From your health to the weather on your wedding day, the insurance industry is willing to insure practically any risk at the right price. And while the insurance industry can be a bore for consumers, insurers can be highly profitable for their investors.

In this week's episode of Industry Focus: Financials, The Motley Fool's Gaby Lapera and Jordan Wathen discuss the insurance industry, how to analyze an insurance company, and whether or not carnival workers are trustworthy people. 

A full transcript follows the video.

This podcast was recorded on April 4, 2016. 

Gaby Lapera: Understanding insurers, this is Industry Focus, financials edition.

Hello everyone and welcome to the show! This is Monday, April 4, 2016. My name is Gaby Lapera and I'm joined on the phone by Jordan Wathen. Before we do anything else I'm under very strict orders to deliver the following message. As some of you may have guessed our Friday show was part of Fool.com's April Fool's Day joke. While we poked fun at private companies using crowd-sourcing platforms for funding, these types of investments are different than stock and publicly traded companies and have some risks the average investor may not be aware of. We'll be doing a full show on it in the next few months.

Love, Dylan Lewis.

That last part was me, not him.

Anyway, this week we're going to be covering insurance companies. We've going from basic to super weeds-y, so I guess if you're bored by the first part just fast forward, you'll have a good time no matter what, I promise. Let's get into it.

Everyone has insurance, or you ought to have insurance, especially if you have a car or are alive, you ought to have insurance. Do you know how insurance companies work? Do you know how to invest in insurance companies? This is what we're going to try and cover today. Starting at the most basic unit of matter, as one would say in chemistry, what do insurance companies do, Jordan?

Jordan Wathen: The best way I've ever heard insurance companies explained is you can think of them like a group saving's account where the money that you can take out isn't based on much you put in, but how much you need, because you've been unlucky in one way or another.

Lapera: That is a really good explanation actually.

Wathen: Yeah, I borrowed that from a book and we'll talk about that later. The way to think about it is money is pooled together from a bunch of people who all have risk of one type or another, health or life or car insurance. As people need it for calamities, they can send a claim into their insurer and the insurer will write them a check for it to cover their losses.

Lapera: Right, and as you covered while you were talking, there's all different types of insurance. There's life insurance, which I think people know about. You die, you kick the bucket, and the company pays out and it helps cover funeral expense or end of life expense or whatever it is, provide a little bit of a living for whatever survivors you leave behind. There's health insurance, which I think everyone is familiar with in the United States of America anyway. Auto insurance, which you should definitely have if you drive a car. There's all sorts of things, but I think what a lot of people don't realize, is that there's a lot of different other types of insurance companies that the average person isn't really going to deal with. The one that springs to mind immediately is reinsurers.

Wathen: Right, reinsurers are a special kind of category, because they actually insure insurance companies. When an insurance company doesn't want to take on the full loss of the premiums they've written, they can pass it on to a reinsurer and mitigate some of their losses should say an extreme event occur, a big loss like a catastrophe or a hurricane, something of that sort.

Lapera: Absolutely. There also are other types of insurers that are super niche-y, I guess. There's an insurance company called Markel (NYSE:MKL). And if you go to their website, they have this whole list of things that they insure. They insure everything from your children's birthday party to blacksmith shops and boats and RVs and all that normal stuff too. It's crazy, they're all over the board.

Wathen: Right, right. Insurers especially tend to make better investments in some of the more common types of insurance, because they tend to be specialized, so there's fewer competitors. Markel is a great case in investing insurance companies, because they've absolutely trumped every other ... I shouldn't every other, but they trump most insurance companies. It's not because they're great at underwriting, they also have a spectacular investor, Tom Gayner.

Lapera: Okay, let's actually talk about that. Insurance companies make their money in two different ways. I think the most intuitive ways that most people would guess that insurance companies make their money, is by paying out less in claims than they take in in premiums. I think that's pretty standard, run of the mill. Premiums, just in case you don't pay insurance for whatever reason, maybe you're 16 and don't pay insurance, but you do invest. Your premium is what you pay to the insurance company so that you are insured every month, and then claims are what the insurance company pays out to people.

Wathen: Right, absolutely. I think most people do assume that insurance companies make money from their underwriting, as in they generate more in premiums than they pay out in losses and expenses, but for the most part that's absolutely not true. Most insurers are happy to break even on their underwriting and make their money by investing the premiums and keeping the investment returns, which [Warren] Buffett calls "float," for example.

Lapera: Yeah. This is how insurance companies end up acting a little bit like banks.

Wathen: Right, yeah. They basically are banks. Most of them have a huge balance sheet of assets that they've invested in with the premiums that they have received from their policy holders.

Lapera: Right, so when you look at an insurance company's balance sheet, there are a few metrics that you definitely need to look at to understand what's going on. They're different than other companies' metrics because there's some things that you look at for any company that you're going to research, but for insurance companies you need to look at the loss ratio, the expense ratio and the combined ratio.

Wathen: Right. Let's break those down. The loss ratio is the percentage of premiums earned that are paid out in losses. If I get in a car accident today and do $1,000 of damage to my car that would show up in the loss ratio because that's actually money paid out for losses. Then you have expenses, which are things like advertising or getting a claims adjuster to show up to look at my car. That would go in the expenses. When you add those together you get the combined ratio, which is the percentage of money paid out in claims and expenses to run the insurance company, as a percentage of premiums.

Lapera: As a percentage of premiums, it's the loss ratio plus the expense ratio over premiums. Would you want a higher or a lower combined ratio? Because this tripped me up the first time that I tried to analyze an insurance company.

Wathen: Right, you definitely want a lower combined ratio. A lower combined ratio would mean that you have a fatter underwriting margin, meaning you're making more money on each dollar of premium that comes in.

Lapera: Right. This is actually I think a really interesting topic. I don't know if everyone thinks this is interesting but actuarial tables are fascinating because they have these lists of risk factors and they can run their fingers across the lines and figure out exactly how risky you are for any given thing. Companies that are better at underwriting, are going to have better combined ratios. This is how you check if a company is doing well on that side of their business, just like, the actual business of insurance.

Wathen: Right, exactly. The key to running a great insurance company is pricing risk correctly. It's very easy to grow premiums, it's very easy to grow revenue. All you have to do is write bad risks, all you have to do is insurance something that should cost $100 for $50. But ultimately, at the end of the day, there's nothing wrong with being small and being very profitable the premiums you do write, or the policies you write.

Lapera: Again just like banks with loans except in this case it's insurance.

Wathen: Right, exactly.

Lapera: How would we evaluate whether or not a company is doing well on the investment side of their business model?

Wathen: If you go to the financial statements and you look at the investments, I like to look at that especially because you can really find out how much risk they're taking. One think they'll always show is the percentage ... Most insurers invest mostly in bonds, so you look and you can see for example by credit rating, they'll show percentage of investments that are held in government securities, percentages that are held in AA corporate bonds. That gives you a good idea of how risky an insurance company is. There was one very small insurer that was run by some very interesting people. For a long time it had a lot of its money invest in gold stocks and gold and silver, which if you think about it is a pretty terrible way to run an insurance balance sheet, because if at the same time gold goes down a huge hurricane [comes] through, you're in a world of hurt.

Lapera: That is really interesting. Gold is whole another issue we could do an entire podcast on. There are definitely issue some gold bugs out there, I think one of my colleagues called them the other day. Which is crazy because ever since, what's his name, William Jennings Bryan I didn't realize that this was still a thing that people were so obsessed with.

Wathen: Right, yeah. If you ever have some survivalist friend, your insurance company might want to double think it. That's one of the biggest risks, but for the most part most major insurance companies are pretty plain vanilla in how they invest their money. It's say 95% fixed income or bonds and 5% stocks. They're not interested in taking too much risk on that, because they know a lot of the money they take in in premiums will have to be paid out in losses and expense relatively soon.

Lapera: Yeah. Okay, here's a thing right, is that we're doing an episode about something that a lot of people think is super boring, so I asked Jordan Wathen to come up with some fun facts about insurers. I think it might be time after talking about some very boring bonds, to come up with a fun fact. Do you want to go for it?

Wathen: Yeah. We can go with some fun facts. Way back in the day ... Actually first I should give a shout out to this book which is called The Invisible Bankers. Actually it was interesting that we talked about insurance companies being like banks. The book is called, Invisible Bankers, I would highly recommend you read it. You can get it on Amazon for all of a dollar, so it's worth checking out. One of the few of the fun things they had in there was one about in the hay day of air travel, insurance companies made a fortune selling life insurance to air travelers. They basically pitched it as this huge risk, that getting on a plane was basically taking a huge risk with your life. But all the same time, while they're selling travelers life insurance on the plane, they're underwriting pilots at the standard rate. Basically they're telling travelers that traveling is so dangerous, but the people who fly for a living, they're just standard risks.

Lapera: That is super sneaky. Again, why maybe people think that people who work in financial services are villains. Take note in case you want to change your perception, insurance companies.

Wathen: Right. Yeah, exactly.

Lapera: Talking about risk, a lot of people when they think about insurance, they think about this stodgy, sweaty accountant with giant glasses who are a little bit nervous and constantly writing things down. They think of insurance as pretty much the opposite of risk, but insurance companies actually have some very interesting risks that other companies might not face necessarily. What kind of risks are there when you invest in an insurance company?

Wathen: There's a lot of risks you wouldn't think about. This year a big one with property and casualty insurers, more specifically car insurers, is that people are driving more because gas prices are low. Because of that they're getting in much more accidents, and actually the cost with each accident has been going up this year, too. Geico reported, which obviously is a subsidiary of Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B), they reported that the severity of claim, how much they pay out, is going up, as well as the frequency, because people are driving more.

Lapera: That's something that you wouldn't [think] about, right? The price of oil dropping, what does that have to do anything with insurance. But if you're an auto insurer, it's a big deal. If you're a health insurer that's insured all these people that are in accidents, it's a big deal.

Wathen: Right exactly. I would have never ... It's not something that when you look at a car insurance company you think, "Oh man, I'd better worry about the price of oil," but the lower it goes, the more people tend to drive, and it makes sense.

Lapera: Yeah. Another one that people don't really think about it, because I think most people don't think about reinsurance, which is again those insurance companies that insure insurers, is natural disasters. I think, I want to say was it 2014? Was that the year of the tsunami? I can't remember. There was a year that there was a ton of natural disasters, and there were a few reinsurers that just went out of business. They couldn't handle the claims.

Wathen: Right exactly. It goes so deep, too. You could go and look, there's a small insurance company based out of Massachusetts, Safety Insurance (NASDAQ:SAFT), that for years has had absolutely stellar underwriting record. They do great in car and home insurance, but then they had something like 7 or 8 feet of snow fall in Boston. What can you do? There's nothing you can do about it, it's just bad luck. But for an insurer bad luck isn't a very good thing.

Lapera: No, and they do the best they can to mitigate these risks with actuaries, but especially when you are gambling on something like good weather, that's when you have to assess what you risk tolerance is, as hilarious as it is to say for insurers.

Wathen: Right, yeah exactly. No, it's not fun. I'm kind of glad that's not my job, because at the end of the day, weathermen can't predict the weather 10 days out, predicting it a year out or 10 years out, I can only imagine the difficulty in doing that.

Lapera: Yeah. Let's talk a little bit about risks that are more common I guess across different companies for insurers. Insurers can go one of two paths. They can either choose to specialize in one thing, like maybe auto and RV and boat insurance, modes of transportation, or they could choose to specialize in a lot of different things. Are there advantages or disadvantages to either of these?

Wathen: I think there's advantages and disadvantages to both. If you think about a very specialized insurer, going back to Safety for instance, the danger with them is that most of their premiums are written in New England. If it snows in New England, that's a bad year for them. If they have a lot of snow fall they have a lot of losses. There's geographic risk there. On the other hand if it doesn't snow or winter is very mild, then it's a great year and they're partying hard like it's 1999, because no one's getting in car accidents, it's beautiful weather, it's fantastic. They're just printing money. Then to some extent, being more diversified it can be good obviously because one risk won't put you under, won't put an insurance company under, but in the same token it's very hard to get the incentives right when you have multiple lines of insurance under one business.

Lapera: Right.

Wathen: If you think about it, let's say there's a company, say a car insurance company and a health insurance company together, and you have executives leading both sides of it. How are you going to compensate them for underwriting performance at one when they're only responsible ... How are you  going to compensate for underwriting performance at the car insurance unit, when they're only responsible for the health and life unit for instance?

Lapera: Right, this actually leads me into my next question which is, is it better to buy stock in a stand-alone insurance company, or in one of these mega financial institutions that do a little bit of everything, like AIG (NYSE:AIG) for example.

Wathen: That's a million-dollar question. If you're going to put me on the spot, I personally would prefer to invest in a pure insurance company, because if you're taking the insurance risk I just want the insurance risk. If you look at the really big insurance companies out there, most of them, especially AIG, hasn't done particularly well recently. It's because I think personally it's very hard to run a company where you're taking so many different risks and truly understand it.

Lapera: Yeah. I don't know if you all know about this but Carl Icahn ... am I pronouncing his last name right? I think I've only ever read his name, I don't think I've ever heard his name.

Wathen: I think you're getting it right.

Lapera: Yeah. He is like this activist investor type person, except he's just one person instead of a group of people. He's taken an interest in AIG, and he really wants AIG to split up its divisions, and partially that's a good idea because that way it will dip underneath the systemically important financial institution line. But he says also that it makes business sense for them, they'll make way more money as a separate set of businesses, as opposed to this conglomeration that they have now.

Wathen: Mm-hmm (affirmative). To some extent I wonder if he might just be a little upset at management personally.

Lapera: He does.

Wathen: Because they finally have a CEO who really doesn't have any industry background, and I think it really concerns a lot of investors, for good reason. If you want a good insurance company executive, you really want someone who's familiar with underwriting and familiar with risk, so that when they see, "Here's what we're actually risking this year," they actually truthfully understand the number.

Lapera: Yeah. That's another thing of course just like any other company, insurers also have management that you have to look into. It's really interesting, because I feel like with a lot of the technology companies or consumer goods companies, they have super dynamic CEOs and you know a lot about them, but with insurance companies and banks and BDCs, there's not really ever a ton of information on managers. It's like, "They went to Harvard and graduated in '89."

Wathen: You're right, they studied engineering, they went to Harvard and then they became a financial industry executive. I just wrote 95% of insurance or financial people's background.

Lapera: Yeah. It's like I don't know whether or not I should trust this guy. In order to do that you look at their track record. The other thing I really like to do is read conference call transcripts, because I think that you can get a sense of whether or not people are being honest and forthright via what they say. I know that's a nebulous thing to quantify, it's just a gut feeling whether or not you trust these people. But besides track record that's all you can really do.

Wathen: Right. Progressive (NYSE:PGR) usually has a really clear conference call. They're very plain and open about what they're looking for. They'll straight up say, "We're shooting for this underwriting margin and we think we can grow by doing this," for example. That's something they've done recently, targeted a lower, or a higher combined ratio rather, getting back to how that's confusing, a higher combined ratio but also growing the top line. Over time you'll see, especially with property and casualty, car insurance, things like that, you can figure out really quickly if they're a good company at underwriting or not, because those policies expire within a year, so either you nailed it or you didn't.

Lapera: Yeah. I think it might be time for another fun fact.

Wathen: Another fun fact?

Lapera: Yeah.

Wathen: All right, let's go back to the gold rush. Apparently, mining for gold is a very, very dangerous industry because back in the day they charged you 4 times the standard rate if you happened to be one of the crazies that went out to San Francisco to mine for gold.

Lapera: I wonder if there's a modern day equivalent of that. Would that be, like, I dated this guy for a while who's really into that Discovery Channel show about deep sea fishing. Do you know what I'm talking about?

Wathen: Yes, I know exactly what you're talking about.

Lapera: Yeah, I wonder if those people have a higher insurance premium.

Wathen: That's actually a fun one. There's been a few studies about that, and actually, say the general population, people who are riskier actually are clergy members, which is really fascinating.

Lapera: What? Really?

Wathen: They think it might be because maybe you just run a red light because your faith will save you, I don't know. Who knows, but yeah that's actually a thing, is that clergy members are typically higher risk than say your standard office worker.

Lapera: That is so interesting. I wouldn't think that that's a profession that puts you in the line of fire.

Wathen: Yeah, exactly. It seems like a profession where life just goes on and you live to be 100, based on all my experiences with church.

Lapera: That is true. I've been at some churches with some very, very, very old nuns. Yeah, wow that's so interesting. Anyway, I think that I've covered everything that I want to know about insurance. Do you have anything else you'd like to talk about Jordan? Any favorite? If you had to invest in an insurance company right now which one would you pick?

Wathen: Probably Progressive, or I would go the easy route and take Berkshire Hathaway.

Lapera: Yeah.

Wathen: This is year wasn't too great for Geico and their other insurers, but if history serves you'll do quite well. They're trading at a valuation that's very cheap on historical basis. It's very interesting to me.

Lapera: Yeah. Yeah, I think that if I had to choose one I would go back to that weird specialty insurer, Markel, just because I'm so fascinated by their business model, and they've done a great job underwriting the risks for all the very, very odd things. I would love it if I could call whoever is in charge of that at Markel and be like, "How do you even go about figuring out the risk for," I don't know, "parasailers?" Very interesting.

Wathen: Exactly. Now, here's a fun one, which is more dangerous? Do you think it's carnival rides or amusement park rides?

Lapera: I want to say amusement park rides, because I feel like people, there's a lot of scrutiny on carnivals, they seem like they're a little bit shiftier.

Wathen: You know see, I was thinking they're shiftier, so they're not as safe, but you're actually right. Amusement rides are less safe because they don't disassemble them and put them back together every day. Which, wouldn't think about that but that's something you only learn by writing that insurance and losing money on it, and then finally figuring out that amusement park rides aren't good bets anymore.

Lapera: See, I would definitely would have guessed it would have been amusement park rides, because I thought that people are generally suspicious of carnival workers, which is a terrible stereotype I guess. I'm sure there are plenty of very nice carnival workers out there. I don't know. I guess I'm just buying into what mainstream media tells us about carnival workers.

Wathen: Yeah, exactly.

Lapera: All right. I think that brings us to the end of our show, unless you have anything else you want to say.

Wathen: No, I think that's it.

Lapera: Great, awesome! If you all have any questions definitely write in to us, especially since Jordan and I talked about stocks that we would invest in. I would to remind our listeners that, as usual, people on the program may have interest in the stocks they talk about, and The Motley Fool may have recommendations for or against, so don't buy or sell stocks based solely on what you hear, especially today. Contact us at industryfocus@fool.com, or by tweeting us @MFIndustryFocus if you have any questions, or to let us know who you're favorite insurer is. Thanks very much for joining us, and I hope you all have a great week!

Gaby Lapera has no position in any stocks mentioned. Jordan Wathen has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Berkshire Hathaway and Markel. The Motley Fool recommends Progressive and Safety Insurance 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.