If thinking of the phrases "car insurance", "health insurance", or "life insurance" cause insuppressible yawning, you're not alone. These are necessary components of modern life, but necessary doesn't mean exciting. Actuarial tables and mortgage amortization tables have the cocktail party conversation zing of pocket lint. When something catastrophic happens you'll be glad you had a current policy and paid your premiums, but most of the time you never think about your plans.
That kind of boring stability can be very good for investors.
Insurance Companies are Boring
How does insurance work? By spreading the risk of catastrophic events over a large population. If one in every thousand homes will suffer a fire this year and one in every hundred fires causes a million dollars of damage, selling millions of policies for a few dollars will cover the cost of fire damage for everyone. The more expensive the catastrophe, either the more money each subscriber has to pay or the more subscribers there have to be.
Insurance companies are big. To handle millions and billions of dollars of payouts every year, they have to have millions of customers, each paying tens to hundreds or thousands of dollars every year. That's a lot of money for them to handle. This is an important point to remember.
Big Insurance Payouts are Rare
A natural disaster like Hurricane Katrina, the Deepwater Horizon oil spill, or Superstorm Sandy is tragic. It does billions of dollars in damage and has irreparable consequences to the lives affected—but it's infrequent. For all of the people paying into an insurance pool, a claim of that magnitude almost never happens.
The premiums you personally pay, over time and on average, will cover the benefits the company expects you to claim. If you are unfortunate enough to suffer a catastrophe, you may come out ahead (cold comfort to the suffering you go through—and you certainly have our best wishes and sympathies).
If a big insurance company has many, many customers and if the frequency of catastrophic events is low and if the average customer payout is a break even event for the customer at best, what does that mean? An insurance company may only pay out a fraction of what it takes in in any given year. It has a lot of money and it doesn't pay it out very often. That's very important to remember too.
Insurance Companies Hate Risk
Auto insurance rates take into account demographic information (younger drivers may be riskier than older, red cars have more moving violations than other colors, a boring station wagon is safer than a zippy mid-life crisis convertible). Home insurance rates consider earthquake, flood, and tornado zones. Health insurance rates factor in personal risks such as smoking or drug use. All of these risk factors are part of actuarial and underwriting calculations. Insurance companies use this information to answer two specific questions. How much money will you get paid out over the span of your coverage? How much money do people in your insurance cohort need to pay in to cover those costs?
Those questions take a lot of time and statistics to calculate for a simple reason: insurance companies hate risk. Miscalculating the likelihood of catastrophic payouts could end up costing the company billions.
In any single year, payouts might exceed revenue, but catastrophes are unpredictable by nature. Instead you can predict that over time things will balance out. Maybe that's a ten year window or a five year window or a fifty year window, but with armies of statisticians and number crunchers working on your models, you can figure out how much money you need to have in reserve to account for that one year when your company has to pay out billions of dollars in claims.
Insurance companies must be rich to make this work.
How much money does an insurance company have in reserve? Billions. Where does it keep that money? Investments. Conservative, conservative investments. They won't make 10% or 20% a year; probably 2% a year in a very safe investment—but 2% of hundreds of billions of dollars is hundreds of billions of dollars.
The rate of return is low, but the amount in dollars is high.
Are Insurance Companies Good Investments?
An insurance company isn't as exciting as the new social media dot-com that's just gone IPO and made a whole bunch of Silicon Valley nerds rich on paper (at least until the company craters in two years), but that's good for the individual investor. Less volatility in the stock and less attention from traders mean that there are more opportunities for value investors. No one wants to admit that he or she made a bundle of money in the stock market on a waste treatment center, a chain of long term care adult homes, or an auto insurance company. There's always a hot biotech startup instead.
That leaves these businesses as a possible investment opportunity for the rest of us: life insurance stocks, investment insurance companies, car insurance stocks, you name it.
Insurance companies plan for the future. They simply must be around in ten or fifty or a hundred years. That's stability. Their big books of invested money make them relatively easy to evaluate, financially speaking. If they pull an AIG and dump money into exotic financial instruments, that's easy to measure too. Capitalization—how much money they have in reserve—is the important thing here.
Boring? No—stable. Conservative? Yes—not wasting investor money. Are you looking for insurance companies to invest in? Maybe you never thought of it before. If you can find a good value, maybe you should.
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