All insurance companies make money by capitalizing on the time delay between when premiums are received and losses are paid out. But the very best companies can generate a profit by collecting more in premiums than they pay out in losses, creating what's known as an underwriting profit.

Underwriting profits are the hallmark of excellent insurance operations. Safety Insurance Group (NASDAQ:SAFT) is an excellent example of a company that has, for many years, generated underwriting profits by pricing its policies high enough to reflect the risk of loss.

In this segment of Industry Focus: Financials, join host Gaby Lapera and contributor Jordan Wathen as they discuss how insurance companies make money for their shareholders.

A full transcript follows the video.

This video was recorded on May 22, 2017.

Gaby Lapera: 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.

Jordan 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 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.

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