Did you know that most insurance companies barely turn a profit from the premiums they collect? In fact, insurance companies generally try to collect just enough income from premiums to cover the money that they pay out. However, they invest that money while it's being held in reserves in order to generate income. As you might imagine, investing billions of dollars of other people's money and keeping the profits can be lucrative.
It's for this reason that a well-managed insurance company can be one of the best long-term investments there is. But which companies are the best to buy right now? We asked three of our contributing writers to share their top picks in the insurance business. Here's what they had to say:
Jordan Wathen: Warren Buffett fans know car insurance can be remarkably profitable. Buffett's stake in GEICO has been one of his best investments, and it now ranks as the largest auto insurer in the U.S.
Unfortunately, you can't own GEICO without buying Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B). But I'd argue that Progressive (NYSE:PGR) is up there with GEICO as one of the best car insurance companies in the market today.
It all starts with proper expense and risk management. In Progressive's case, it has held its combined ratio to an average of 93% over the last five years. This means that for every $1 in premiums paid into the company, it incurred just $0.93 in insurance losses and operating expenses. The investment income it earns on its float is just icing on the cake.
On top of this, smart underwriting has enabled it to generate long-term returns on equity of nearly 20% per year -- an excellent return for a property and casualty insurer, especially in a low-rate environment. A jump in interest rates would be a boon for Progressive, but even without the extra bump up in its income, today's price of 2.2 times book value and 15 times earnings seems a fair price to pay for a company like this.
A common misconception about insurers is how they make money. The reality is, many barely break even on their insurance revenues, instead making profits from investing the "float," or premiums held to cover claims, usually in fixed-income instruments like bonds. With today's low-yield market, that doesn't leave much meat on the bone for investors.
This is part of what makes Markel special. Not only does it generate revenue from investing its float, but it also has a profitable underwriting business, reporting a combined ratio of 95%, 97%, and 97% over the past three years.
Over the past decade, Markel has used its underwriting and investing profits to build a collection of wholly owned subsidiaries. This produces further profits and free cash flow, which are then added to the pile, and invested once again.
Markel also has a powerful portfolio of stock holdings, worth about $3.8 billion, that Chief Investment Officer Tom Gayner has built up over the years. Today, about 36% of the company's stock value is derived from this portfolio, which regularly outperforms the S&P 500. Last year was a great example, with the Markel equity portfolio returning 18.6% versus about 14.7% for the S&P 500.
Markel has a rare combination of profitable underwriting and great leadership that invests both the float and underwriting profits to further grow returns in ways most insurers just can't match. From a valuation perspective, even though its price-to-book ratio is higher than it has been since before the recession, Markel looks like a fair value for an excellent company.
First of all, many U.S. investors don't realize that about three-fourths of Aflac's business comes from Japan. The Japanese Yen has been weak for some time right now, which has suppressed earnings growth (in dollar terms).
Also, as Jordan and Jason mentioned, insurance companies make money from investing its "float," and it's difficult to produce good returns in the current low interest rate environment. For 2014, Aflac earned a 3.2% yield on its investments, down significantly from its pre-crisis performance. Because of this, Aflac is taking a "disciplined" approach to selling new products in the short-term, which will reduce cash flows to the investment portfolio for the time being, but could turn out to be a positive catalyst over the long run once rates start to rise.
Aflac has increased its dividend for 32 consecutive years, and has an excellent share repurchase program. The company produced a return on equity of 16.3% for the fourth quarter (18.9% excluding the Yen's impact), and the ROE hasn't fallen below 16% in the past decade.
In short, Aflac is a profitable and well-managed insurance company that could produce market-beating returns once interest rates rise and the Yen begins to strengthen.