An insurance company can generate tons of cash. Just ask Warren Buffett; he built Berkshire Hathaway on the shoulders of insurance businesses.
If you're unfamiliar with how this works, here's a very simplified version, using car insurance as our example:
- You buy a car insurance policy and pay monthly premiums to your insurer.
- The insurance company takes that money -- called the float -- and invests it.
- If you get in an accident, the insurance company pays your claim. If you don't, it keeps your money and continues to invest it.
The investments that companies make with this money are incredibly important. In some cases, a company may pay out more in claims than it brings in on premiums -- but in the end, it's OK because the company invested the money wisely in the interim. These investments allow cash to build up over the years, which usually makes insurance stocks ripe for dividend payments.
Let's look at six dividend stocks with three different metrics to evaluate.
These metrics will allow us to see:
- The dividend yield -- how much bang for our buck we'll get.
- The payout ratio -- how sustainable the dividend is. The lower the number, the more sustainable it is.
- The dividend growth rate -- though the past isn't a perfect proxy for the future, this gives us an idea of whether we can expect to see a dividend increase in the future.
All three of these metrics are important when evaluating dividend stocks.
5-Year Dividend Growth Rate
When I'm looking into dividend stocks in the insurance field, I like to see a yield of at least 2%, a payout ratio of less than 60%, and a growth rate of at least 5%. Using these criteria, that leaves us with ACE Limited and Universal Insurance as excellent dividend candidates.
Evaluating the underlying business
Just as it's important to evaluate the health of a company's dividend, you also need to investigate how healthy the insurance business is that provides these dividends. As I mentioned, claims being paid out can sometimes be greater than premiums being taken in. We obviously want to avoid situations like this.
One metric that insurance companies provide to help us evaluate their health is called the combined ratio. In essence, the ratio is the result of taking claims paid out and dividing them by premiums taken in. If the ratio is less than 100%, then the underwriting business is profitable on its own, without taking investments into account.
This can be especially important when business isn't going well, as the company should still be able to turn a profit without the extra boost its investments provide. Here are the ratios for the companies we have left.
ACE seems to be the company with one of the healthiest dividends and the strongest underwriting business.
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