Investors who buy insurance companies with low long-term combined ratios should eventually be rewarded with superior investment returns. Just ask Warren Buffett.

An insurer's combined ratio measures the percentage of premiums an insurer has to pay out in claims and expenses. This is done simply by combining the expense and loss ratios. A combined ratio of 102% means that an insurer is underwriting at a loss -- for every $1 in premiums taken in, $1.02 in claims and expenses are paid out. Fortunately, insurers also earn investment income from their float, so an insurer can still earn a profit even with a combined ratio in excess of 100%.

Expense ratio
Calculated as underwriting expenses divided by net premiums earned, the expense ratio measures an insurer's efficiency. To attract customers, insurers have to advertise. They also must pay commissions to insurance agents and brokers, give their employees a salary, and pay taxes and other operational expenses. Every dollar paid in underwriting expense is a dollar that doesn't flow to the insurer's bottom line, so investors naturally should look for insurers that run a tight ship.

Some insurers have low expense ratios because of economies of scale -- they can leverage advertising spending and have well-known brand names that help attract customers. Other insurers employ direct-sales techniques to cut out the insurance agents and brokers. In the auto-insurance industry, GEICO, a unit of Berkshire Hathaway and Progressive (NYSE:PGR), has contributed to its own long-term success by having eliminated the middleman -- similar to how Dell's direct sales method gives it a pricing advantage over competitors by cutting out the retailing middlemen.

Loss ratio
The loss ratio, calculated as loss and loss adjustment expense divided by net premium earned, measures the percentage of premium paid out in claims and associate expenses. It is an indicator of an insurer's underwriting discipline and skill at mitigating risk.

The underwriting cycle
Because most insurance policies are commodities, insurers generally lack pricing power. In other words, most people don't care who writes their insurance policy as long as the price is cheap. Thus, insurance prices are a function of supply and demand. When times are good, insurers make underwriting profits, and loss ratios decrease. As a result of the smaller losses, some insurers, driven by short-term greed, increase capacity by writing more policies. This increase in supply results in decreasing prices. Eventually, the cycle turns, losses increase, and insurers who wrote a lot of policies at low prices are left holding the bag. This situation is extremely similar to the boom-bust cycle of the stock market.

Investors should therefore look for insurers that stay disciplined. When loss ratios are low and insurance prices are soft, the disciplined insurers cut back on premium growth, even if it means giving up short-term profits -- similar to how great value investors refused to jump on dot-com stocks, even if not investing made them look like idiots in the short term. The value investors had the last laugh. Similarly with insurance, the underwriting cycle turns, and undisciplined insurers will be saddled with large losses. Some will even go out of business. The resulting decrease in capacity means tantalizing profits for insurers who patiently waited for better pricing.

Invest with the best
Investors should generally stick to investing in low-cost and disciplined insurers. In 2005, Zenith's (NYSE:ZNT) combined ratio in workers' compensation insurance was 80.9%, a whopping 25.3 percentage points better than the industry's 106.2% combined average. Investors who bought shares in this disciplined insurer would've seen their shares nearly triple over the past four years. Some other disciplined insurers that investors might want to consider include Alleghany (NYSE:Y), Old Republic International (NYSE:ORI), Progressive, Markel (NYSE:MKL) and White Mountains (NYSE:WTM).

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Fool contributor Emil Lee is an analyst and a disciple of value investing. He owns shares of Dell and appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.

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