How the Insurance Industry Makes Money

By Motley Fool Staff Markets Fool.com

All insurance companies make money by capitalizing on the time delay between when premiums are received and losses are paid out. But the very best companies can generate a profit by collecting more in premiums than they pay out in losses, creating what's known as an underwriting profit.

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Underwriting profits are the hallmark of excellent insurance operations. Safety Insurance Group (NASDAQ: SAFT) is an excellent example of a company that has, for many years, generated underwriting profits by pricing its policies high enough to reflect the risk of loss.

In this segment of Industry Focus: Financials, join host Gaby Lapera and contributor Jordan Wathen as they discuss how insurance companies make money for their shareholders.

A full transcript follows the video.

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This video was recorded on May 22, 2017.

Gaby Lapera: Here are a couple things that you need to know about before you start trying to invest in an insurance company.Thefirst thing is the combined ratio.

Jordan 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 Groupis 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.

Gaby Lapera has no position in any stocks mentioned. Jordan Wathen has no position in any stocks mentioned. The Motley Fool recommends Safety Insurance Group. The Motley Fool has a disclosure policy.