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.