How Insurance Companies Work

By Jordan Wathen and Gaby Lapera Markets

It's Insurance Day on Industry Focus: Financials. In today's episode, Motley Fool analyst Gaby Lapera and contributor Jordan Wathen explain the most important things that investors need to know about how insurance companies operate. Then they answer listener questions about all things insurance.

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Find out how insurance companies make money, how they diversify risk, what reinsurers are and how they work, why there are so many different insurance companies, the most important numbers for investors to check before buying in and how to make sense of them, how mortgage insurance companies are different from other types of insurers, and a few things that investors should understand about the industry before buying in... and more.

A full transcript follows the video.

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This video was recorded on May 22, 2017.

Gaby Lapera: Hello, everyone!Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. You arelistening to the Financials edition,taped today onMonday, May 22nd, 2017. My name is Gaby Lapera, andjoining me on Skype is Jordan Wathen,beloved Motley Fool contributor andexpert infinancial companies. How's it going, Jordan?

Jordan Wathen: It'sgoing alright. How are you, Gaby?

Lapera: Pretty good,are you happy to be a beloved contributor?

Wathen: I'm very happy to be a beloved contributor.I think that's better than my last introduction,which was something about being exotic, so I'll take it.

Lapera: Yeah,that's OK. I thinkexotic can be good, too,in certain contexts. Anyway,listeners, just in case you don't remember, this week isInsurance Day on Industry Focus: Financials. So the fronthalf of the show is going to be basics aboutinsurance companies, what they are,how they make money, somestuff you need to look out for when you'rethinking about investing. The lasthalf of the show is going to be listener-submittedquestions that we're going to answer. If you ever want yourquestion answered on Industry Focus, justsend us an email at Let'sdive right into it, because this is going to be an action-packed show. Let's start with a super easy question,which is, what is an insurance company?

Wathen: The basics of aninsurance company is that it exists to spread risks around them amonga bunch of different customers. One ofthe best explanations I ever heard was thatyou can think of insurance companies like banks where they takedeposits, or your premiums, andallow you to withdraw money only whenyou experience a large financial loss. I thinkhomeowners insurance is probablythe type of insurance that's easiest to explain. A home isthe most expensive thing that most people will ever own. So most homeowners buyhomeowners insurance toprotect them from the financial risks if their home is destroyed by fire, or wind, orsome other kind of disaster. Apolicy like that costs, maybe, 1% or 2% of the home's value each year in premiums.

Lapera: Yeah, itmakes sense. The idea is,you have all these people whoare not having a disaster at any given timehelping to pay for the one or twopeople who are having a disaster,and then you just scale this up to amassive scale, and you have an insurance company.

Wathen: That's a good point,because most homeowners insurance companies,ideally, they would have risks in higher-risk states like, say,Florida, and balance it out withhomeowners who own a home in Texas. So when a hurricane strikes Florida -- God forbid that ever happens again, but you know it's going to -- they willhave the money coming in from Texas, andhopefully there's no natural disaster there, so they'll have profits in one state topay for the losses in another.

Lapera: Yeah. This modelcarries over pretty much regardless ofwhat you're talking about. Car insurance, health insurance -- those are the two thatI think people are probably most familiar with. So insurance companiesmake money twodifferent ways. One is the way that you would expect,which is that they write all these policies andpeople pay them premiums, butideally, not everyone needs to claimsomething from the insurance company every year, sothe company keeps the differencebetween the premiums paid in and the losses paid out. That'sthe first way they make money. The second way they make money isactually really interesting. Jordan,do you want to take this one?

Wathen: Thesecond way theymake money is, when you pay your premiums, there'susually a time difference between whenpremiums are taken in and losses are paid out. So in between that time, insurers sit on billions of dollars,probably trillions globally, wherethey can invest that money and keep the return they earn on it. Theycall the money that they have taken in, butnot yet paid out, the float. WarrenBuffett is a big proponent of float. He hassomething like $100 billion in float at Berkshire Hathaway(NYSE: BRK-A) (NYSE: BRK-B), andthey make billions of dollars a year justsitting on their customers' moneyuntil it gets paid back out.

Lapera: Yeah, andthat's exactly what I was going to say. Warren Buffett made his money byhaving insurance companies and using the float to invest.Geico, for example, is aBerkshire Hathaway company. So you knowwhat an insurance company is now,just in case you didn't before. Maybe you're 15 anddon't have to worry about those things. In that case,good on you for listening to aninvesting podcast. If you didn't know,now you know some more. It's good to learn something newevery day. That's what my mother always says. You knowhow they make money. So here are a couple things that you need to know about before you starttrying to invest in an insurance company. Thefirst thing is the combined ratio.

Wathen: Right. Acombined ratio -- thisgets back to the first way they make money, which is bypaying out less than they take in in premiums. Most insurance companies don't do that, we should throw that in there. Mostinsurance companies actually pay out more than they take in in premiums, andmake up the difference by investingthe float. But good insurance companies should show a combined ratio over time of less than 100%. Basically, thecombined ratio takes the losses that you pay out and theoperating expensesof the business and divide that by the premiums. Ideally, that would be less than 100%.

Lapera: Yeah. Themost important thing is to make sure youlook at the combined ratio over time. If a company has a really great quarter, that's awesome. But if theircombined ratio has been120% for the last 10 years, (a) they'reprobably not in business, but (b) that's a sign thatyou should probably worry about that company, becausetheir underwriting practices aren't strong, and they'renot doing a very good job of managing their risk.

Wathen: Right. Overmultiyear periods, agood way to seeif they're doing well or not isif they consistently reportwhat's called a favorable prior-year development. This is basically insurance speak for, "Our lossassumptions proved to bemore conservative than they actually were, so we lostless than we thought we would on these policies."Safety Insurance Group(NASDAQ: SAFT) is a publicly traded company. They're acompany that's done really well over time withactually being very conservative in their assumptions. Historically, they generallygenerate these favorable prior-year developments over time.

Lapera: Are they the ones that are up inNew England and had that one really bad yearbecause of that snowstorm?

Wathen: Oh, yeah,they had a horrible year in 2015,it was a record-loss year.I think something like nine feet of snow fell on Massachusetts in the Boston area, which is where they underwrite a lot of car andhomeowners insurance policies, andthe losses were tremendous. Of course,now they're getting the benefit of that,because of being able to charge higher rates.

Lapera: Yeah,if you look at their combined ratio over time,like Jordan said, it's really good. And it's notunusual for an insurance company to have onereally bad year here or there,especially if they insure a non-diversegeographic area, so if they're just in one space. But justtry to keep all that in mind as you're wading through thesedocuments.

Wathen: Also, another thingI like to look at is the quality of the investment portfolio. Mostcompanies that underwrite insurance willinvest in short-term bonds, bonds,generally, safer investments like that. Something thatI look for personally is, theyalways show an average credit rating. I like to see that an insurance company takes risk writing insurance, and not so many risks in itsinvestmentportfolio. You could do one or the other, butyou probably shouldn't do both. Youshouldn't be taking obscene risks in yourinvestment portfolio and taking massive risks in your insurance portfolio, too.

Lapera: Yeah,that's definitely really good advice. You shouldalways look atwhat is going on in their investment portfolio. Insurancecompanies are required to disclose what they have going on in there, in their 10-Ks and 10-Qs. So that's a good way to figure out what's going on. As always,make sure you go back to the primary-source documents andlook at things for yourself. We talked aboutcombined ratio over time andlooking at the investment portfolio. Thelast thing you should look at is, youwant to think about what kind ofmacro effects there might be on insurance. For example, health insurance. No one really knows, at least in theUnited States, what's going to happen with health insurance over the course ofthe next four to 10 years, really. So that'ssomething you should think about when you're looking toinvest in a health insurer.

Wathen: Yeah,that's actually a really good example. There'shealth insurance, which is short term, they're here-and-now needs. Abusiness that has not done very well over time andinsurance is long-term care insurance, because basically, theassumptions were, thecost of healthcare would only go up X% per year for so long. Lo and behold,nothing has risen as fast as, well,student expenses first, but then health costs second. So a lot of these companies underwrote these policieson the assumption that prices might grow at 3% a year, whenin reality, they grew 4% or 5% a year, and theyended up losingtheir shirts onsomething like that.

Lapera: Yeah. The other thing that a lot of these insurance companies are facing now arepeople who got long-term insurance, like, 20 or 30 years ago. People areliving a lot longer than they used to. It doesaffect their bottom line. So there's a lot of outside factors that might affect that. Anexample that we brought up the other day on thatWarren Buffett episode -- if you didn't hear it,you can either search through ourhistory for Berkshire Hathaway, oremail me and I can send you the episode -- is thatdriverless cars are going to affect car insurance, becausethe more people who are not driving, the fewer people who needactual car insurance. Plus,driverless cars should, in theory, reducethe number of accidents thatpeople are going to get into. So that'ssomething to think about if you're going to invest in an auto insurer.

Wathen: Definitely. I think autoinsurance is actually really interesting,because one of the benefits ofdriverless cars, if they happen, is thatthe insurance premiums you pay every month shouldtheoretically go down. That'sone of the economic reasons whydriverless cars would be a big deal if they happen. That may be years away, but it'sdefinitely a risk that you have to know about.

Lapera: Yeah. We mostly talked aboutpretty well-known types of insurance, but there's also some more weird insurance. Theinsurer thatalways comes to mind for me isMarkel(NYSE: MKL). They'll insure giant parties, they'llinsure your thoroughbred racing horse, they'll insurerestaurants. They insure weird things thatother people have a hard timefiguring out how to do the underwriting for.

Wathen: Right.I was actually involvedwith a charity that does a golf tournament, and they buyhole-in-one insurance,because if you hit a hole in one, you get $10,000, or a new car,something like that. Butthey don't have the money to pay that out, so they buy hole-in-one insurancejust in case that happens.

Lapera: Yeah,stuff like that. Or reinsurers, whichI think we've talked about before on the show. I think it was actually me and Jordan, becauseJordan and I always do, like, "Let'stalk about weird financial companies." Reinsurers arebasically insurance companies for insurance companies. So insurance companies take out a policy with reinsurers because they're worried that if a hugenatural disaster happens,they won't be able to pay outcompletely, so they have these reinsurers come and helpdisperse the costs.

Wathen: Right. Alot of insurance companies buy reinsurance, sobasically they end up just beingmarketing companies -- they'reout there just selling policies andpassing on the risk to someone else.

Lapera: Yeah. There aredifferent types of insurance companies that you can look into, andmaybe they won't be as affected by innovation as other companies are, or asaffected by the political landscape as other companies. But yeah,I think that pretty much sums up the bare-bones basics -- you knowhow to go out and at least approach the idea of investing in an insurance company.

On theback half of our show, we're going to answerlistener questions about insurance. We'regoing to start with the most basic and work our way out to most niche. There's four questions, in case you're curious. To start: There are tons of insurance companies. Why?

Wathen: There area lot of insurance companies. Thefirst reason is, it's kind of the natural state of the insurance industry to have a lot of insurers. If you think about it,insurance is all about spreading risk around, and that's not justamong the insurance companies' clients, but also among insurers. The worldwould be a worse place if there were 10 insurance companies who owned the market in one state and underwrote car insurance policies, orhomeowners insurance, or whatever, just in one state rather than having a bunch of different companies compete in a bunch of different states anda bunch of different markets and spread the risks around that way. So I think the natural state of this industry is always going bevery competitive. Thesecond reason, actually, speaking of states, is thatinsurance companies are licensed in states. Whenyou think about starting an insurance company, it'smuch easier than starting another financial institution, like a bank. Theregulatory regime isn't nearly as strict oninsurance companies as it is on, say, a bank. For that reason,it's easier to start an insurance company than it is a bank.

Lapera: Yeah. Asyou mentioned earlier, you were saying, with it being good that there's a lot of insurers, that ties into our conversation about reinsurance that we had at thefront half of the show. Theother thing that you mentioned is, it'skind of easy to start an insurance company,but it's really hard to get rid of an insurance company.

Wathen: Right. Winding down an insurance company is hard. One of the biggestbenefits that you can have as an insurance company is scale -- that you're bigger and yousupport this massive customer-service organization, or whatever. To go down, to underwrite less insurance, is really hard to do. It's bad foremployee morale, it'sbad for the economics of the business. You havescale working against you as you get smaller. So it's hard to wind down an insurance company, to say the least.

Lapera: Yeah,and there are regulations aroundhow to do that, whichjust makes it that much harder. Youcan't just wake up one day and be, like, "We'reout of business, sorry everyone who hasinsurance with us!"

Wathen: Right. If you writeinsurance for five years, you can't just shut that down. Youhave to have someone to take over the policy. It's just not easy -- insurance is a long-run business and it'snot easy to run something like that down. You have the investment portfolio to wind down. It'sjust a mess.

Lapera: Yeah. So that's whythere's so many insurance companies. They'reeasy to start, they're hard to shut down, andit's good for everyone that there's more.

Wathen: And thetax benefits can be tremendous, too. This is a fun one. Abunch ofhedge funds are starting reinsurance companies in Bermuda now, and they write a small amount of insurance so they can call themselves reinsurers, but really they'rejust hedge fundsthat are trying to get tax advantages. That's aninteresting angle, too.

Lapera: Yeah. I think theanswer to that questionwas a lot more complicated thanI originally thought it would be. So I'm reallyhappy for the person who asked that question. What is the float typicallyinvested in?

Wathen: That depends. The whole idea -- most insurance companies reallywant to build an investment portfolio so that theduration of their assets matches that of their liabilities. A car insurance company writes short-term contracts, soit's going to primarily invest in short-term bonds. On the other hand, a company that writeslife insurance or annuities, for example, isgoing to invest in longer-term assets. Togive you an example of that,let's useProgressive (NYSE: PGR). As a car insurance company,80% of its investment portfolio, itsfixed-income portfolio, at least, is inshort-term bonds that mature in less than five years. On the other hand,MetLife -- which does life and annuity insurance, long-terminsurance contracts -- 70% of itsportfolio is invested in bonds that mature in more than five years. So the whole idea is,depending on how long it will take you to pay out your claims,generally speaking, thelonger you can invest your capital, sothe longer you can invest in longer-term bonds or even stocks.

Lapera: Yeah,that makes sense to me. I think a question thatpeople will probably also have is, you talked a lot about bonds... what about stocks?

Wathen: Generally speaking,Progressive, for example,only has about 10% of its capital invested in stocks, because stocksgyrate so much more. Ifthey need to go sell stocks, andsomething like 2009 happens, youdon't want to be in the scenario where you're selling stocks at a loss to pay out claims. So generally speaking, these insurers try to keep into super-safeinvestments -- 90% or more of their portfolio in bonds.

Lapera: Yeah,that makes sense to me. That's what I would do if I were an insurer. But insurance companies typically arekind of conservative animals,because they have to be. OK. Second-to-last question: What percentage of premiums paidmake up the float formost insurance companies?

Wathen: Ultimately, premiums are the source of float. The question is, really, how much in unearned premiums, orpremiums that are paid in advance of the contract? If you pay on March 30th yourinsurance premium for April, May, and June, that's an unearnedpremium for the insurance company. That periodhasn't come yet. So Progressive, for instance, its unearnedpremiums on its balance sheetwhen it last reported it was about $8 billion. So there's$8 billion of capital there. Then, if you look a little bit further, you'll see their loss and loss-adjustment reserves, which is how much theyexpect to lose that they haven't paid out yet. That was$11.6 billion. So forProgressive, the big generator of the float reallyisn't so much premiums they'vetaken in in advanceof the contract. It'sreally the amount of time it takes for them to pay out on losses,if that makes any sense.

Lapera: That makes a ton of sense. Thank youso much for answering that. Listeners, we also have a really old article --I don't want to mislead you, it's from 2006 -- but it helped also answer this question. If you want it, email me at Theinformation in it is still relevant,it's just very old. It's over 10 years old at this point. Last question, this is definitely different from the other ones: AreEssent's(NYSE: ESNT) 68% net margins too good to be true? Some background for listeners,Essentis a mortgage insurer. That's theprivate mortgage insurance you need to buy if you put down less than 20% on down payment for a house.

Wathen: Yeah. This is a billion-dollarquestion. The answer is,it's hard to say. I guess,come back when home values aregoing down rather than up. Mortgage insurance is just tough. On a long timeline, it seems like allmortgage insurers eventually go to zero,because the industrybasically went extinct during the Great Depression. Half of them blew upin the 1980s,many of them blew up, or almost blew up, in2008. So you have these long, generational cycles of profits, and then house values go down and they lose a fortune,because they're basically taking the first loss on houses. Personally,I don't spend too much timefollowing it because the cycles are so long, andbecause it's one of those industries where the government playsa really big role.So if the government comes out andwants to promote homeownership,they could really ruin the mortgage insurance industry if they want to. Or they could make it obscenely profitable bymaking it harder. It's just an industry that,truthfully, I don't understand too well. AndI think you would really have to haveyour finger on the pulse of Washington politics to really understand it.

Lapera: Yeah,and not just Washington politics, but,like you mentioned, the housing cycletends to be very boom and bust, and the problem isprivate mortgage insurers arenot the oneswriting the loans for the houses. In that case, it's two steps ofunderwriting. It's the bank's underwriting plusthe insurer's underwriting that iscreating this policy for this person. So if the bank did a really bad job underwriting that house, then the insurers aredefinitely going to lose out. So it's just something that has a lot of variables and is hard to control. So just think about that before youconsider investing in private mortgage insurance.

Wathen: That'sa good point. Because these cycles are so long,someone could theoretically join amortgage insurance company out of college,become an executive, andthrough that whole timeline where theymove up thecompany, basically, theyoperate in an industry during the time whenthey experience almost no losses. So all they've been rewarded for is underwriting more and more and more insurance. Psychologically, it's something that'sreally difficult to grasp,because eventually, the losses do come -- it'sjust a matter of time. But someone could easily see 10-30 years of excess profits, and thenall of a sudden, it's just complete wipeout in one year when house values go down.

Lapera: Yeah,definitely. Do you have anything else you want to say about insurers before we wrap up?

Wathen: They'reboring, butbecause they're boring, they can make for greatinvestments. Personally,I actually like the insurance industry more than most, I guess,in the financial space. I like them more than banks, for instance. I think the risks are better. But it's not everyone's cup of tea,and I get that, too.

Lapera: Yeah,that's totally fair.I think insurance companies are reallyinteresting because I think the macro factors that areaffecting insurance companies area little bit more interesting than banks, soI think it's a more interesting thing tothink about. Not that I don't love banks. Don't worry, Maxfield will be back, and we'll talk about banks again, I'm sure.

As usual, people on the program may have interests in the stocks they talk about, and The Motley Fool may have recommendations for or against, so don't buy or sell stocks based solely on what you hear.

If you still have anyquestions about insurance, feel free to email us, and we'lltake it onto another show eventually. Contact us at,or by tweeting us @MFIndustryFocus. Listeners,I have aTwitter account.I post infrequently,I have to admit, but if you tweet me,I will eventually see it and respond to you. It's @TMFCaffeine. I don't really know how to pitchTwitter handles, soI hope that's enough for you to find it. And thank you to Austin Morgan, today'sproducer, patient, patient editor. I screwed up a couple times, andI know he's going to fix it. Thanks for making me sound good.

Austin Morgan: Always.

Lapera: Andthanks to Jordan. Thank youeveryone for joining us, andI hope everyone has a great week!

Gaby Lapera has no position in any stocks mentioned. Jordan Wathen has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares), Markel, and Twitter. The Motley Fool recommends Safety Insurance Group. The Motley Fool has a disclosure policy.