Saturday, April 14, 2007

Getting to know the insurance business

The astute Warren Buffett hasn’t done too badly insurance stocks. Warren used to own a bank that was possibly the best-run bank in the U.S., with a 2.3% return on assets in 1979 (that performance would roughly put it in the top 2.5% of banks today). However, the Bank Holding Company Act of 1969 required that Buffett chose between insurance and banking. He chose insurance. Yes, the stodgy old insurance, perhaps one of the great creators of wealth in the world. Here’s why.

Float is the by-product when policyholders pay insurers upfront and don’t expect their money back until the event that is insured happens. Meanwhile, between this interval, the insurer can deploy the money by investing and pocket the returns. Keep in mind, the insurer gets to use other people’s money (OPM) to invest for itself.

In 2005, Berkshire Hathaway had $49 billion in float. If it invested this in 4.97% one-year Treasury Notes, it could make about $2.4 billion without taking any risk or whatsoever. Another insurance company, Cincinnati Financial used its float to buy shares in Fifth Third Bancorp’s stock and turned a $283 million investment into $2.7 billion as of the end of 2005 – a gain that directly increases the intrinsic value of Cincinnati’s stock.

The ability to make money using OPM money is the hallmark of a great investor. Banks, mutual funds, hedge funds, and private equity funds all use OPM money, but what makes insurance superior to all these other OPM users is the fact that insurers can have a positive cost of capital.

In a nutshell, the combined ratio indicates how much an insurer pays out in premiums or losses. A combined ratio under 100% indicates that the insurer is making an underwriting profit. In this case, not only does the insurer get to use the premium collected to make money for itself, it also doesn’t have to pay back the full amount it “borrowed.” It’s as if someone came up to you and said, “Hey, here’s a billion dollars, you can do whatever you want with it, as long as you give me $990 million back. Pretty sweet deal, isn’t it?

Similarly, banks too use OPM. Customers deposit funds at banks, and the banks loan those funds out and collect interest, which it pockets. The key difference is that depositors, in exchange for allowing the bank to use their money, expect to receive interest payments, so banks have to pay them 2% to 5%. In other words, the bank has a negative cost of capital. On the surface, mutual funds have it a little bit better. Investors give the fund their money, and the mutual fund gets to keep about 1% of assets – a positive cost of funds, right? Wrong. Whereas banks and insurers keep the profits from reinvestment, all the reinvestment profits that mutual funds earn belong to the investor, not the mutual fund manager. Not only that, but investors expect mutual funds to earn a reasonable return of capital. Otherwise, they yank back their money. And thus, this is an implied cost of funds.

So, to a well-run insurer, float is an awesome weapon. It can be used to internally fund the business. It can be reinvested for profit. It often generates its own income. Best of all, the insurer keeps all the profit for itself.

Now, here’s the bad news. If, by now, you’re convinced of the total awesomeness of the insurance industry, it’s time to add some caveats. The downside is that insurance involves taking risks. In 2004, Montpelier Re’s combined ratio was 77.8%, in other words, the company retained $0.22 for each dollar of premium collected. This was incredibly impressive given that 2004 was, at the time, the worst year ever in property and casualty insurance history. In 2005, which was much worse than 2004, Montpelier Re’s combined ratio was 200.7%, meaning it paid out $2.007 for every dollar it took in. Needless to say, this resulted in huge losses and the stock took a nose dive. Although reinsurance tends to have more risk than more predictable types of insurance, such as auto insurance, the point is that year-to-year results for insurers can fluctuate, on account of the inherent volatility of the business. Having said that, what separates a superior insurer from a mediocre one is underwriting discipline.

Before investing in an insurance business, there’re two things: who and when. “Who” refers to picking the right insurers – the ones who have low expense ratios, disciplined underwriters, and a knack for investing float profitably. Personally, the insurers I admire are Berkshire Hathaway (do I have to list this, this is so obvious), Progressive, Markel, White Mountains, USAA (not listed), Zenith, Torchmark, Old Republic, Mercury General, and Cincinnati Financial.

“When” refers to timing. Like in investing, the best time to invest is when blood is on the street. Why? Because I know if a disciplined underwriting is writing policies at a 100% combined ratio (i.e., breaking even on underwriting), then others are probably losing money and will have to cut capacity or go out of business – suggesting more future profits for a disciplined underwriter. This also helps to buy at low valuations (preferably at a low price to tangible book ratio).

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