Investing in the insurance industry

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Taco insurance 101

Picture the scene: it’s 2001, you’re the CEO of Taco Bell, and it’s been reported that a space station is about to crash into the South Pacific. So you make the (totally obvious and totally normal) decision to stick a Bell-branded target in the ocean, and you tell the world that if the space station hits that target, you’ll give every American citizen a free taco.

Now, it’s very unlikely the station will hit the target, but it is theoretically possible. And if it does, you’re going to have to deliver on your promise to the tune of a cool $400 million. That’s a possibility you’re probably not comfortable with – but that promotion sure sounds like a good way to put tacos on the map. So you decide to take out insurance. Taco insurance.

You do it because you know that, in exchange for a fee (known as a premium), your insurer will agree to compensate you in the event a risk becomes a reality. In this case, the firm will guarantee to pay for America’s taco bonanza in the unlikely event the space station lands on that one spot. And yes, this really happened.

**Why would the insurer agree to this? *A $400 million sum might knock the filling out of Taco Bell, but insurers are very clever about how they manage risk. Let's say the firm has worked out there’s a 1% chance the station will hit the target, and it charges Taco Bell $4 million for its policy. That means it believes it’ll have to pay out once in every one hundred crashes. So if there were 99 other companies that had the same idea as Taco Bell (unlikely, sure, but bear with us), it could charge each of them $4 million. The insurer would then have a $400 million pot ready in case it actually needs to cover the costs of a payout. Or, better still, the station won’t hit anyone’s* target and the insurer won’t have to pay out at all.

That’s insurance in a nutshell. But it’s a $5.2 trillion industry with sneaky secrets galore, and if you’re all clued up on the ins and outs, you stand to win big. That’s precisely why it attracts big-name investors like Elon Musk and Warren Buffet. In fact, many argue that Buffett is only where he is today thanks to his insurance investments.

The takeaway: Insurance is the business of risk transfer – and it’s a favourite of successful investors.

The real insurance business

The insurance industry is split into three segments. There’s life insurance, which pays out to your nearest and dearest when you die. There’s property and casualty insurance (often abbreviated to P/C), which covers events like car crashes, hurricane damage, theft and so on. And there’s health insurance, which covers your medical bills – though this is generally treated as part of the healthcare industry.

The business model seems simple: an insurer sells insurance products, collecting premiums in return for absorbing customers’ risk. Subtract the costs of doing business (admin, sales reps, claim assessors etc.), as well as the inevitable payouts, and it pockets whatever’s left as profit. See: simple, right?

Actually, there are a lot of factors that complicate things. A big payout season – following a hurricane, for example – can cost insurers billions. They’ll try to reduce those costs, of course: with reinsurance policies (insurance for insurers themselves) or, in rare cases, by fraudulently rejecting claims. But it doesn’t do much to shift the balance, especially since premiums are already low given the amount of competition in the sector. So low, in fact, that those premiums generally aren’t enough to cover costs. That generates what’s called an underwriting loss.

How do they make money then? Given the delay between the initial payment of the premium and the subsequent payout, firms tend to sit on big piles of cash: US providers have around $8.5 trillion between them, to be exact. It’s called a float, and it’s the industry’s money-printing machine.

Insurers are allowed to invest their float. And invest they do, typically putting the money into safe(ish) investments like government bonds, investment-grade corporate bonds, and stocks. Life insurers, who can predict with relative accuracy when they’ll have to pay out (their actuaries do a mortifyingly good job of guessing when you’ll die), tend to prefer investments with guaranteed capital return dates. P/C insurers, meanwhile, gamble a little more in search of higher returns.

The gains generated by these investments are what really make insurers money. In 2018, the US P/C industry posted an underwriting loss of $100 million. But you can put away that small violin: thanks to $55 billion in investment income, things weren’t looking too shabby for its constituent companies.

Insurers aren’t the only institutions that use other people’s money to invest: hedge funds and banks do the same. But insurance is special because of the numbers involved. Underwriting losses are often pretty small: in the past 18 years, the average P/C industry loss is just 1% of its income from premiums. That means insurers have essentially been paying a 1% fee to borrow the money – which is a lot less than it costs to borrow money any other way. And, of course, they don’t have to deliver returns to pesky clients…

Some insurers (like Warren Buffett’s) are so good at managing risk they even produce an underwriting profit (sometimes, at least). In other words, the premiums cover the payouts, so Buffett’s insurers are being paid to borrow money. No wonder it’s the Oracle of Omaha’s favourite industry…

And many big insurers looking for an even bigger payday now offer a lot more than just insurance. They’ve effectively become big financial services companies, managing pensions, annuities, and other investors’ wealth. Sometimes they even trade risky derivatives – although that doesn’t always go well. Still, we’re going to focus on the actual insurance part of their business: issuing policies and investing the float. It’s a proven business in today’s world – but, as we’re about to explore, that world is changing fast…

The takeaway: Insurers bring in cash from premiums and other financial services – but the big money’s in investing customer premiums.

The impact of societal change

Climate change, cybercrime, an aging population: society isn’t looking too hot for the Average Joe. But it’s a different story for insurers.

The benefits aren’t immediately obvious. In the last few years, climate change-linked disasters have led to bumper payouts: 2018’s California Camp Fire, for example, cost insurers $12 billion. But over time, people are going to become more tuned into these new risks, and the number of policies taken out to guard against them will start to climb. Insurers, meanwhile, will be able to keep upping their premiums.

The globe’s aging population also provides ample opportunities for insurers – especially those that have diversified into other products. Longer lives mean bigger pensions, more annuities, and pricier health insurance products. And as the population’s wealth grows in emerging markets like China and India, there’s huge potential for growth in those markets. Half-year profits at China’s Ping An, the world’s biggest insurer, grew a massive 68% between 2018 and 2019 alone.

Then there are dangers like “ransomware”, where hackers infiltrate a business’s computer systems and threaten to delete all the data unless the victim pays a ransom. Insurers often pay these ransoms on the firm’s behalf because it’s cheaper than recovering the data. But that tends to encourage the hackers, which in turn increases the risk of cybercrime… and the demand for insurance policies.

What about insurance-linked securities? We’re glad you asked. In future, profits could also be set to grow thanks to the rise of “insurance-linked securities” (ILS) – financial products that transfer risk from companies directly to investors.

“Catastrophe bonds” are the best-known example. If an insurer is exposed to $200 million in hurricane-damage losses, it might issue catastrophe bonds for investors to buy. Their cash will then be put into a special account earmarked for hurricane costs. If the insurer’s losses go over a certain threshold, the investors’ money covers the rest (and the investors lose out). But if the hurricane passes without major incident, the investors are paid a dividend that is typically greater than your garden variety bond yield.

Catastrophe bonds and similar products have exploded in popularity in recent years, as they’re pushing the risk away from insurers and onto investors. That means insurers will increasingly be able to manage money without taking on the same kind of risk, creating an even more attractive business model than today’s.

But that also means they’ll have to confront the same challenge as every other money manager in the world: plummeting interest rates. Low (or even negative) returns from government bonds mean an insurers’ typical strategy of playing it safe will no longer cut it. That means they’re now hunting for returns elsewhere – in riskier bonds, private equity, and real estate.

And that’s not insurance firms’ only challenge. As you’ll see in the next session, technology is upending the status quo of the industry – as well as presenting swathes of new opportunities for those who learn to adapt.

The takeaway: Increased global risk is providing all sorts of new opportunities for insurers, but they might still be hamstrung by widespread low interest rates.

The impact of technology

No industry is safe from “disruption”, but insurers are particularly susceptible. A recent study says insurance underwriters have a 98.9% chance of being replaced by artificial intelligence – making it the most under-threat white-collar profession out there. AI is, after all, tailor-made for the pattern-spotting nature of risk assessment.

Take “Insurtech” startup Lapetus, which is helping life insurers calculate what to charge customers. It assesses a range of factors based on a selfie – your BMI, your skin and so on – to work out when you’re likely to, er, kick the bucket. Aerobotics, meanwhile, uses drone technology to analyse crop health, and then turns that data into an accurate premium. And as data-collection techniques become even more advanced, trends like these will only accelerate. US health insurers, for example, are banned from using genetics-based pricing – but given that life insurers aren’t, it might only be a matter of time...

Meanwhile, insurers have generally relied pretty heavily on sales agents, brokers, or “bancassurance” (cool name, bro) to sell their policies. But thanks to improvements in digital services, customers have become more willing to buy insurance directly from the providers themselves – and these middlemen are disappearing. And that could mean massively reduced costs: Prudential employs 660,000 agents in Asia alone.

What else is on the agenda? Many insurers are encouraging customers to turn their homes into smart homes as a way to improve security and – more importantly – limit the need for payouts at all. Some even expect to follow Silicon Valley firms in moving to a service model: according to an executive at Swiss insurer Chubb, a monthly subscription fee could get you a “predict and prevent” service to protect your home.

But insurers will also likely be affected by all the other implications of the subscription economy. As a society we’re increasingly choosing to rent rather than buy – homes, cars, you name it. And most traditional insurers still aren’t up to speed with new markets like ride-sharing or Airbnbs. That’s led to an influx of startups that are – like Lenny, which offers very short-term insurance on vehicles, and Guardhog, a home-sharing insurer.

The big players aren’t blind to the threats posed by the new kids on the block. So it’s probably a smart move on German giant Allianz’s part that it’s providing insurance for car-sharing startup Drivy. Keeping up with the times is key: adapt or die – or worse, change your LinkedIn status to “Looking for new challenges”.

The takeaway: Tech is changing the insurance industry by cutting costs, opening up new markets and inviting challenger brands onto the scene.

Analyzing insurance stocks

Why should I care about insurance? If you have a policy with a mutual firm like USAA, the success of the firm directly affects you: your policy means you own a piece of the company and might get paid a dividend when it’s doing well. Even if you don’t, many insurers are public companies whose shares you can buy. But it can be tricky to decide which of them to invest in. After all, if you’d invested in Ping An back in 2004, your money would have increased 18 times over by September 2019. To decide, there are a few questions you’ll need to ask yourself...

How risk exposed is the insurer? If a property and casualty insurer has made most of its money selling policies in an area that’s about to be hit by a hurricane, it’s probably not an ideal investment. And there are tools that help you assess exposure to a particular risk. But you’re often best off finding the company’s “financial strength rating” from ratings agencies like A.M. Best and Standard & Poor’s, which measures how likely an insurer is to meet its payouts and stay afloat. You should find these on the insurers’ investor relations sites, or by Googling it. The company’s offering can make a big difference here: a firm that makes money from asset management as well as insurance is less at risk if one of those businesses tanks.

How much does the insurer pay to borrow cash? According to Warren Buffett, the main thing that matters when evaluating an insurance business is its cost of float. That’s the underwriting loss we talked about earlier: how much it costs the insurer to borrow money. You can find this out by looking up its combined ratio – the ratio of costs to premiums, in other words. The figure’s disclosed in an insurer’s financial statement, which you can find with a quick Google.

If the insurer’s combined ratio is below 100%, it’s running an underwriting profit. In other words, it’s getting paid to borrow other people’s money. If the ratio’s sitting above 100%, it’s running a loss. That loss isn’t necessarily a problem: it’s how big the loss is that matters. For context, the US average combined ratio for P/C firms over the past 10 years is 101%.

How much does the insurer make from investing? Borrowing money is only useful if you can actually generate a return from it – so you need to make sure an insurance firm does. Check its financial statement for its investment portfolio return, and compare it to its competitors’. If you can’t find the portfolio return, divide the investment income and “other comprehensive income” (which reflects unrealized portfolio gains) by the value of assets under management. That should give you a rough percentage return.

How expensive is the insurer’s stock? By looking at a firm’s price-to-book (P/B) ratio – the value of the stock relative to the value of assets it has – you’ll be able to see how expensive its stock is compared to its peers. A good rule of thumb is that a P/B of 1 is cheap, and 2 or higher is expensive. But you’re best off making direct comparisons between the firms to see what’s cheapest. All this data is on Yahoo! Finance under the Statistics tab.

Has the stock delivered a return? This one’s simple: take a look at return on equity. That’s the profit an insurer delivers in a year divided by the company’s assets. It shows how well the company’s performing as a whole, and can be used to compare insurance stocks with other industries too. Again, Yahoo! Finance has got you covered.

And if all that seems like too much work, you could always just invest in a basket of insurance stocks with an exchange-traded fund (ETF).️ There are ETFs specifically geared toward the US and European markets, or toward individual insurance sectors like life and P/C.

So sure, insurance may seem boring, but boring is good. There’s not much hype to lead you astray, and the products are ones that people will always need. And if you know your stuff (which you totes do now), you'll know how to spot a boring company that could go from strength to strength. “Boring”? Give us boring gains over sexy losses any day of the week...

In this Pack, you’ve learned:

🔹 An insurance firm makes most of its money from investing premiums, rather than the premiums themselves (which are often outweighed by payouts)

🔹 AI and digital sales are shaking up the entire insurance industry, eliminating jobs in favour of faster processes and more accurate predictions

🔹 New global risks could benefit insurers, and emerging markets are offering growth opportunities – but low bond yields are sending investors elsewhere for returns

🔹 There are a few ways to assess insurers’ stocks, including combined ratio, risk profile, and investment income.