but also generates substantial returns by wisely investing its float, creating a powerful, compounding financial machine. This dual-engine model is precisely why legendary investors like `Warren Buffett` have made insurance the cornerstone of their empires.

At its heart, an insurance business has two distinct but interconnected functions. Success requires excellence in both.

This is the classic “insurance” part of the business that everyone knows. Underwriters are the gatekeepers. Their job is to assess the probability of a loss and the potential size of that loss.

• The Goal: To collect more in premiums than the company pays out in claims and expenses. When successful, this results in an `underwriting profit`. If claims and expenses exceed premiums, the company suffers an `underwriting loss`.
• The Key Metric: The single most important number for judging an underwriter's skill is the `combined ratio`. It’s calculated as: (Incurred Losses + Expenses) / Earned Premiums.
  1. A ratio below 100% means the company made an underwriting profit.
  2. A ratio above 100% means the company suffered an underwriting loss.

A disciplined underwriter will walk away from business if the price isn't right, even if it means sacrificing growth.

This is where the real magic happens for investors. Float is the sum of all premiums collected that have not yet been paid out to cover claims. Because premiums are collected upfront and claims are paid out later (sometimes much later), the insurer gets to hold and invest this money in the meantime. Imagine you pay your car insurance premium for the whole year on January 1st. Your insurer holds onto that cash. Unless you have an accident, they won't pay anything out. They can invest your money—and the money of millions of other policyholders—for the entire year. This massive pool of temporarily available funds is the float. For an investor, it's essentially an interest-free loan that can be used to buy stocks, bonds, and other assets.

The combination of disciplined underwriting and savvy investing of float is what makes some insurance companies phenomenal long-term investments.

The best-in-class insurers, like the subsidiaries of `Berkshire Hathaway`, regularly achieve a combined ratio below 100%. This means their underwriting is profitable on its own. Think about what this implies for their float. Not only do they get to invest a huge sum of money that isn't theirs, but they are also being paid to do so through their underwriting profits. This is often called “negative-cost float,” and it's one of the most powerful financial concepts in the world. It’s like getting a loan and having the lender pay you interest on it. Even insurers with a combined ratio slightly over 100% (e.g., 103%) can be good investments. In this case, their float has a “cost” of 3%. If the company can generate investment returns on that float of more than 3%, the overall operation is still profitable.

• A Low and Stable Combined Ratio: This is the hallmark of underwriting discipline. Look for a history of keeping the ratio below 100% or very close to it.
• “Long-tail” vs. “Short-tail” Business: Be aware of the type of insurance written. `Long-tail insurance` (like workers' compensation or product liability) means claims may not be paid for many years, giving the insurer a very long time to invest the float. `Short-tail insurance` (like property insurance) has claims that are paid quickly, resulting in less powerful float.
• Investment Savvy: Look at how the company invests its float. Is the portfolio full of conservative bonds, or is management skilled at allocating capital to high-quality stocks for the long run?

Insurance is not a risk-free game. The industry is intensely competitive, which can lead companies to irrationally price their policies just to gain market share, resulting in huge underwriting losses. Furthermore, insurers are exposed to massive, unpredictable catastrophe risks (e.g., a major hurricane or earthquake) that can wipe out years of profit in an instant. Finally, accounting in insurance can be a “black box,” with companies sometimes failing to set aside enough money (`reserves`) for future claims. Despite the risks, understanding the dual engines of insurance operations—underwriting and investing—is essential for any serious investor. It unlocks the secret behind some of the world's greatest compounding machines.