Buying insurance can seem overwhelming. Few people do it enough to get really good at it. Investing in insurance can feel daunting, too, but it doesn’t have to be.
If investors are willing to spend the time to learn some insurance basics, an entire sector of opportunity can open up. The field is broad.
There are about 130 publicly traded insurers listed in the U.S., worth almost $700 billon dollars. They have insured assets—ranging from lives to homes to cars—worth more than $3 trillion. And they manage more than $3 trillion in investments, putting to work the money that comes in the door in the form of premiums.
Centuries of History
Insurance may not be the oldest industry, but it is one of the oldest. The famous Lloyd’s of London, for instance, was formed in 1686. The Dutch East India Company—a very early corporation—was founded in 1602.
In the U.S., Hartford Financial Services Group (ticker: HIG) traces its roots back to 1810. It sold fire insurance.
Insurance has been around for a long time because people have always needed to protect against catastrophic loss. The likelihood of a devastating home fire is low for one person, but fires will happen. It’s better for the community to pool resources—paying a little each year—to protect everyone from large losses.
An Industry Unlike Industry
Insurers are, ultimately, financial companies. And they trade a little like bank stocks. Both are heavily regulated, with the government exercising control of the amount of risks they can take on.
Financial companies differ from, say, industrial firms because their assets are made of paper. A bank’s assets are loans and securities. It finances them with customer deposits.
An industrial company, on the other hand, has plants and equipment churning out cars or jet engines. The plants were built with a mix of debt and equity. There are no customer deposits on an industrial balance sheet.
For insurers, the bulk of the assets are the investment securities bought with customer premiums to help pay off the liabilities—the promises made to policyholders.
Bank stocks often trade at a multiple of book value, a measure of the equity in the business. It’s the same with insurers. The goal of insurers, and financial companies, in one respect, is to increase book value per share.
Warren Buffett, for instance, uses growth in Berkshire Hathaway’s (ticker: BRK. A) book value to compare his performance versus the S&P 500. It’s no coincidence that Berkshire has huge insurance operations. Book value is in Buffett’s DNA.
These days, insurers trade for a little below book value, a slight discount to historical averages.
The Jargon
Every industry has an alphabet soup of acronyms. Some have more than others; insurance appears to be on the higher end.
Within insurance, there are more obscure terms like EPLI, short for employment practices liability insurance. That protects a business if it is sued by unhappy workers.
There are more accessible acronyms too, such as P&C, short for property and casualty. Property insurance is easy enough to grasp in that it deals with property. Casualty insurance isn’t life insurance, though. Not all casualties are fatalities. It refers to anyone hurt. Almost any insurance outside of that covering physical assets can be put in the casualty bucket.
The Ratios
The combined ratio is probably the most important insurance number to know. The combined ratio compares the sum of expenses and insured losses—claims paid out—to an insurer’s premium income. The lower the number, the better.
A combined ratio of 100% means all the losses and costs to run the company exactly met the insurance premium received. A ratio like that would leave little room for profit, but insurance companies can also earn investment income from the premiums they are holding to eventually pay claims.
Combined ratios will differ by type of insurance—automotive insurance, property & casualty, and life—but they are critical in every case. Health insurers, however, don’t usually use that language.
Duration
Health insurers have slightly different language because their claim “duration” is much shorter. Duration, in this instance, refers to how long the insured liability runs for. Health insurance typically pays claims generated in the same year. Life insurance, on the other hand, pays claims today based on policies written long ago. Property & Casualty, from a duration perspective, falls in the middle.
The longer the duration, the more sensitive an insurer is to interest rates. A life insurer has to earn returns on premiums to be ready to pay off a life policy years down the road. Low rates make it harder to earn investment income.
Health care insurers, on the other hand, don’t investing like that. Their job is to process and pay claims. Their expertise is in building medical networks and controlling costs, making them a little different from traditional insurers.
The Road Ahead
That’s it. Armed with the basics, investing in insurance becomes just like putting money into any other sector. The task is simply to find the best management teams in the best segments of the industry, at attractive prices.
Write to Al Root at allen.root@dowjones.com
