It is no secret Warren Buffett is a big fan of insurance companies. Warren Buffet made his first serious investment in insurance businesses slightly over 52 years ago, when Berkshire Hathaway acquired National Indemnity Company and another smaller insurer for US$8.6 million.
Buffett attributes much of Berkshire’s success to the acquisition of National Indemnity, telling shareholders in 2004 that if Berkshire had not acquired the insurance business, “Berkshire would be lucky to be worth half of what it is today.”
Toady, insurance still forms the heart of Berkshire. With that in mind, here are three reasons insurance companies can make good investments.
Stable underwriting profit
Insurance companies take in money as insurance premiums. In return, insurers are obligated to pay out claims.
Insurance companies that manage their risk well can earn an underwriting profit when the insurance premiums collected add up to more than what is paid out for claims.
The combined ratio is a commonly used metric to assess whether an insurance company is making underwriting losses or profit. The ratio is calculated by dividing claims and expenses by premiums collected.
For instance, Singapore-listed Great Eastern Holdings Limited (SGX: G07) and United Overseas Insurance Limited (SGX: U13) have consistently made underwriting profits over the past few years.
Predictable and recurring premiums
As most of us with insurance plans know, premiums usually have certain clauses that make it highly unprofitable to cancel before a fixed date.
For instance, cancelling a health insurance plan and restarting it on a later date can also be very costly, as there may be a surrender fee. You may also lose out on other benefits.
As such, when we buy a plan, we tend to continue paying these premiums for years, if not decades. Because of this, insurance companies usually have a stable and recurring revenue stream.
Perhaps the crucial reason insurance companies can be so profitable is that the insurer collects a lot of cash that is not needed until claims are made. Based on actuary studies, the cash collected may, in fact, not be used for decades — this is called the “float.”
As such, insurance companies can invest the float and keep all of the profit they make on these investments. This is why insurance companies can have an average return on equity of around 11%.
Insurance companies also tend to have low dividend payout ratios, and they can reinvest the profits back into the company to generate higher income each year.
The Foolish bottom line
Investing in insurance companies can be highly profitable and a good option for income investors who seek regular dividend payments. One great example is the Singapore-listed Prudential PLC (SGX: K6S), which has managed to increase its dividend consistently in the past. Between 2013 to 2018, Prudential’s annual dividend per share rose 47% from 33.57 Great British Pounds to 49.35 Great British Pounds.
Moreover, if you have a good amount of capital allocated in the business, insurance companies, with their large floats, can easily generate 20%-plus returns on equity. When you think about that and with Buffett widely-regarded as the best capital-allocators of all time, it is no wonder Buffett loves insurance businesses.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. The Motley Fool Singapore has recommended shares of United Overseas Insurance Limited. Motley Fool Singapore contributor Jeremy Chia does not own shares of any companies mentioned.