An insurance contract transfers risk from the customer (the insured) to the insurance company (the insurer). If, for example, an insured customer gets into a car accident, his insurance company ends up footing the bill. In return for taking on this risk, customers must pay the insurance company premiums.

Premiums for insurance companies are essentially equivalent to sales for retail companies. Insurance companies take in premiums from customers, from which they pay out losses and expenses. Written premiums refer to the amount of new business an insurance company "sells" each year. If an auto insurance company acquires 1,000 new customers in a year, with each contract requiring customers to pay $1,000 in premiums, then that insurance company's written premiums are $1 million (1,000 customers x $1,000 premiums per insurance contract).

Pretty simple, right? The total amount of premiums an insurer is entitled to receive from its customers over the life of their insurance contracts is the gross written premiums.

Net premiums
Risks come in many different shapes and sizes, and sometimes an insurance company doesn't want to take on certain risks, or it wants to transfer some of its risk to another insurer (known as reinsurance). The insurance company must pay reinsurance premiums to the reinsurer. These reinsurance costs must be subtracted from gross premiums, and the result equals net insurance premiums. Just as net sales are a better measure of a retail customer's business, net premiums are a more accurate measure of an insurance company's business.

Net premiums earned
Accrual-based accounting states that revenues and costs must be matched to the periods for which they are applicable. In other words, if a customer pays you today for a service to be rendered in a year, you cannot recognize that revenue (and the associated costs) until the service is performed. Likewise, because insurance contracts are often written for multiyear periods, the portion of the premium earned must be recognized on an accrual basis. For example, if a customer pays an insurer $10 million in premiums in order to insure its risk for 10 years, then every year it is earning a tenth of the total net premium written, so its yearly net premiums earned figure is $1 million.

Some real-world examples
Like any other type of company, the more business an insurer does, the better (assuming the business is profitable, of course). The companies that are able to generate a lot of premiums are generally more valuable. Some investors like to use price-to-sales ratios (market cap divided by sales) when judging retail companies. Likewise, it's worth taking a glance at the price-to-net-premiums-earned ratio in order to ascertain an insurance company's premium-generating ability. Keep in mind that insurers have other sources of revenue besides premiums, and the amount of premium that flows through to net income varies depending on the company.

Some of the top insurance companies are Progressive (NYSE:PGR), White Mountains (NYSE:WTM), Markel (NYSE:MKL), Cincinnati Financial (NASDAQ:CINF), and W.R. Berkley (NYSE:BER). These companies have price-to-net-premiums-earned ratios of 1.2, 1.7, 2.3, 2.5, and 1.5, respectively.

Lastly, like great value investors, great insurance companies do business only when risk-adjusted returns are favorable. In this manner, investors should look for insurance companies that grow net premiums earned when risk premiums are high (and customers are willing to pay up), which usually occurs after a catastrophe or an industry shake-out, and stay disciplined when risk premiums are low. This is the simple formula Warren Buffett has used to turn Berkshire Hathaway (NYSE:BRK-A), which owns GEICO and General Re, into the insurance juggernaut it is today.

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Berkshire Hathaway is an Inside Value recommendation. Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above and appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.

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