Why I love insurance…as an investment that is

I had known for many years that Warren Buffett was a big fan of the insurance businesses. What I didn’t get, until several years ago, was why he loves insurance.

The problem I had was understanding how the insurance business works. I found it easier to analyze industrial and technology companies: raise capital, buy factory, hire people, buy raw materials, make product, sell product, collect money, repeat. But with insurance, how does the insurer know what to charge? How do they know what the final claim will be? How do they make money?

When I did figure it out, it seemed simple to me in many ways, and very profitable if done right. There are two basic keys to making money in insurance: underwriting and investing. I’ll explain underwriting first.

Let me use a simplified version of car insurance to illustrate. If you are an insurer, and you insure someone who gets in a car accident every 5 years, and the damage caused each time is $10,000, then you should charge $2,000 a year ($10,000/5 years) in premiums to cover your risk. Now, granted, it’s very difficult to know how frequently one person will get in an accident, and how much damage will be caused. But, when you insure thousands of people, it’s much easier to figure out how frequently accidents will happen and how severe they will be in terms of dollars paid out in claims. It comes down to understanding averages.

So, the first key to a profitable insurance operation is successful underwriting. If the insurer collects enough money to pay out claims, then they are said to be making an underwriting profit, and that’s successful underwriting.

The second key is investing. The $2,000 a year paid in premiums in the illustration above aren’t paid out for 5 years. So, if that $2,000 a year is successfully invested, the insurer can make even more money.

An insurance company can stay in business if they underwrite well or invest well. But, to really make money, they have to do both well. You see, if underwriting is profitable, the insurance company receives an interest free loan until the claim is paid! And, if you get good investing results, the impact of that interest free loan multiplies your return.

Let me use another illustration to drive this point home. Suppose you could buy a $300,000 house and you thought it would appreciate at 5% a year. Also suppose you only have to put down 20%, or $60,000, and someone else was willing to lend you the other $240,000 with no interest, due in 5 years. You’d be able to lock in a 18.95% annualized returns over those 5 years! And that’s what insurers can do!

First, underwrite insurance to sufficiently pay out future claims. That leads to an interest free loan. Second, get great investing returns. The higher the investment returns, the greater the returns for the insurer because of the multiplier of having an interest free loan.

Please note, I’ve oversimplified things to illustrate the point. Getting underwriting profits is not that easy. With many risks, it’s much harder than my simple example to know how frequently payouts will occur and how severe those payouts will be. Think about insuring medical malpractice where you have a very hazy idea when claims will occur and an even hazier idea how much you’ll have to pay.

Premiums are also highly regulated by states for most common insurance like automobile, homeowner, life, etc. There’s no guarantee you’ll be able to charge sufficient premiums or that you’ll be able to compete with bad insurers who don’t charge enough.

I’ve also oversimplified the multiplier effect of interest free premiums. Insurance companies have many costs to deal with in addition to just paying claims. There is still a multiplier effect, it just isn’t as grand as I described it.

Getting high investment returns isn’t that easy, either. Insurance companies must invest most of the premiums they receive in low risk, highly liquid fixed income securities so they can pay out claims. Only a portion of their investments can be in riskier investments that can provide bigger returns.

Regardless of these complexities, insurance can be a great business. There are profitable insurers who focus more on either underwriting or investing, but the really great results are produced by insurers who focus on and are very good at both. That’s one of the keys to Warren Buffett’s wealth, and the wealth of several other smart insurers.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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Earnings season is upon us!

For those who seriously pay attention to the stock market, earnings season is an important time each quarter. Earnings season is when companies report their quarterly financial results both in conference calls and press releases. It’s not only a chance to see how businesses have done, but, more importantly, it’s a chance to get a peek at how businesses will do going forward. And that peek, more than anything else, is what drives stock prices in the short term.

What are the prognosticators seeing in their crystal balls this quarter? For the first time since the second quarter of 2003, earnings are forecast to grow at a slower than 10% pace year-over-year. What many stock market watchers are worried about is that companies will not only report slower growth, but that they will forecast slower growth for more than a quarter or two. Gasp! Horror! (sarcasm)

In the long run, a stock’s price is determined by what a company will earn over time. The thing that moves stock prices in the short term, however, is not so much how companies are doing, but how they are doing relative to the view of market participants. John Maynard Keynes, a famous economist and successful investor, once compared picking short term investment winners to a beauty contest. Instead of trying to pick the most beautiful person, you end up trying to guess who everyone else thinks is beautiful. The game, in the short run at least, it to try to outwit all the other people trying to outwit you in guessing how everyone will react to short term information.

Would you like to guess how well this methodology works over the long term? Answer: not so good. The problem is that quarterly earnings reports and guesses about how things in the economy are shaping up are extremely noisy–by which I mean they move around a lot and don’t necessarily indicate long term information. This noisiness means that trying to guess what will happen seems to be a fools errand. And yet, most on Wall Street and most money managers try to play it. Want to guess why 80% of professional money managers don’t beat the market?

I’m not saying quarterly earnings reports are a waste of time. Quite the contrary. A lot of valuable information can be gleaned by listening to conference calls and reading quarterly financial reports over a long period of time. That’s why I read quarterly reports and listen to conference calls.

The problem is the importance that’s placed on such noisy data. And this importance is what makes stock market prices much more volatile than the earnings of underlying companies. It’s all those bozo’s trying to guess what will happen over the next 12 seconds that leads prices to go so far astray from underlying value. While such volatility makes consistently beating the market in the short term almost impossible, it does lead to wonderful opportunities to buy good companies at overly low prices.

And, that’s the real reason I love earnings season.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Protectionism is an economic disaster waiting to happen

On Friday, the Bush administration announced its decision to impose duties on imports of coated paper from China. At the same time, there’s bipartisan support in Congress to impose tariffs on Chinese goods unless China allows its currency to appreciate against the dollar more quickly.

Let me quickly quote Santayana, “Those who cannot remember the past are condemned to repeat it.”

One of the leading causes of the Great Depression was the Smoot Hawley Tariff Act, signed into law on June 17, 1930. This act raised tariffs on 20,000 imported goods and led to a trade war as many countries retaliated by raising tariffs on American goods. The result: American exports and imports plunged by more than half.

Am I saying that these actions will lead to another depression? Not necessarily, but it’s a dangerous step in that direction.

If the President, Congress and anti-globalization-types get their way, what would be the result? Chinese currency increasing would probably lead to a higher inflation, higher interest rates, an increase in the cost of goods for most Americans, and maybe a slight, temporary increase in exports.

Higher inflation would mean increased costs for Americans which would further squeeze their already indebted lifestyles. It would also lead to higher interest rates as lenders and bond purchasers demanded higher rates to deal with inflation.

Higher interest rates could lead to dangerous consequences in the housing market as those unable to pay their floating rate mortgages or refinance would have to punt their homes back to their lenders. Higher interest rates would also lead to lower asset prices for stocks, bonds and real estate as investors would insist on higher returns to make up for losses due to inflation.

Higher costs would decrease discretionary income for consumers, leading to higher unemployment and more loan defaults. This could cause a negative spiral in the financial services and housing industries.

Oh, and some special interest groups who have been lobbying Congress will be better off for a couple of weeks before all these negative impacts set in.

Everybody out there should be watching this development like a hawk, because your financial situation may very well depend on the outcome of these recent actions by the President and Congress.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.