Everything You Need to Know About Insurers: The Business

Most Americans have plenty of experience with insurance in their financial lives, but few care to take a deeper look into the businesses behind their auto or life policies. With their products and services among the "necessary evils" of everyday finance, insurers offer an investment opportunity for those looking for solid businesses with an essential function in the marketplace. Over the next few days, we'll take a closer look at the insurance industry, including the business in general, its biggest players, the variety of products, and how to decide which insurer would be right for your investment portfolio.

The bare necessities
The list of basic needs for everyone on the globe is very simple: food, shelter, and clothing. But if you're a member of a developed society, you may have to add one more item to that list -- insurance. Due to some mandatory insurance requirements in the U.S., with mandates on auto coverage, and now the Affordable Care Act, the insurance market is huge. According to the National Association of Insurance Commissioners, in America alone, the top 25 insurance providers make up a $1.3 trillion market based on the premiums they collect. If you compare that to the most recent annual data on the other basic needs, you can see the importance of insurance as a basic necessity:

Source: Food Marketing Institute; Textiles Intelligence; YCharts; NAIC.

Second only to housing in the comparison above, the insurance market is most certainly a necessity for most as a way to mitigate big financial risks.

A premiums service
We all experience events in our life that will cost us huge sums of money -- whether it be a medical emergency, a totaled car, or a flooded house. In order to avoid financial distress, consumers turn to insurers to provide financial support in the face of such expensive risks. The insurers in turn ask their policyholders to pay up-front premiums for the service. By paying premiums on a regular basis, consumers transfer the financial risk to their insurer for future covered events. So, not only does this allow the consumer to better manage costs over a period of time, but it gives insurers consistent income.

Premiums are the obvious source of any insurer's revenue generation, but many people aren't aware that the money they send in to their insurance provider each month plays double duty in the company's business model.

Pools of cash
Through their underwriting process and statistical analysis, insurers know that their policyholders are not likely to all experience a loss at the same time; so by pooling the premiums (and thereby the risk), they can leverage their cash inflows to generate more income. If you've ever read a Berkshire Hathaway (BRK.B 0.91%) annual report, Warren Buffett loves discussing the "float," which is the pool of premiums of Berkshire's insurance clients. Insurers take their float and invest it in a variety of instruments to generate more income. Investment income is an integral part of any insurer's operations.

With investments playing such a huge role in their business models, investors need to be aware that insurers are sensitive to overall economic shifts, such as the low interest rate environment we've experienced for the past few years. With the change in conditions, insurers have to adjust their strategies in order to maintain their investment yields. Lately, low interest rates have put pressure on investment income, with several companies noting lower yields:

Source: Company second quarter releases.

Berkshire's yield is extremely low compared to its historical average of 5.7% over the past five years. But as the company accumulates more income during the remainder of the year, it may level out. AIG, Allstate, and others have noted that their investments now include nontraditional instruments in order to boost their yields. AIG has turned to some hedge funds, commercial mortgage-backed securities, and other investments that will provide higher returns in the current environment.

Multifaceted
One of the final things to note about the insurance industry is the focus on several core divisions of insurance products. Companies that make up the market can mix and match those divisions depending on their business strategy. Below is a simplified breakdown of some of the key divisions of the insurance business.

So, while you may get your auto coverage through Berkshire's Geico division, you may not be aware that the company operates some of the world's largest reinsurance businesses, which would be considered a specialty. Over the coming days, we'll explore each division and what they provide, as well as the key players in each market.

Down to business
Though this was a quick introduction into the insurance industry, it should help you understand how the different insurers operate and the keys to their revenue streams, which are important to keep in mind when evaluating an insurer you'd like to invest in. For the next installment, we'll dive deeper into the property and casualty operations of the country's largest insurers.