How Insurance Companies Work

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This video was available on May 22, 2017.

Gaby Lapera: Hello, everyone! Welcome to Industry Focus, a podcast that dives into a opposite zone of a batch marketplace any day. You are listening to a Financials edition, taped currently on Monday, May 22nd, 2017. My name is Gaby Lapera, and joining me on Skype is Jordan Wathen, beloved Motley Fool writer and expert in financial companies. How’s it going, Jordan?

Jordan Wathen: It’s going alright. How are you, Gaby?

Lapera: Pretty good, are we happy to be a dear contributor?

Wathen: I’m unequivocally happy to be a dear contributor. I consider that’s improved than my final introduction, which was something about being exotic, so I’ll take it.

Lapera: Yeah, that’s OK. we think exotic can be good, too, in certain contexts. Anyway, listeners, usually in box we don’t remember, this week is Insurance Day on Industry Focus: Financials. So a front half of a uncover is going to be basis about insurance companies, what they are, how they make money, some stuff we need to demeanour out for when you’re thinking about investing. The last half of a uncover is going to be listener-submitted questions that we’re going to answer. If we ever wish your question answered on Industry Focus, just send us an email during Let’s dive right into it, since this is going to be an action-packed show. Let’s start with a super easy question, which is, what is an word company?

Wathen: The basis of an insurance association is that it exists to widespread risks around them among a garland of opposite customers. One of the best explanations we ever listened was that you can consider of word companies like banks where they take deposits, or your premiums, and allow we to repel income usually when you knowledge a vast financial loss. we think homeowners word is probably the form of word that’s easiest to explain. A home is the many costly thing that many people will ever own. So many homeowners buy homeowners word to protect them from a financial risks if their home is broken by fire, or wind, or some other kind of disaster. A policy like that costs, maybe, 1% or 2% of a home’s value any year in premiums.

Lapera: Yeah, it makes sense. The suspicion is, you have all these people who are not carrying a disaster during any given time helping to compensate for a one or two people who are carrying a disaster, and afterwards we usually scale this adult to a massive scale, and we have an word company.

Wathen: That’s a good point, because many homeowners word companies, ideally, they would have risks in higher-risk states like, say, Florida, and change it out with homeowners who possess a home in Texas. So when a whirly strikes Florida — God dissuade that ever happens again, though we know it’s going to — they will have a income entrance in from Texas, and hopefully there’s no healthy disaster there, so they’ll have increase in one state to pay for a waste in another.

Lapera: Yeah. This model carries over flattering many regardless of what you’re articulate about. Car insurance, health word — those are a dual that I consider people are substantially many informed with. So word companies make income two different ways. One is a proceed that we would expect, which is that they write all these policies and people compensate them premiums, but ideally, not everybody needs to claim something from a word association any year, so the association keeps a difference between a premiums paid in and a waste paid out. That’s the initial proceed they make money. The second proceed they make income is actually unequivocally interesting. Jordan, do we wish to take this one?

Wathen: The second proceed they make income is, when we compensate your premiums, there’s usually a time disproportion between when premiums are taken in and waste are paid out. So in between that time, insurers lay on billions of dollars, probably trillions globally, where they can deposit that income and keep a lapse they acquire on it. They call a income that they have taken in, but not nonetheless paid out, a float. Warren Buffett is a large proponent of float. He has something like $100 billion in boyant at Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B), and they make billions of dollars a year just sitting on their customers’ money until it gets paid behind out.

Lapera: Yeah, and that’s accurately what we was going to say. Warren Buffett finished his income by having word companies and regulating a boyant to invest. Geico, for example, is a Berkshire Hathaway company. So we know what an word association is now, just in box we didn’t before. Maybe you’re 15 and don’t have to worry about those things. In that case, good on we for listening to an investing podcast. If we didn’t know, now we know some more. It’s good to learn something new every day. That’s what my mom always says. You know how they make money. So here are a integrate things that we need to know about before we start trying to deposit in an word company. The first thing is a total ratio.

Wathen: Right. A combined ratio — this gets behind to a initial proceed they make money, that is by paying out reduction than they take in in premiums. Most word companies don’t do that, we should chuck that in there. Most insurance companies indeed compensate out some-more than they take in in premiums, and make adult a disproportion by investing the float. But good word companies should uncover a total ratio over time of reduction than 100%. Basically, the combined ratio takes a waste that we compensate out and the operating expenses of a business and order that by a premiums. Ideally, that would be reduction than 100%.

Lapera: Yeah. The most critical thing is to make certain you look during a total ratio over time. If a association has a unequivocally good quarter, that’s awesome. But if their combined ratio has been 120% for a final 10 years, (a) they’re probably not in business, though (b) that’s a pointer that you should substantially worry about that company, because their underwriting practices aren’t strong, and they’re not doing a unequivocally good pursuit of handling their risk.

Wathen: Right. Over multiyear periods, a good proceed to see if they’re doing good or not is if they consistently report what’s called a auspicious prior-year development. This is fundamentally word pronounce for, “Our loss assumptions valid to be more regressive than they indeed were, so we lost less than we suspicion we would on these policies.” Safety Insurance Group (NASDAQ:SAFT) is a publicly traded company. They’re a company that’s finished unequivocally good over time with actually being unequivocally regressive in their assumptions. Historically, they generally generate these auspicious prior-year developments over time.

Lapera: Are they a ones that are adult in New England and had that one unequivocally bad year because of that snowstorm?

Wathen: Oh, yeah, they had a terrible year in 2015, it was a record-loss year. I consider something like 9 feet of sleet fell on Massachusetts in a Boston area, that is where they safeguard a lot of automobile and homeowners word policies, and the waste were tremendous. Of course, now they’re removing a advantage of that, because of being means to assign aloft rates.

Lapera: Yeah, if we demeanour during their total ratio over time, like Jordan said, it’s unequivocally good. And it’s not unusual for an word association to have one really bad year here or there, especially if they protection a non-diverse geographic area, so if they’re usually in one space. But just try to keep all that in mind as you’re wading by these documents.

Wathen: Also, another thing I like to demeanour during is a peculiarity of a investment portfolio. Most companies that safeguard word will invest in short-term bonds, bonds, generally, safer investments like that. Something that I demeanour for privately is, they always uncover an normal credit rating. we like to see that an word association takes risk essay insurance, and not so many risks in its investment portfolio. You could do one or a other, but you substantially shouldn’t do both. You shouldn’t be holding pornographic risks in your investment portfolio and holding large risks in your word portfolio, too.

Lapera: Yeah, that’s unequivocally unequivocally good advice. You should always demeanour at what is going on in their investment portfolio. Insurance companies are compulsory to divulge what they have going on in there, in their 10-Ks and 10-Qs. So that’s a good proceed to figure out what’s going on. As always, make certain we go behind to a primary-source papers and look during things for yourself. We talked about combined ratio over time and looking during a investment portfolio. The last thing we should demeanour during is, you want to consider about what kind of macro effects there competence be on insurance. For example, health insurance. No one unequivocally knows, during slightest in the United States, what’s going to occur with health word over a march of the subsequent 4 to 10 years, really. So that’s something we should consider about when you’re looking to invest in a health insurer.

Wathen: Yeah, that’s indeed a unequivocally good example. There’s health insurance, that is brief term, they’re here-and-now needs. A business that has not finished unequivocally good over time and insurance is long-term caring insurance, since basically, the assumptions were, the cost of medical would usually go adult X% per year for so long. Lo and behold, nothing has risen as quick as, well, student waste first, though afterwards health costs second. So a lot of these companies underwrote these policies on a arrogance that prices competence grow during 3% a year, when in reality, they grew 4% or 5% a year, and they ended adult losing their shirts on something like that.

Lapera: Yeah. The other thing that a lot of these word companies are confronting now are people who got long-term insurance, like, 20 or 30 years ago. People are living a lot longer than they used to. It does affect their bottom line. So there’s a lot of outward factors that competence impact that. An example that we brought adult a other day on that Warren Buffett part — if we didn’t hear it, you can possibly hunt by our history for Berkshire Hathaway, or email me and we can send we a part — is that driverless cars are going to impact automobile insurance, because the some-more people who are not driving, a fewer people who need actual automobile insurance. Plus, driverless cars should, in theory, reduce the series of accidents that people are going to get into. So that’s something to consider about if you’re going to deposit in an automobile insurer.

Wathen: Definitely. we consider auto insurance is indeed unequivocally interesting, because one of a advantages of driverless cars, if they happen, is that the word premiums we compensate any month should theoretically go down. That’s one of a mercantile reasons why driverless cars would be a large understanding if they happen. That might be years away, though it’s definitely a risk that we have to know about.

Lapera: Yeah. We mostly talked about pretty obvious forms of insurance, though there’s also some some-more uncanny insurance. The insurer that always comes to mind for me is Markel (NYSE:MKL). They’ll protection hulk parties, they’ll insure your racer racing horse, they’ll insure restaurants. They protection uncanny things that other people have a tough time figuring out how to do a underwriting for.

Wathen: Right. I was indeed involved with a gift that does a golf tournament, and they buy hole-in-one insurance, because if we strike a hole in one, we get $10,000, or a new car, something like that. But they don’t have a income to compensate that out, so they buy hole-in-one insurance just in box that happens.

Lapera: Yeah, stuff like that. Or reinsurers, which I consider we’ve talked about before on a show. we consider it was indeed me and Jordan, because Jordan and we always do, like, “Let’s talk about uncanny financial companies.” Reinsurers are basically word companies for word companies. So word companies take out a process with reinsurers since they’re disturbed that if a huge natural disaster happens, they won’t be means to compensate out completely, so they have these reinsurers come and help disperse a costs.

Wathen: Right. A lot of word companies buy reinsurance, so basically they finish adult usually being marketing companies — they’re out there usually offered policies and passing on a risk to someone else.

Lapera: Yeah. There are different forms of word companies that we can demeanour into, and maybe they won’t be as influenced by creation as other companies are, or as affected by a domestic landscape as other companies. But yeah, I consider that flattering many sums adult a bare-bones basis — we know how to go out and during slightest proceed a suspicion of investing in an word company.

On the back half of a show, we’re going to answer listener questions about insurance. We’re going to start with a many simple and work a proceed out to many niche. There’s 4 questions, in box you’re curious. To start: There are tons of word companies. Why?

Wathen: There are a lot of word companies. The first reason is, it’s kind of a healthy state of a word attention to have a lot of insurers. If we consider about it, insurance is all about swelling risk around, and that’s not just among a word companies’ clients, though also among insurers. The world would be a worse place if there were 10 word companies who owned a marketplace in one state and underwrote automobile word policies, or homeowners insurance, or whatever, usually in one state rather than carrying a garland of opposite companies contest in a garland of opposite states and a garland of opposite markets and widespread a risks around that way. So we consider a healthy state of this attention is always going be very competitive. The second reason, actually, vocalization of states, is that insurance companies are protected in states. When you consider about starting an word company, it’s much easier than starting another financial institution, like a bank. The regulatory regime isn’t scarcely as despotic on insurance companies as it is on, say, a bank. For that reason, it’s easier to start an word association than it is a bank.

Lapera: Yeah. As you mentioned earlier, we were saying, with it being good that there’s a lot of insurers, that ties into a review about reinsurance that we had during the front half of a show. The other thing that we mentioned is, it’s kind of easy to start an word company, but it’s unequivocally tough to get absolved of an word company.

Wathen: Right. Winding down an word association is hard. One of a biggest benefits that we can have as an word association is scale — that you’re bigger and you support this large customer-service organization, or whatever. To go down, to safeguard reduction insurance, is unequivocally tough to do. It’s bad for employee morale, it’s bad for a economics of a business. You have scale operative opposite we as we get smaller. So it’s tough to breeze down an word company, to contend a least.

Lapera: Yeah, and there are regulations around how to do that, which just creates it that many harder. You can’t usually arise adult one day and be, like, “We’re out of business, contemptible everybody who has insurance with us!”

Wathen: Right. If we write insurance for 5 years, we can’t usually close that down. You have to have someone to take over a policy. It’s usually not easy — word is a long-run business and it’s not easy to run something like that down. You have a investment portfolio to breeze down. It’s just a mess.

Lapera: Yeah. So that’s why there’s so many word companies. They’re easy to start, they’re tough to close down, and it’s good for everybody that there’s more.

Wathen: And the tax advantages can be tremendous, too. This is a fun one. A bunch of hedge supports are starting reinsurance companies in Bermuda now, and they write a tiny volume of word so they can call themselves reinsurers, though unequivocally they’re just sidestep funds that are perplexing to get taxation advantages. That’s an interesting angle, too.

Lapera: Yeah. we consider the answer to that question was a lot some-more formidable than I creatively suspicion it would be. So I’m really happy for a chairman who asked that question. What is a boyant typically invested in?

Wathen: That depends. The whole suspicion — many word companies really want to build an investment portfolio so that the duration of their resources matches that of their liabilities. A automobile word association writes short-term contracts, so it’s going to essentially deposit in short-term bonds. On a other hand, a association that writes life word or annuities, for example, is going to deposit in longer-term assets. To give we an instance of that, let’s use Progressive (NYSE:PGR). As a automobile word company, 80% of a investment portfolio, its fixed-income portfolio, during least, is in short-term holds that mature in reduction than 5 years. On a other hand, MetLife — that does life and payments insurance, long-term insurance contracts — 70% of its portfolio is invested in holds that mature in some-more than 5 years. So a whole suspicion is, depending on how prolonged it will take we to compensate out your claims, generally speaking, the longer we can deposit your capital, so the longer we can deposit in longer-term holds or even stocks.

Lapera: Yeah, that creates clarity to me. we consider a doubt that people will substantially also have is, we talked a lot about bonds… what about stocks?

Wathen: Generally speaking, Progressive, for example, only has about 10% of a collateral invested in stocks, since stocks gyrate so many more. If they need to go sell stocks, and something like 2009 happens, you don’t wish to be in a unfolding where you’re offered holds during a detriment to compensate out claims. So generally speaking, these insurers try to keep into super-safe investments — 90% or some-more of their portfolio in bonds.

Lapera: Yeah, that creates clarity to me. That’s what we would do if we were an insurer. But word companies typically are kind of regressive animals, because they have to be. OK. Second-to-last question: What commission of premiums paid make adult a boyant for most word companies?

Wathen: Ultimately, premiums are a source of float. The doubt is, really, how many in unmerited premiums, or premiums that are paid in allege of a contract? If we compensate on Mar 30th your insurance reward for April, May, and June, that’s an unearned premium for a word company. That period hasn’t come yet. So Progressive, for instance, a unearned premiums on a change sheet when it final reported it was about $8 billion. So there’s $8 billion of collateral there. Then, if we demeanour a small bit further, you’ll see their detriment and loss-adjustment reserves, that is how many they expect to remove that they haven’t paid out yet. That was $11.6 billion. So for Progressive, a large generator of a boyant really isn’t so many premiums they’ve taken in in advance of a contract. It’s really a volume of time it takes for them to compensate out on losses, if that creates any sense.

Lapera: That creates a ton of sense. Thank you so many for responding that. Listeners, we also have a unequivocally aged essay — I don’t wish to trick you, it’s from 2006 — though it helped also answer this question. If we wish it, email me during The information in it is still relevant, it’s usually unequivocally old. It’s over 10 years aged during this point. Last question, this is unequivocally opposite from a other ones: Are Essent‘s (NYSE:ESNT) 68% net margins too good to be true? Some credentials for listeners, Essent is a debt insurer. That’s the private debt word we need to buy if we put down reduction than 20% on down remuneration for a house.

Wathen: Yeah. This is a billion-dollar question. The answer is, it’s tough to say. we guess, come behind when home values are going down rather than up. Mortgage word is usually tough. On a prolonged timeline, it seems like all mortgage insurers eventually go to zero, because a industry basically went archaic during a Great Depression. Half of them blew up in a 1980s, many of them blew up, or roughly blew up, in 2008. So we have these long, generational cycles of profits, and afterwards residence values go down and they remove a fortune, because they’re fundamentally holding a initial detriment on houses. Personally, I don’t spend too many time following it since a cycles are so long, and because it’s one of those industries where a supervision plays a unequivocally large role. So if a supervision comes out and wants to foster homeownership, they could unequivocally hurt a debt word attention if they wish to. Or they could make it obscenely essential by making it harder. It’s usually an attention that, truthfully, we don’t know too well. And I consider we would unequivocally have to have your finger on a beat of Washington politics to unequivocally know it.

Lapera: Yeah, and not usually Washington politics, but, like we mentioned, a housing cycle tends to be unequivocally bang and bust, and a problem is private debt insurers are not a ones writing a loans for a houses. In that case, it’s dual stairs of underwriting. It’s a bank’s underwriting plus the insurer’s underwriting that is creating this process for this person. So if a bank did a unequivocally bad pursuit underwriting that house, afterwards a insurers are definitely going to remove out. So it’s usually something that has a lot of variables and is tough to control. So usually consider about that before you consider investing in private debt insurance.

Wathen: That’s a good point. Because these cycles are so long, someone could theoretically join a mortgage word association out of college, become an executive, and through that whole timeline where they move adult the company, basically, they operate in an attention during a time when they knowledge roughly no losses. So all they’ve been rewarded for is underwriting some-more and some-more and some-more insurance. Psychologically, it’s something that’s really formidable to grasp, because eventually, a waste do come — it’s just a matter of time. But someone could simply see 10-30 years of additional profits, and then all of a sudden, it’s usually finish wipeout in one year when residence values go down.

Lapera: Yeah, definitely. Do we have anything else we wish to contend about insurers before we hang up?

Wathen: They’re boring, but because they’re boring, they can make for great investments. Personally, I indeed like a word attention some-more than most, we guess, in a financial space. we like them some-more than banks, for instance. we consider a risks are better. But it’s not everyone’s crater of tea, and we get that, too.

Lapera: Yeah, that’s totally fair. I consider word companies are really interesting since we consider a macro factors that are affecting word companies are a small bit some-more engaging than banks, so I consider it’s a some-more engaging thing to think about. Not that we don’t adore banks. Don’t worry, Maxfield will be back, and we’ll speak about banks again, I’m sure. 

As usual, people on a module might have interests in a holds they speak about, and The Motley Fool might have recommendations for or against, so don’t buy or sell holds formed only on what we hear.

If we still have any questions about insurance, feel giveaway to email us, and we’ll take it onto another uncover eventually. Contact us during, or by tweeting us @MFIndustryFocus. Listeners, I have a Twitter account. I post infrequently, I have to admit, though if we twitter me, I will eventually see it and respond to you. It’s @TMFCaffeine. we don’t unequivocally know how to pitch Twitter handles, so I wish that’s adequate for we to find it. And appreciate we to Austin Morgan, today’s producer, patient, studious editor. we screwed adult a integrate times, and I know he’s going to repair it. Thanks for creation me sound good.

Austin Morgan: Always.

Lapera: And thanks to Jordan. Thank you everyone for fasten us, and I wish everybody has a good week!

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