There are many risks that investors wouldn't think of when it comes to insurance stocks. Recently, oil prices plunged, resulting in increasing losses for car insurance companies because drivers are taking advantage of low gas prices and driving more.
Join The Motley Fool's Gaby Lapera and Jordan Wathen as they discuss the hard to predict risks that affect companies like Berkshire Hathaway (BRK.A 0.10%)(BRK.B -0.03%) and Safety Insurance (SAFT 0.85%).
A transcript follows the video.
This podcast was recorded on April 4, 2016.
Gaby 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?
Jordan 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, 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 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, 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.
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?