The best insurance companies have one thing in common: they adequately price risk. That is, these companies more than cover their expenses and insurance losses with their premiums.
If it seems simple, that's because it is. But over the history of the industry, there are countless examples of companies that have sacrificed profits in the pursuit of growth. The best insurance stocks play more defense than offense.
With that in mind, here are two insurance stocks that have proven to be excellent in managing risks and delivering market-beating returns for investors.
1. Chubb Corp. (NYSE:CB)
Chubb is an excellent example of a great insurance company because it fits the framework of a defensive insurer. In fact, in the 10 years from 2005 to 2014, its premium revenue grew by an anemic 1.2%. In any other industry, you'd call a company like this a failure. In insurance, this is the hallmark of a conservative operator.
Chubb's insurance lines are broken into three main segments: personal, commercial, and specialty insurance.
Chubb really sets itself apart in personal and specialty insurance. The complexity of these business lines mean they are less competitive, and therefore subject to less pricing pressure. Not surprisingly, with less competition Chubb has more pricing power -- and it shows.
Chubb's personal and specialty insurance segments have historically operated with combined ratios of less than 90%. That is, for every $1 in premiums, it pays out less than $0.90 in combined losses and operating expenses. The investment income it earns in holding its customers' money in the meantime is simply icing on the cake.
Its larger commercial segment faces stiffer competition, and commercial customers are more likely to shop for lower rates than are individuals, resulting in less impressive underwriting profits. Despite that headwind, Chubb has historically generated underwriting profits in commercial insurance, where most insurers are lucky to simply break even. Thus, yet again, the entirety of its investment return from this segment is simply a bonus.
To offset its slow growth, the company aggressively pays out profits to shareholders in the form of dividends and stock buybacks. In the last decade, its earnings per share have nearly doubled, its dividend has grown by more than 130%, and its stock price has more than tripled, despite virtually zero growth in premiums. Playing defense isn't so bad, after all.
2. Markel Corp. (NYSE:MKL)
Markel exists on the opposite side of the spectrum from Chubb. It's a smart operator and risk manager, but its long-term outperformance stems more from its premium growth and investing record.
Many call Markel a "baby Berkshire," a tip of the hat to its record of producing excellent underwriting and investing results, very much like Warren Buffett's Berkshire Hathaway.
Markel's best attribute is that it is primarily a specialty insurer, focused on hard-to-price risks that other insurance companies would prefer not to deal with. Think things like boats, snowmobiles, horses -- even special events and stolen gifts at your wedding. With these niche insurance lines bolstering its profits, the company's combined ratio has averaged 95% over the last decade.
Separately, Markel CIO Tom Gayner has proven to be an excellent investor. Over the last quarter-century, he has presided over a stock portfolio that has topped the S&P 500 index by an average of 2% per year. Over long periods of time, that advantage compounds tremendously for shareholders.
Markel has recently taken his investing prowess into newer, niche corners. A subsidiary, Markel Ventures, invests in private businesses, hoping to duplicate the success that other insurers (most notably Berkshire Hathaway) have achieved in buying out whole companies. Investing in less-efficient markets -- like the private markets for small businesses -- could provide even greater outperformance than its public stock investments.
If there is one criteria by which you can judge great insurance companies, it's long-term combined ratios. Insurers that get the hard stuff right -- keeping losses and expenses low as a percentage of premiums -- have a massive advantage on rivals that must swing for the fences just to eke out of a small profit quarter after quarter, and year after year.
Jordan Wathen has no position in any stocks mentioned. The Motley Fool recommends Berkshire Hathaway and Markel. The Motley Fool owns shares of Berkshire Hathaway and Markel. 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.