Everybody has insurance. Whether it's for your life, your car, your house, your business or countless other things, Americans across the country have insurance policies spanning a wide range of circumstances and situations.
And while there are a number of differences between the types of policies individuals can receive, investors need to know a few of the basic principals, regardless of the policy, what drives the industry, how it functions, and how it delivers returns.
What is casualty insurance?
Casualty insurance is a policy an individual or company purchases to make sure the potential losses stemming from a direct accident are covered by an insurer who the policy is with.
The state of Kentucky notes casualty insurance includes vehicle insurance, liability insurance, workers' compensation and employer's liability, burglary and theft, personal property, glass, boiler and machinery. And those were just the first seven things on its 17 possible policies which would fall into its list.
It's important to highlight that the term "property casualty" (P&C) insurance is said more generally. Unlike casualty insurance which covers accidents, property insurance covers specific events (such as theft).
Despite the carious definitions, at its core, insurance is surprisingly straightforward. A group of folks pay a specific amount, known as premiums, to their insurance companies to guaranty coverage if some sort of loss occurs. As long as the insurer appropriately prices its policies to ensure it pays out less in coverage than what it collects, it should churn a healthy profit.
How big is casualty insurance?
At last count, the total policies written in the property casualty insurance industry in the United State alone stood at nearly $500 billion, and the ten biggest firms held nearly half of the market.
In addition, to truly put the broader insurance industry into perspective, the 75 largest publically traded insurance companies had total assets worth more than $6 trillion. Although that list included those which offer beyond just property casualty insurance, it shows what a massive market the insurance industry is.
How does casualty insurance work?
As mentioned earlier, insurers hope to collect more in premiums they receive from their customers than what they ultimately pay out. For example, let's say Firm ABC has 100 clients who pay $101 for $10,000 worth of insurance. If after one year, just one individual files a claim and gets $10,000 back, the firm will actually collect an underwriting profit of $100.
One way to measure this is known as the loss ratio. In the example above, the firm would have paid out $10,000 in losses, but collected $10,100, which would give them a loss ratio of 99%. Or said differently, they were only able to keep 1% of the money they brought in. This is known as an underwriting gain.
But as Warren Buffett noted in his 2013 letter to shareholders, far too often, underwriting gains aren't easy to find:
Unfortunately, the wish of all insurers to achieve this happy result [of an underwriting profit] creates intense competition, so vigorous in most years that it causes the P/C industry as a whole to operate at a significant underwriting loss. This loss, in effect, is what the industry pays to hold its float. For example, State Farm, by far the country's largest insurer and a well-managed company besides, incurred an underwriting loss in nine of the twelve years ending in 2012.
But there is a more to an insurer than simply hoping to not pay out more than what it receives from the policies it has written. The rest of the story comes from what Warren Buffett affectionately calls "the float."
This is the difference between what the insurer collects upfront and ultimately what it has to pay out later. And depending on the type of policy written, that "later" may be decades down the road. Insurers invest this float.
Using the same example above, let's say Firm ABC didn't park that $10,000 money into a bank account and let it sit there until it had to pay it out. Instead let's say the insurer was able to generate a return of 5%, or $500, through its own investing.
Theoretically, Firm ABC could be started without a single dollar, and provided the policies are priced right, and it makes sound investments, you can see how wildly profitable insurance can be.
What are the drivers of casualty insurance?
Like nearly every other industry, insurance ebbs and flows, in periods when pricing is either "hard" or "soft."
A soft market is one in which insurers have ample amounts of cash on hand -- likely resulting from no major disasters -- and as a result, they become more willing to take on riskier policies. This often means competition in the industry heats up as insurers seek to find new business and policies to write. As a result, profits begin to fall.
But then at some point, the cycle will flip, and it will move from being a soft market to hard market. In the hard markets, insurers tighten the standards for underwriting, and the supply of available insurance goes down. As a result, both the prices consumers pay, and the profits insurers draw in, rise.
Of course, when profits rise, competition heats up as more insurers seek to find new policies to write, and the cycle starts all over again. Just as it has for the last 40 years:
It's hard to quantitatively gauge the condition of the market and whether or not it is hard or soft, but it is critical to listen to management of the companies as most will explicitly talk about the pricing environment they are experiencing.
In addition, as mentioned earlier, insurance is beyond just writing policies. Using their float, most firms will actively invest in government or other types of bonds, while others will buy stock in companies, or simply buy companies outright and add them to their business.
As a result, broader market conditions can be a key driver of an insurers profit. With low interest rates, insurers struggle to generate the returns they seek. But if those rates rise too quickly, then the vast array of bonds they hold will see their value plummet .
This is why a 2012 study by Towers Watson revealed nearly half of the life insurance industry CFOs polled felt a low interest rate environment was the greatest risk to their business:
The bottom line on casualty insurance
In theory, insurance is one of the most attractive industries you can think of. As Buffett said 2013:
If our premiums exceed the total of our expenses and eventual losses, we register an underwriting profit that adds to the investment income our float produces. When such a profit is earned, we enjoy the use of free money – and, better yet, get paid for holding it.
Yet far too often that isn't the rule, but the exception. As a result, before buying shares of an insurer, careful analysis on a wide range of topics -- including some of those mentioned above -- needs to be done before any decision is made.
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Patrick Morris owns shares of Berkshire Hathaway. The Motley Fool recommends Berkshire Hathaway. The Motley Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.