3 Metrics You Can Use to Assess Insurance Companies

It is no secret that Warren Buffett loves investing in insurance businesses.

Throughout his career, he has been accumulating shares of insurance companies and holding on to them for substantial periods of time. Even his investment holding company has three main insurance businesses propelling it.

So why does Buffett love insurance businesses? Unlike popular belief, insurance companies’ main aim is not to earn an underwriting profit from premiums collected. In fact, many insurance companies report losses in this segment of their business, as they pay out more in claims than the premiums they collect.

The real aim of the business is to make use of the money they collect from premiums to invest. This occurs, as there is usually an amount of time before the money collected in premiums is required to pay out claims. Called “float”, this money can hence be put to good use as investments. Buffett, being the brilliant money manager he is, is able to make use of this liquidity to great use, building an empire in the process.

Insurance companies can hence be great investments. In light of this, I have listed three important metrics to take note of before investing in an insurance company.

Combined Ratio

The combined ratio measures the profitability of an insurance company’s main business of collecting premiums. It is calculated as follows:

Combined ratio= (Incurred losses+Expenses)/Premiums Earned

A ratio above one means that the insurance company is incurring losses in its insurance segment of its business, while a figure under one will signal that the company is profitable.

Although I mentioned earlier that many insurance businesses incur losses in this regard, an insurer who can constantly turn a profit might signal stronger business fundamentals. It also means that the insurance company is conservative in growing its business and is less likely to fall into unnecessary liquidity issues in the future.

Acid Test Ratio or Quick Ratio

Every company that we invest in should have enough liquidity to ensure that they are capable of paying off short-term liabilities. This is even more important for an insurance company where an unforeseen circumstance could cause a huge influx in claims. This can happen because of a natural disaster or an infection epidemic. Because of this, the acid test ratio is an important metric to take note of.

We can calculate it as follows:

Acid Test Ratio = (Cash + Accounts receivable + Short term investments)/Current liabilities

A result of more than one means that the company has sufficient short-term liquidity to pay off its near term debt. For insurance companies, it is important that there is some margin of safety in this respect in case of an exigency.

Lapse Ratio

Insurers pay agents a substantial commission for bringing in new business. Therefore, it is especially important for existing clients to renew their insurance plans with the insurer. These renewals generate a larger profit as commission expense is lower in these scenarios.

Lapse ratio measures the insurer’s ability to hold on to existing clients. It is calculated as follows:

Lapse Ratio= number of policies not renewed/total number of policies

A lower lapse ratio indicates that the insurance company has greater loyalty amongst its customers and hence, may have higher profitability going forward.

The Foolish Bottom Line

Insurance companies have been investment gold for Warren Buffett as he has made use of their great cash flows to generate outstanding returns.

For investors who are looking at insurance companies as an investment, these three key metrics should provide you with the first few steps in assessing the company.

Meanwhile, for more (free!) investing insights, sign up here for your FREE subscription to The Motley Fool's investing newsletter, Take Stock Singapore. It will teach you how you can grow your wealth in the years ahead.

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Jeremy Chia doesn't own shares in any companies mentioned.