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# Understanding Insurers: An In-Depth Look at the Insurance Industry

On April 4th, 2016, Gaby Lapera and Jordan Wathen hosted a comprehensive episode of *Industry Focus*, dedicated to unraveling the complexities of insurance companies. The discussion wandered from basic concepts to fascinating trivia, offering valuable insights for investors and curious listeners alike.

## The Basics: What Do Insurance Companies Do?

At its core, an insurance company's primary function is to pool risk. Wathen explained insurance firms as akin to a collective savings account where the deposited funds—premiums—are set aside to cover potential claims. Essentially, people pay premiums in exchange for protection against unforeseen calamities, whether it’s an accident, health crisis, or death.

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Lapera highlighted the variety of insurance types: life, health, auto, and beyond. She also drew attention to niche players like reinsurers, which insure other insurance companies. Reinsurers help spread risk, especially for large-scale disasters like hurricanes, preventing any single insurer from suffering catastrophic losses.

Additionally, some specialty insurers, such as Markel, insure a broad and sometimes surprising range of risks—from birthday parties to blacksmith shops to recreational vehicles. This diversification can be advantageous, but it also introduces unique challenges in managing risk and profitability.

## How Do Insurance Companies Make Money?

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Most people assume that insurance firms profit by underwriting—that is, collecting more in premiums than they pay out in claims. Wathen corrects this common misconception, noting that **most insurers aim to break even or even pay out more in claims than they receive in premiums**.

The real profit driver, as Wathen points out, is **investing the premiums**—a practice often referred to as earning the "float." This fund, accumulated from premiums before claims are paid, is invested in assets like bonds, stocks, or other securities to generate returns. Warren Buffett famously described this as "float" and emphasized its importance in building long-term value.

When evaluating an insurance company's financial health, investors analyze key metrics including:

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- **Loss Ratio**: The percentage of premiums paid out as claims. A lower loss ratio indicates better underwriting performance.

- **Expense Ratio**: The portion of premiums spent on operational expenses like advertising and claims adjustment.

- **Combined Ratio**: The sum of the loss and expense ratios, expressed as a percentage of premiums. A ratio below 100% signifies profitability from underwriting; above 100% indicates deficit.

Optimally, insurance firms seek to maintain a **low combined ratio**, ensuring they earn enough premiums to cover claims and expenses while leaving room for profit and investment income.

## The Art of Risk Management

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Pricing risk accurately is paramount in insurance. Wathen emphasized that the key to a successful insurer is **correct risk assessment and underwriting**. Adverse selection—where an insurer inadvertently attracts riskier clients—can erode profitability.

He highlighted the importance of **actuarial tables**, which help insurers gauge individual risk based on factors like age, health, or driving habits. Companies that excel at underwriting tend to have superior combined ratios, translating into higher profitability.

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Investment strategies also play a critical role, with most insurers favoring **low-risk, fixed-income assets** like government bonds or highly rated corporate bonds. An interesting anecdote was shared about small insurers that invested heavily in gold, which could be risky—particularly if gold prices decline simultaneously with catastrophic events.

## Risks Faced by Insurance Companies

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Insurance companies face a variety of risks beyond poor underwriting. For example, Wathen discussed how low oil prices have led to increased driving and, consequently, more auto accidents, raising claims costs for auto insurers like Geico. Similarly, natural disasters, such as hurricanes or snowstorms, can cause massive, unpredictable losses. When catastrophic events occur, some reinsurers have even gone out of business because they couldn't handle the claims load.

Weather-related risks are especially difficult to forecast. For instance, heavy snowfall in Boston or earthquake-prone regions can result in unexpected losses, testing the resilience and risk management strategies of insurers.

## Specialization vs. Diversification

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A strategic decision for insurance companies is whether to focus on a niche or diversify across multiple lines of insurance. Wathen observed that specialization allows insurers like Safety Insurance to excel in specific markets but exposes them to geographic risks, such as harsh winters in New England.

Conversely, diversified insurers can mitigate individual risks but may face management challenges, such as aligning incentives across different lines. Wathen favors standalone insurers, assuming that specialization and focused expertise lead to better underwriting and financial performance.

## Investing in Insurance Stocks

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For investors, a key question is whether to buy stocks in standalone insurance companies or larger financial conglomerates like AIG, which operate diverse financial services. Wathen prefers pure insurance firms because they isolate insurance risks, making their performance more transparent.

He also referenced activist investor Carl Icahn’s push for AIG to split its units, which could unlock value by allowing each division to operate more efficiently and avoid systemic risks. He cautioned that management quality is vital, noting that recent struggles of giant insurers like AIG partly stem from leadership without deep industry experience.

## Risks and Fun Facts

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Beyond traditional risks, Wathen shared intriguing trivia: during the golden age of air travel, insurers profited immensely from selling life insurance to travelers, despite considering flying dangerous. Interestingly, research suggests that clergy members, despite their peaceful image, tend to have higher insurance risks than expected—possibly because they feel protected by faith or simply live fewer risky lifestyles.

The discussion also touched on the safety of carnival rides versus amusement park rides. Surprisingly, amusement park rides are statistically riskier because they are disassembled and reassembled regularly, increasing maintenance risks.

## Final Thoughts and Recommendations

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Wathen expressed confidence in longstanding insurers like Berkshire Hathaway’s Geico, which, despite recent setbacks, remains a strong investment due to its valuation and consistent performance.

Lapera expressed fascination with specialty insurer Markel, noting its unique approach to insuring unconventional risks.

**In conclusion**, investing in insurance companies requires understanding both their underwriting discipline and investment strategies. A well-managed insurer balances accurate risk pricing, prudent asset allocation, and operational excellence to create sustained value.

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If you're considering investing in insurance stocks, remember to analyze metrics like the combined ratio, review management credibility, and assess the firm's risk appetite. As always, diligent research and understanding of industry nuances are key to making informed decisions.

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*For questions or comments, contact us at [industryfocus@fool.com](mailto:industryfocus@fool.com) or follow us on Twitter @MFIndustryFocus. Stay insured and stay informed!**