Many people fret at the thought of purchasing insurance. And I don’t blame you. Insurance, whilst necessary, is a terrible thing to purchase .After all, for the insurance industry to make make money, you have to have wasted your money. And this happens more often than not. The fact that the insurance industry not only exists but is the largest industry in the world by revenue just proves that they are making profits and you are wasting money. Except of course, if your house does gets burnt by a fire or your car gets into an accident…
Insurance has now almost become a necessity or part of your cost of living. Much like an electric bill or water bill, most people have insurance of some sort. And whilst this is bad for most people as it increases costs, insurance shares can prove to be great for investors in the long run.
When most people look at industries that provide investors with superior returns, insurance stocks are normally overlooked. This is because the insurance business is hard to understand and it seems to take huge an awful lot of risks, and thus many investors shy away from this.
But if you look at the great investors, most focus their portfolios on insurance stocks…
Just look at Warren Buffet, the greatest investor of our time and possibly the greatest investor that ever lived. The foundation of his conglomerate, Berkshire Hathaway, is insurance companies. He talks about the beauty of insurance in almost every one of his annual letters. In one letter, he explained why he’s put insurance companies at the centre of his financial empire…
“Insurers receive premiums upfront and pay claims later. In extreme cases, such as those arising from certain workers’ compensation accidents, payments can stretch over decades. This collect-now, pay-later model leaves us holding large sums – money we call “float” – that will eventually go to others. Meanwhile, we get to invest this float for Berkshire’s benefit…
If our premiums exceed the total of our expenses and eventual losses, we register an underwriting profit that adds to the investment income our float produces. When such a profit occurs, we enjoy the use of free money – and, better yet, get paid for holding it.
We have now operated at an underwriting profit for nine consecutive years, our gain for the period having totaled $17 billion. I believe it likely that we will continue to underwrite profitably in most – though certainly not all – future years.
If we accomplish that, our float will be better than cost-free. We will profit just as we would if some party deposited $70.6 billion with us, paid us a fee for holding its money and then let us invest its funds for our own benefit. “
I want you to read and re-read the above to understand the economics of the insurance industry. By understanding it, you see how great the business model is.
In the case of berkshire Hathaway, the insurance companies have earned more in premiums than they’ve paid in claims for the past nine years. The result is that the company is able to invest the premiums (which total $70 billion) and keep all of the gains for itself. Berkshire has made $17 billion on the premiums alone.The insurance industry is one of the secrets behind Warren Buffets success as it has allowed him to greatly increases his ability to compound his returns over time.
From the year 2000 onwards, the size of Berkshire’s float – the amount of insurance premiums it holds for investment, has grown from $27 billion to a whopping $70 billion. These premiums aren’t like bank deposits. They can’t be taken back. They aren’t like an investment with a hedge fund. They can’t be redeemed. They are paid in full. Thus, they are a form of permanent capital. How extraordinary is that!
Picture yourself being given $70 billion a year to manage, where all the gains you make is yours to keep. Now imagine if, in addition to the investment income, you were also paid $17 billion over nine years simply for the privilege of holding the capital!
The nature of the insurance business gives Berkshire – and other prudent insurance firms who can earn a profit with their underwriting and their investments – a truly mind-boggling advantage. And that’s not the only one.
Their other huge advantage of the business model insurance firms use is that they don’t have to pay taxes on the underwriting gains they make for many, many years because, on paper, they haven’t technically earned any of the float until all of the possible claims on the capital have expired. So unlike most companies that have to pay taxes on revenue and profits before investing capital, Berkshire and other insurance companies get to invest all of the float, without paying any taxes for years and years and years. This substantially increases the compounded return over time.
Another aspect of the float means the insurance companies are typically highly leveraged to the financial markets i.e. their investment portfolios are typically large relative to the equity of the firms. So if you perceive a bull market coming up ahead, insurance stocks will perform well.
But whilst the insurance industry does have many things going for it, it does have one major drawback – most insurance companies aren’t able to consistently earn a profit on their underwriting. And in those cases, the float becomes a liability.