Warren Buffett has said time and time again that he likes making investments within his "wheelhouse". This means investing strictly in the sectors and companies you understand.
The stock market is, however, a vast field of opportunity, and investors of all standing should always be looking to expand their knowledge base.
Insurance companies are undoubtedly complex in nature; however, I'm going to walk through three quick tips to better understand companies like Markel (NYSE:MKL), W.R. Berkley (NYSE:WRB), and American International Group (NYSE:AIG).
1. What kind of insurance are they writing?
We live in a world filled with risks. Those risks, however, come in many different flavors. Some we all deal with, and some are a little more specialized.
For your average, run-of-the-mill, risk Allstate has you covered with products like personal property and casualty insurance, life insurance, and retirement and investment products.
On the other end of the spectrum is Markel and W.R. Berkley. These businesses write specialty insurance – which is essentially "hard-to-place risk".These tend to be more expensive niche plans that can cover anything from earthquakes to fine museum art.
AIG falls somewhere in between. The massive company covers everything from the mundane to the highly specialized.
2. How profitable is the insurance company?
While there are some exceptions to the rule, it's best to find companies with a history of strong underwriting. This means collecting more in client premiums than the company has to eventually pay out in claims.
The simplest way of determining an insurer's underwriting profitability is looking at the combined ratio.
When the ratio is above 100% it means the insurer took an underwriting loss, and the lower the ratio is under 100% the more profitable the insurer.
The chart may look a bit confusing, but let me direct your attention to a few key points:
- AIG has taken underwriting losses five years running, which is definitely a concerning trend.
- Markel has been fairly volatile, but has posted profitable underwriting four out of the last five years.
- W.R. Berkley looks like the clear winner, and has continued its strong performance into 2013.
3. How is the company investing its float?
The collected sum of insurance premiums are referred to as a company's "float". While some of the money will eventually need to be paid out in claims, this money is able to be invested in the meantime.
The insurance industry, however, is highly regulated and companies are obligated to maintain a sizable amount of liquidity in order to pay customer claims.
It's for that reason all three companies allocate more than 70% of investments into fixed securities like: government bonds, mortgage-backed securities, corporate bonds and the like. These tend to be lower yield and safer investments.
The companies diverge when it comes to investing the other 25% to 30%. The most glaring difference, though, is the amount of capital allocated toward equities.
W.R. Berkley and AIG have approximately 2% and 1% in equities, respectively. Markel, however, allocates closer to 20% of its investments.
That huge difference showed in 2012 as Markel's Chief Investment Officer Tom Gayner was able to return 20% on these equity investments. This helped push the company's total investment yield to 9%.
This is compared to W.R. Berkley and AIG's returns of closer to 4% in the same time.
Investors should keep in mind that equities can be much more volatile and therefore could have a greater impact on Markel's bottom line – but in the long-term they have proven to have the best returns.
Preparing for Fourth Quarter Earnings
W.R. Berkley was the first of the three companies to report full-year 2013 earnings. The company saw an 11% increase in premiums and an improvement in combined ratios. However, net investment income and earnings per share decreased year-over-year.
AIG will report earning on February the 13th, while Markel will most likely release earnings between the third and seventh of February. Investors would be wise to keep an eye on each company's combined ratio and net investment income.
Dave Koppenheffer has no position in any stocks mentioned. The Motley Fool recommends American International Group and Markel. The Motley Fool owns shares of American International Group, Markel, and W.R. Berkley and has the following options: long January 2016 $30 calls on American International Group. 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.