In light of all that is happening on the east coast, it might be time to turn our attention to the insurance industry. Like utilities, insurance companies have been a place of safety for investors. They are big, profitable cash cows that usually pay very good dividends.
Why Invest in Insurance Companies
Insurance companies are in the business of taking in premiums and hopefully paying out less money in claims. In the meantime, they hold those premiums in investments which provide more income for the company, which is essentially how insurance companies gamble with your money.
Insurance companies make for good investments because they usually have a significant amount of assets backing their valuation, are a necessary part of the economy (insurance isn't going anywhere!), and typically trade at a discount to the broad market because insurance is sleep-inducing and mostly predictable.
Here's how to spot insurance companies that provide the best safety for our investment dollars:
- Combined Ratios – Insurance companies are measured by their combined ratios, or the amount of claims paid plus operating costs as a percentage of premiums taken in. The companies with the lowest historical average combined ratios are usually the safest as they not only make money on their investments, but also from premiums as these funds come in. Firms with higher combined ratios find their earnings more closely tied to the returns of their investments than their insurance sales, making their stock much more like a double bet on the stock market.
- Types of Insurance – As a general rule, insurance companies that issue “property and casualty” insurance – insurance for cars, homes, businesses – are safer than insurance companies dealing in life insurance or pensions. Property and casualty insurers make a lot of their money on underwriting, whereas life insurance companies earnings' power comes from their investments. Life insurance companies write policies based on long-term assumptions (how long will this 20-year old live and how much can we earn on his or her premiums during the period?). Property and casualty insurance is written on much shorter-term assumptions (what's the risk that this 16-year old driver has an accident in the next 12 months?). Property and casualty insurance is less sensitive to interest rates than the life insurance business, a truth proven by life insurance companies' falling profits in the last 5 years.
- Portfolio & Book Value – Insurance companies have an investment pool which holds capital reserved for future claims and money which cannot be immediately used in the business of selling insurance. Insurance companies disclose their equity (stock) and fixed-income (bond) allocations in their portfolios. You can also use book value to discover the company's share price relative to the net assets on the books of the insurance company. Insurance companies selling for a book value of less than 1 are usually the safest. A book value of less than 1 says that for every $1 in share price, the company has book value (assets including cash, plus the portfolio minus liabilities) worth more than $1.
- Underwriting Diversification – Insurance companies benefit from diversification just like investors do. Not all risks are known, so diversification protects insurance companies from losing it all on one bad risk. When it comes to property and casualty insurance, it's nice to see a diversified collection of policies over many different geographic areas. Whereas one tornado or hurricane can devastate a single state, a single event won't affect the entire continental US or the world.
- Policy Growth – There are more humans, cars, homes, businesses, and “things” to insure each year. If a company is not growing, it is not keeping up. I like to see at least some policy growth in the total number of insurance policies sold and outstanding, as well as total revenue growth.
- Reinsurance – It's always good to have a backstop. Companies that have reinsurance to protect themselves from exceptionally catastrophic and costly events are obviously safer than those that roll the dice each time bad weather comes around.
It's Okay to Look Backwards
Insurance is one of the few businesses where it's okay to look to past performance to get an idea of future results. Looking at several years of underwriting earnings, investment earnings, and combined ratios helps us to smooth out the ups and downs of the business over many years. There is no such thing as an “average year” when you are in the business of insuring against catastrophes that are not at all average.
Insurance companies that have not substantially changed their business model or product mix can be easily valued based on the average of their historical earnings. The killer combination is growing revenues, rising book value, combined ratios under 100%, and management that is committed to returning shareholder wealth through buybacks and dividends.
As Wall Street comes back this week from Sandy, investors might have the chance to invest in insurance stocks at a discount.
Are you going to look at the insurance sector this week?