It's Insurance Day on Industry Focus: Financials. In today's episode, Motley Fool analyst Gaby Lapera and contributor Jordan Wathen explain the most important things that investors need to know about how insurance companies operate. Then they answer listener questions about all things insurance.

Find out how insurance companies make money, how they diversify risk, what reinsurers are and how they work, why there are so many different insurance companies, the most important numbers for investors to check before buying in and how to make sense of them, how mortgage insurance companies are different from other types of insurers, and a few things that investors should understand about the industry before buying in... and more.

A full transcript follows the video.

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This video was recorded on May 22, 2017.

Gaby Lapera: Hello, everyone! Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. You are listening to the Financials edition, taped today on Monday, May 22nd, 2017. My name is Gaby Lapera, and joining me on Skype is Jordan Wathen, beloved Motley Fool contributor and expert in financial companies. How's it going, Jordan?

Jordan Wathen: It's going alright. How are you, Gaby?

Lapera: Pretty good, are you happy to be a beloved contributor?

Wathen: I'm very happy to be a beloved contributor. I think that's better than my last introduction, which was something about being exotic, so I'll take it.

Lapera: Yeah, that's OK. I think exotic can be good, too, in certain contexts. Anyway, listeners, just in case you don't remember, this week is Insurance Day on Industry Focus: Financials. So the front half of the show is going to be basics about insurance companies, what they are, how they make money, some stuff you need to look out for when you're thinking about investing. The last half of the show is going to be listener-submitted questions that we're going to answer. If you ever want your question answered on Industry Focus, just send us an email at [email protected]. Let's dive right into it, because this is going to be an action-packed show. Let's start with a super easy question, which is, what is an insurance company?

Wathen: The basics of an insurance company is that it exists to spread risks around them among a bunch of different customers. One of the best explanations I ever heard was that you can think of insurance companies like banks where they take deposits, or your premiums, and allow you to withdraw money only when you experience a large financial loss. I think homeowners insurance is probably the type of insurance that's easiest to explain. A home is the most expensive thing that most people will ever own. So most homeowners buy homeowners insurance to protect them from the financial risks if their home is destroyed by fire, or wind, or some other kind of disaster. A policy like that costs, maybe, 1% or 2% of the home's value each year in premiums.

Lapera: Yeah, it makes sense. The idea is, you have all these people who are not having a disaster at any given time helping to pay for the one or two people who are having a disaster, and then you just scale this up to a massive scale, and you have an insurance company.

Wathen: That's a good point, because most homeowners insurance companies, ideally, they would have risks in higher-risk states like, say, Florida, and balance it out with homeowners who own a home in Texas. So when a hurricane strikes Florida -- God forbid that ever happens again, but you know it's going to -- they will have the money coming in from Texas, and hopefully there's no natural disaster there, so they'll have profits in one state to pay for the losses in another.

Lapera: Yeah. This model carries over pretty much regardless of what you're talking about. Car insurance, health insurance -- those are the two that I think people are probably most familiar with. So insurance companies make money two different ways. One is the way that you would expect, which is that they write all these policies and people pay them premiums, but ideally, not everyone needs to claim something from the insurance company every year, so the company keeps the difference between the premiums paid in and the losses paid out. That's the first way they make money. The second way they make money is actually really interesting. Jordan, do you want to take this one?

Wathen: The second way they make money is, when you pay your premiums, there's usually a time difference between when premiums are taken in and losses are paid out. So in between that time, insurers sit on billions of dollars, probably trillions globally, where they can invest that money and keep the return they earn on it. They call the money that they have taken in, but not yet paid out, the float. Warren Buffett is a big proponent of float. He has something like $100 billion in float at Berkshire Hathaway (BRK.A 0.99%) (BRK.B 0.91%), and they make billions of dollars a year just sitting on their customers' money until it gets paid back out.

Lapera: Yeah, and that's exactly what I was going to say. Warren Buffett made his money by having insurance companies and using the float to invest. Geico, for example, is a Berkshire Hathaway company. So you know what an insurance company is now, just in case you didn't before. Maybe you're 15 and don't have to worry about those things. In that case, good on you for listening to an investing podcast. If you didn't know, now you know some more. It's good to learn something new every day. That's what my mother always says. You know how they make money. So here are a couple things that you need to know about before you start trying to invest in an insurance company. The first thing is the combined ratio.

Wathen: Right. A combined ratio -- this gets back to the first way they make money, which is by paying out less than they take in in premiums. Most insurance companies don't do that, we should throw that in there. Most insurance companies actually pay out more than they take in in premiums, and make up the difference by investing the float. But good insurance companies should show a combined ratio over time of less than 100%. Basically, the combined ratio takes the losses that you pay out and the operating expenses of the business and divide that by the premiums. Ideally, that would be less than 100%.

Lapera: Yeah. The most important thing is to make sure you look at the combined ratio over time. If a company has a really great quarter, that's awesome. But if their combined ratio has been 120% for the last 10 years, (a) they're probably not in business, but (b) that's a sign that you should probably worry about that company, because their underwriting practices aren't strong, and they're not doing a very good job of managing their risk.

Wathen: Right. Over multiyear periods, a good way to see if they're doing well or not is if they consistently report what's called a favorable prior-year development. This is basically insurance speak for, "Our loss assumptions proved to be more conservative than they actually were, so we lost less than we thought we would on these policies." Safety Insurance Group (SAFT 0.56%) is a publicly traded company. They're a company that's done really well over time with actually being very conservative in their assumptions. Historically, they generally generate these favorable prior-year developments over time.

Lapera: Are they the ones that are up in New England and had that one really bad year because of that snowstorm?

Wathen: Oh, yeah, they had a horrible year in 2015, it was a record-loss year. I think something like nine feet of snow fell on Massachusetts in the Boston area, which is where they underwrite a lot of car and homeowners insurance policies, and the losses were tremendous. Of course, now they're getting the benefit of that, because of being able to charge higher rates.

Lapera: Yeah, if you look at their combined ratio over time, like Jordan said, it's really good. And it's not unusual for an insurance company to have one really bad year here or there, especially if they insure a non-diverse geographic area, so if they're just in one space. But just try to keep all that in mind as you're wading through these documents.

Wathen: Also, another thing I like to look at is the quality of the investment portfolio. Most companies that underwrite insurance will invest in short-term bonds, bonds, generally, safer investments like that. Something that I look for personally is, they always show an average credit rating. I like to see that an insurance company takes risk writing insurance, and not so many risks in its investment portfolio. You could do one or the other, but you probably shouldn't do both. You shouldn't be taking obscene risks in your investment portfolio and taking massive risks in your insurance portfolio, too.

Lapera: Yeah, that's definitely really good advice. You should always look at what is going on in their investment portfolio. Insurance companies are required to disclose what they have going on in there, in their 10-Ks and 10-Qs. So that's a good way to figure out what's going on. As always, make sure you go back to the primary-source documents and look at things for yourself. We talked about combined ratio over time and looking at the investment portfolio. The last thing you should look at is, you want to think about what kind of macro effects there might be on insurance. For example, health insurance. No one really knows, at least in the United States, what's going to happen with health insurance over the course of the next four to 10 years, really. So that's something you should think about when you're looking to invest in a health insurer.

Wathen: Yeah, that's actually a really good example. There's health insurance, which is short term, they're here-and-now needs. A business that has not done very well over time and insurance is long-term care insurance, because basically, the assumptions were, the cost of healthcare would only go up X% per year for so long. Lo and behold, nothing has risen as fast as, well, student expenses first, but then health costs second. So a lot of these companies underwrote these policies on the assumption that prices might grow at 3% a year, when in reality, they grew 4% or 5% a year, and they ended up losing their shirts on something like that.

Lapera: Yeah. The other thing that a lot of these insurance companies are facing now are people who got long-term insurance, like, 20 or 30 years ago. People are living a lot longer than they used to. It does affect their bottom line. So there's a lot of outside factors that might affect that. An example that we brought up the other day on that Warren Buffett episode -- if you didn't hear it, you can either search through our history for Berkshire Hathaway, or email me and I can send you the episode -- is that driverless cars are going to affect car insurance, because the more people who are not driving, the fewer people who need actual car insurance. Plus, driverless cars should, in theory, reduce the number of accidents that people are going to get into. So that's something to think about if you're going to invest in an auto insurer.

Wathen: Definitely. I think auto insurance is actually really interesting, because one of the benefits of driverless cars, if they happen, is that the insurance premiums you pay every month should theoretically go down. That's one of the economic reasons why driverless cars would be a big deal if they happen. That may be years away, but it's definitely a risk that you have to know about.

Lapera: Yeah. We mostly talked about pretty well-known types of insurance, but there's also some more weird insurance. The insurer that always comes to mind for me is Markel (MKL 1.01%). They'll insure giant parties, they'll insure your thoroughbred racing horse, they'll insure restaurants. They insure weird things that other people have a hard time figuring out how to do the underwriting for.

Wathen: Right. I was actually involved with a charity that does a golf tournament, and they buy hole-in-one insurance, because if you hit a hole in one, you get $10,000, or a new car, something like that. But they don't have the money to pay that out, so they buy hole-in-one insurance just in case that happens.

Lapera: Yeah, stuff like that. Or reinsurers, which I think we've talked about before on the show. I think it was actually me and Jordan, because Jordan and I always do, like, "Let's talk about weird financial companies." Reinsurers are basically insurance companies for insurance companies. So insurance companies take out a policy with reinsurers because they're worried that if a huge natural disaster happens, they won't be able to pay out completely, so they have these reinsurers come and help disperse the costs.

Wathen: Right. A lot of insurance companies buy reinsurance, so basically they end up just being marketing companies -- they're out there just selling policies and passing on the risk to someone else.

Lapera: Yeah. There are different types of insurance companies that you can look into, and maybe they won't be as affected by innovation as other companies are, or as affected by the political landscape as other companies. But yeah, I think that pretty much sums up the bare-bones basics -- you know how to go out and at least approach the idea of investing in an insurance company.

On the back half of our show, we're going to answer listener questions about insurance. We're going to start with the most basic and work our way out to most niche. There's four questions, in case you're curious. To start: There are tons of insurance companies. Why?

Wathen: There are a lot of insurance companies. The first reason is, it's kind of the natural state of the insurance industry to have a lot of insurers. If you think about it, insurance is all about spreading risk around, and that's not just among the insurance companies' clients, but also among insurers. The world would be a worse place if there were 10 insurance companies who owned the market in one state and underwrote car insurance policies, or homeowners insurance, or whatever, just in one state rather than having a bunch of different companies compete in a bunch of different states and a bunch of different markets and spread the risks around that way. So I think the natural state of this industry is always going be very competitive. The second reason, actually, speaking of states, is that insurance companies are licensed in states. When you think about starting an insurance company, it's much easier than starting another financial institution, like a bank. The regulatory regime isn't nearly as strict on insurance companies as it is on, say, a bank. For that reason, it's easier to start an insurance company than it is a bank.

Lapera: Yeah. As you mentioned earlier, you were saying, with it being good that there's a lot of insurers, that ties into our conversation about reinsurance that we had at the front half of the show. The other thing that you mentioned is, it's kind of easy to start an insurance company, but it's really hard to get rid of an insurance company.

Wathen: Right. Winding down an insurance company is hard. One of the biggest benefits that you can have as an insurance company is scale -- that you're bigger and you support this massive customer-service organization, or whatever. To go down, to underwrite less insurance, is really hard to do. It's bad for employee morale, it's bad for the economics of the business. You have scale working against you as you get smaller. So it's hard to wind down an insurance company, to say the least.

Lapera: Yeah, and there are regulations around how to do that, which just makes it that much harder. You can't just wake up one day and be, like, "We're out of business, sorry everyone who has insurance with us!"

Wathen: Right. If you write insurance for five years, you can't just shut that down. You have to have someone to take over the policy. It's just not easy -- insurance is a long-run business and it's not easy to run something like that down. You have the investment portfolio to wind down. It's just a mess.

Lapera: Yeah. So that's why there's so many insurance companies. They're easy to start, they're hard to shut down, and it's good for everyone that there's more.

Wathen: And the tax benefits can be tremendous, too. This is a fun one. A bunch of hedge funds are starting reinsurance companies in Bermuda now, and they write a small amount of insurance so they can call themselves reinsurers, but really they're just hedge funds that are trying to get tax advantages. That's an interesting angle, too.

Lapera: Yeah. I think the answer to that question was a lot more complicated than I originally thought it would be. So I'm really happy for the person who asked that question. What is the float typically invested in?

Wathen: That depends. The whole idea -- most insurance companies really want to build an investment portfolio so that the duration of their assets matches that of their liabilities. A car insurance company writes short-term contracts, so it's going to primarily invest in short-term bonds. On the other hand, a company that writes life insurance or annuities, for example, is going to invest in longer-term assets. To give you an example of that, let's use Progressive (PGR -0.79%). As a car insurance company, 80% of its investment portfolio, its fixed-income portfolio, at least, is in short-term bonds that mature in less than five years. On the other hand, MetLife -- which does life and annuity insurance, long-term insurance contracts -- 70% of its portfolio is invested in bonds that mature in more than five years. So the whole idea is, depending on how long it will take you to pay out your claims, generally speaking, the longer you can invest your capital, so the longer you can invest in longer-term bonds or even stocks.

Lapera: Yeah, that makes sense to me. I think a question that people will probably also have is, you talked a lot about bonds... what about stocks?

Wathen: Generally speaking, Progressive, for example, only has about 10% of its capital invested in stocks, because stocks gyrate so much more. If they need to go sell stocks, and something like 2009 happens, you don't want to be in the scenario where you're selling stocks at a loss to pay out claims. So generally speaking, these insurers try to keep into super-safe investments -- 90% or more of their portfolio in bonds.

Lapera: Yeah, that makes sense to me. That's what I would do if I were an insurer. But insurance companies typically are kind of conservative animals, because they have to be. OK. Second-to-last question: What percentage of premiums paid make up the float for most insurance companies?

Wathen: Ultimately, premiums are the source of float. The question is, really, how much in unearned premiums, or premiums that are paid in advance of the contract? If you pay on March 30th your insurance premium for April, May, and June, that's an unearned premium for the insurance company. That period hasn't come yet. So Progressive, for instance, its unearned premiums on its balance sheet when it last reported it was about $8 billion. So there's $8 billion of capital there. Then, if you look a little bit further, you'll see their loss and loss-adjustment reserves, which is how much they expect to lose that they haven't paid out yet. That was $11.6 billion. So for Progressive, the big generator of the float really isn't so much premiums they've taken in in advance of the contract. It's really the amount of time it takes for them to pay out on losses, if that makes any sense.

Lapera: That makes a ton of sense. Thank you so much for answering that. Listeners, we also have a really old article -- I don't want to mislead you, it's from 2006 -- but it helped also answer this question. If you want it, email me at [email protected]. The information in it is still relevant, it's just very old. It's over 10 years old at this point. Last question, this is definitely different from the other ones: Are Essent's (ESNT 0.84%) 68% net margins too good to be true? Some background for listeners, Essent is a mortgage insurer. That's the private mortgage insurance you need to buy if you put down less than 20% on down payment for a house.

Wathen: Yeah. This is a billion-dollar question. The answer is, it's hard to say. I guess, come back when home values are going down rather than up. Mortgage insurance is just tough. On a long timeline, it seems like all mortgage insurers eventually go to zero, because the industry basically went extinct during the Great Depression. Half of them blew up in the 1980s, many of them blew up, or almost blew up, in 2008. So you have these long, generational cycles of profits, and then house values go down and they lose a fortune, because they're basically taking the first loss on houses. Personally, I don't spend too much time following it because the cycles are so long, and because it's one of those industries where the government plays a really big role. So if the government comes out and wants to promote homeownership, they could really ruin the mortgage insurance industry if they want to. Or they could make it obscenely profitable by making it harder. It's just an industry that, truthfully, I don't understand too well. And I think you would really have to have your finger on the pulse of Washington politics to really understand it.

Lapera: Yeah, and not just Washington politics, but, like you mentioned, the housing cycle tends to be very boom and bust, and the problem is private mortgage insurers are not the ones writing the loans for the houses. In that case, it's two steps of underwriting. It's the bank's underwriting plus the insurer's underwriting that is creating this policy for this person. So if the bank did a really bad job underwriting that house, then the insurers are definitely going to lose out. So it's just something that has a lot of variables and is hard to control. So just think about that before you consider investing in private mortgage insurance.

Wathen: That's a good point. Because these cycles are so long, someone could theoretically join a mortgage insurance company out of college, become an executive, and through that whole timeline where they move up the company, basically, they operate in an industry during the time when they experience almost no losses. So all they've been rewarded for is underwriting more and more and more insurance. Psychologically, it's something that's really difficult to grasp, because eventually, the losses do come -- it's just a matter of time. But someone could easily see 10-30 years of excess profits, and then all of a sudden, it's just complete wipeout in one year when house values go down.

Lapera: Yeah, definitely. Do you have anything else you want to say about insurers before we wrap up?

Wathen: They're boring, but because they're boring, they can make for great investments. Personally, I actually like the insurance industry more than most, I guess, in the financial space. I like them more than banks, for instance. I think the risks are better. But it's not everyone's cup of tea, and I get that, too.

Lapera: Yeah, that's totally fair. I think insurance companies are really interesting because I think the macro factors that are affecting insurance companies are a little bit more interesting than banks, so I think it's a more interesting thing to think about. Not that I don't love banks. Don't worry, Maxfield will be back, and we'll talk about banks again, I'm sure. 

As usual, people on the program may have interests in the stocks they talk about, and The Motley Fool may have recommendations for or against, so don't buy or sell stocks based solely on what you hear.

If you still have any questions about insurance, feel free to email us, and we'll take it onto another show eventually. Contact us at [email protected], or by tweeting us @MFIndustryFocus. Listeners, I have a Twitter account. I post infrequently, I have to admit, but if you tweet me, I will eventually see it and respond to you. It's @TMFCaffeine. I don't really know how to pitch Twitter handles, so I hope that's enough for you to find it. And thank you to Austin Morgan, today's producer, patient, patient editor. I screwed up a couple times, and I know he's going to fix it. Thanks for making me sound good.

Austin Morgan: Always.

Lapera: And thanks to Jordan. Thank you everyone for joining us, and I hope everyone has a great week!