Here are the basic concepts behind how insurance companies make their money.
At its core, the insurance business is quite simple. In this clip from Industry Focus: Financials, host Michael Douglass and financials specialist Matt Frankel break down the two primary ways insurers make their money.
A full transcript follows the video.
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This video was recorded on June 18, 2018.
Michael Douglass: Insurance at its core is a pretty simple business. Personally, I think I’m a pretty good driver. I don’t get in car accidents very often. When they do happen, I don’t want to be on the hook for that expensive paint job and for fixing up my bumper. Insurers take the opposite end of that equation, taking on the risk in exchange for premiums that folks like you and me pay them. Insurers make money one of two ways: underwriting profits and investing income. Let’s talk about that a little bit, Matt.
Matt Frankel: Sure. First of all, I want to piggyback on what Michael said and thank the listener for suggesting White Mountains. It’s a stock I used to follow, up until about ten years ago, because it used to be in Warren Buffett’s portfolio, which we’ll probably mention a little bit later, too.
Douglass: Probably five or ten times. [laughs]
Frankel: [laughs] Probably five or ten times, especially when we start talking about Berkshire. But, this is kind of what you were talking about. It gives us a great opportunity to talk about a stock that might have fallen off of our radar, or we just otherwise wouldn’t have gotten a deep dive into, so, thank you!
Going back to how insurance companies make money, there are two main revenue streams. First is collecting premiums and making what’s called an underwriting profit. That is that the amount of money that’s coming in as premiums is greater than the amount of money being paid out for claims. Responsible insurers or well-run insurers, you want to look for a positive underwriting profit consistently. It’s not going to happen all the time, especially if there’s a major natural disaster that happens during a quarter, you might see a negative underwriting profit. But generally, that’s what you want to look for.
The other is investment income. This is really how insurers, especially the ones that we love, make a lot of their money. The beauty of the insurance business is that you’re getting billions of dollars paid in premiums, and there’s a time period between when those premiums come in and when you have to pay out claims to policyholders. Insurance companies can invest that money in the meantime while they’re waiting to pay out claims, and essentially keep all the profits they make on the investments. So, underwriting profits is one area, and investment profit is the other one. And insurance companies have very different ways that they make investment profits, which we’re about to get into.
Douglass: Yeah, there’s a lot to unpack there. But, generally speaking, think of it as these two buckets. The real big question with insurers, and one of the things that really makes Markel and Berkshire different from a lot of other insurers, is what they then do with, hopefully, an underwriting profit, but at least with the float, that is, the premiums that have been paid that they haven’t yet had to pay out for losses or damage, whatever happens, that they’re then able to invest. That’s one of the key things in insurance. You’ve got to have a good capital allocator that invests exceptionally well if you’re going to really do well as a company.
Matthew Frankel owns shares of Berkshire Hathaway (B shares) and Markel. Michael Douglass owns shares of Berkshire Hathaway (B shares). The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares) and Markel. The Motley Fool has a disclosure policy.