Warning: Extremely long and boring post. Seeks to explain how insurance firm makes money and explore if we can profit from owning such firms.
I’m interested in how insurance firm in general makes money. I’d like to put down what I think I know in words such that I’m able to review my train of thoughts later on.
So how do insurance companies make their profit?
Traditional insurance companies essentially have 2 sources of income;
1. Underwriting profit / loss
2. Investment profit / loss
Underwriting profit is generated if the company manage to sell insurance product that pays out LESS than what it gets. Imagine, people pay their premium to get insured, of all the people that bought the insurance, only a small percentage would eventually claim for it.
Example
- 1,000 motorcyclists buy insurance, paying a total amount of premium of $1,000,000.
- 5% of motorcyclists eventually claim for injury/death/vehicle damages, etc, which amount to -- $600,000 in total (average of 12k per claim).
- Administrative expense for the firm is 150k
> Underwriting profit is thus 250 k, (1mil- 600k – 150k)
In insurance terms, this company has a “combined ratio” of 75%, which means that for every $100 premium, it roughly generates $25 underwriting profit.
Now, we know that there’s a time lag between the time where premiums is received and final claim is made. So the insurance firm can invest the money and make return on this money that is technically ‘not his’.
Example (continued from above)
- Premium of $1,000,000 is received on 1st Jan
- Claims will only be paid on 31st Dec.
- Company buys a 1 year risk free govt bond which gives a return of 5%, ie $50k.
-Therefore investment profit is $50k
> Total profit for the year would be 250k + 50k, presto! Money materialise out of thin air with little capital injected.
Here comes the tough part, few insurance firm generate high underwriting profit. In a bid to win market share, most companies will sacrifice profitability for growth. Furthermore, there are also some risks that are not known for many years. Warren Buffett commented that Berkshire Hathaway under charged for its terrorism related insurance contract pre-911. Few people perceived the risk of terrorism to be so high before that day.
Furthermore, if previously uncorrelated risk occurs together, the insurance firm may not have the capital to pay up when insured parties file claims. Imagine from our example, 10% (instead of 5%) of motorcyclist got into accident in that year. Then the total claim would be $1.2 million. Wiping out the premium earned for that year and investment return.
With all these risks in mind, there are some stellar insurance firms around. Of course there’s Buffett’s Berkshire Hathaway, US car insurer Progressive Corp, and P&C insurer Markel Corp. All three generates healthy combined ratio, and Berkshire and Markel in particular generate super healthy return on its investment portfolio.
I love Progressive because it is one of the most rational auto-policy underwriter in the US. It adopts a very low cost model, and is a super lean corporation. It wrote less insurance contract last year and returned money to shareholder as the competitors undercut each other to gain market share. It takes guts to NOT do silly things when everyone else goes crazy. When prices get better, Progressive will be once again be well capitalised and prepared to capture profitable growth.
Value Traps???
In the market turmoil over the last year, a few companies have fallen hard. Two of the insurers that is interesting are AIG and MBIA. AIG has fallen on hard times as its investment in many assets that are related to derivatives instruments and sub prime suffer huge write down. However it is still generating huge underwriting profits with a healthy combined ratio of 96.8. It is one of the largest insurer in US and Asia. There are few insurer in Asia with the depth and breath of knowledge that can match AIG. It is selling at a very low P/B of 1.12. Lowest in nearly a decade. Is it a great value stock? Or are there hidden dangers that we know not.
MBIA is a more extreme example. It has ‘lost’ billions of dollars on insurance contract that insures CDOs and other RMBS (residential mortgage backed securities). Much of the suffering it is going through now is purely its own doing.
Historically its combined ratio is around 60% to 75%, obscenely profitable. Being overconfident with its financial models, they began to underwrite insurance on assets which are new and shiny - different type of securitised contracts. They got caught with their pants down over the past year as different securities defaults and or missed their interest payment. Buffett once said that, “Only when the tide goes out do you discover who's been swimming naked”. However this time round you get to see not only MBIA swimming naked, but also frolicking with the likes of rating agencies, banks and even government agencies.
Oh ya, why am I interested in this very badly behaved creature? Cuz its so cheap. Its selling at a P/B of 0.2. Assuming that (i) it survives this storm for the next 3 years without raising additional capital, (ii)even if it does not make a single cent, (iii) not lose too much money, and (iv) the market realize that it’s not going to go bust, then it should sell around a P/B of at least 1.
Worse case: company goes bust, and there goes my investment. Normal case, company survives and capital market returns to normal within 3 years, and stocks sells at book. Assume a 50/50 chance, then E(X) = (500%)(0.5) + (0)(0.5) = 250% of return for the 0.2 cents I put in. 35% annulized. Not bad. However, with my current knowledge, it is as good as gambling (with I think slightly better odds than Toto or 4D). If I figure this out, I may just put some money in for this experiment. AND I fully admit that this is SPECULATION, not Investing as safety of principle cannot be ascertained.
Furthermore, I don’t fully understand the impact of fair value accounting on the books of AIG and MBIA due to my limited accounting knowledge. Some of the losses booked by both companies has not incurred, and is unlikely to occur. But I dun understand the gibberish in their 10k and 10Q notes to accounts!
Ahhh!!! Gotta expand my tools on hand fast.
Disclosure: I own stocks of Markel and Progressive.
Added some links at the side that i think is rather useful. Do tag/email me if you've got any suggestions to other great sites!
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