Warren Buffett (Trades, Portfolio) is one of the most well-known people in the insurance business. Via Berkshire Hathaway Inc. (BRK.A, Financial) (BRK.B, Financial), Buffett reinsures billions worth of policies across various sectors. While Berkshire Hathaway is not a pure-play insurance company, in a note to investors in March this year, Buffett revealed the insurance business is its most important asset.
This statement reaffirmed Buffett is a huge fan of the insurance business. The reasons as to why he likes insurance, however, may be misconceived by many.
Many believe insurance companies make money by netting returns from premiums received versus claims paid. This, in addition to the rigorous due diligence investigations insurers conduct before settling a claim, has made most people not trust insurance companies.
But what are the current challenges facing insurance companies?
-Berkshire Hathaway reported an underwriting profit of $2.1 billion in 2016.
Research has shown most insurance companies tend to pay more in claims than they receive in premiums. This results in an underwriting deficit, especially in the non-life insurance industry.
A report by India Times says only one in 22 non-life insurers in the country report underwriting profits. This can easily be applied to the rest of the world.
There are also new developments in the insurance industry that are making it a lot more difficult for insurers to make money from the business.
For instance, in today’s insurance market, I do not have to wait indefinitely for my life policy to mature to receive cash payments. As reported by a policy settlements agency, I can easily sell my life insurance policy for a cash settlement before it matures.
Some of the main reasons people sell their insurance policies include:
- If the cost of the policy outweighs the benefits- at times, the policyholder might choose to sell their policy when the premium payments are too much to bear every year. They can then invest the money in a more profitable market, like the stock market.
- If there is no purpose to hold the policy anymore. For instance, if the beneficiary no longer needs the policy, then the policyholder might choose to sell it to invest the money elsewhere.
- The third reason is you need to change the policy and replace it with another one that is more aligned with your immediate needs.
In relation to this practice, research has found it is in the insurance company’s interest to delay claims for as long as possible. Others have also claimed insurance companies tend to pay claims represented by lawyers and prefer to do this outside of the court system.
When individuals sell their policies, then it is likely that when the time to claim comes, the company that bought the policy will be paid more promptly compared to the individual. The simple reason being the entity claiming compensation will be a corporation that has the financial power to get the best lawyers.
The insured are also becoming very cunning, finding ways to claim the insured amount through self-inflicted injuries or intentional accidents. Some of these cases end up in the courtroom, which can be very costly for the insurer.
So, in general, it is becoming tougher to make money from premiums received.
So how do you make money in the insurance business?
Insurers have focused their efforts toward reinvesting the money received as premiums and the resulting float is what makes the insurance industry a cash cow for investors like Buffett.
To put things into perspective, The Motley Fool reported Berkshire Hathaway’s insurance float grew from about $39 billion in 1970 to more than $91 billion last year.
The company has also been one of the few players to report an underwriting profit for each of the past 14 years, while its competitors struggle with insurance claims that exceed premiums received periodically.
Conclusion
While insurance companies try their best to make money from net underwritings, their most powerful revenue generator is the float from reinvested premiums.
Since premiums are, in most cases, predictable and are paid continuously for several years, it becomes very easy when coming up with reinvestment strategies.
Disclosure: I have no positions in the stocks mentioned in this article.
