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Rupert Hargreaves
Rupert Hargreaves
Articles (257)  | Author's Website |

Why Insurance Is the Key to Buffett’s Success

Guru has been able to succeed by using the strange nature of the insurance business

May 18, 2017

Warren Buffett (TradesPortfolio)’s greatest secret is insurance. This industry, which is used by everyone but understood by only a few, is hugely profitable for many different reasons, and it’s incredibly easy to make money from insurance if you know what you are talking about.

Inefficient business

Insurance is a relatively inefficient business. Although the industry is changing rapidly, the market still revolves around human judgment of risks, specifically in the more implied areas of the market.

Insurance companies are looking to make as much money as possible but at the same time cannot undercut competitors too much for fear of underestimating the potential payout if the thing they are insuring against actually happens. If the insurance company has done its job correctly, the value of money paid out in insurance claims will be lower than the premiums received every year.

The inefficiency comes from the pricing of risk. As it’s impossible to tell when disasters such as hurricanes and air crashes will happen, companies have to demand a premium income that adequately compensates them for taking on this risk every year.

Some years disasters won’t happen; other years lots of accidents will happen but if the company has done its job correctly, profits in the good years will more than make up for the losses in bad ones. Holding gains back one year in anticipation of another bad year is not a unique trait of the insurance industry, but the desire to achieve a steady return on these assets to boost overall income is. This retained profit is what Buffett calls a float, and the ability for him to use this cash reserve has been instrumental in accelerating investment returns over the years. The structure is also extremely tax efficient.

Cyclical business

The insurance industry tends to operate, like most industries, in cycles. A string of good years is usually followed by a series of bad years, giving insurers time to save up a healthy reserve and put in place reinsurance policies to ensure losses in the bad years are not catastrophic. In the good years, a return on capital of 10% to 20% is not uncommon as investment gains add on top of premium income. There are very few other industries that can compound at such an alarming speed.

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But such returns are only possible if an insurance company has one of two things: 1) scale and 2) specialism.

Two ways to succeed

Mass-market insurance policies such as auto and home insurance require scale. Economies of scale lower costs and as it’s impossible to accurately price each risk (millions of inquiries every week) there are bound to be some unwanted losses (this is changing as technology helps insurers better understand their customers, but the same principle remains; technology is only likely to reduce premium income across the industry giving the largest operators even more of a windfall).

On the other hand, specialist policies such as insuring the Empire State Building against the risk of a nuclear strike or insuring against the loss of a satellite on the launch pad don’t need to scale but require a specialist operator. The event being insured against may not happen for a decade (during which time the company can compound potentially 20% per annum), but when it does the company needs to be sure that the specialist underwriting has been accurate enough (or inefficient enough) to guarantee there are enough profits in the bank to meet any liabilities. You can usually spot bad insurers or the ones that operate in mass-market industries without scale and failed to specialize because they have years of underwriting losses.

The bottom line

Overall, insurance is the secret to Buffett’s success over the years, and if you do your research, you too can make a lot of money from this industry. The good thing is, due to the lack of understanding about insurance companies, they tend to be undervalued in the public markets, trading at a discount to book or low earning multiple. All that’s required is some information arbitrage to profit.

Disclosure: The author owns no share mentioned.

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About the author:

Rupert Hargreaves
Rupert is a committed value investor and regularly writes and invests following the principles set out by Benjamin Graham. Prior to his investing and writing career, Rupert was as a proprietary currency trader. Rupert holds qualifications from the Chartered Institute for Securities & Investment and the CFA Society of the UK. He covers everything value investing for ValueWalk and other sites on a freelance basis.

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