[ Insurance Industry Basics - Premiums, Floats... ]
> Insurance Premiums
An insurance contract transfers risk from the customer (the insured) to the insurance company (the insurer). If, for example, an insured customer gets into a car accident, his insurance company ends up footing the bill. In return for taking on this risk, customers must pay the insurance company premiums.
Premiums for insurance companies are essentially equivalent to sales for retail companies. Insurance companies take in premiums from customers, from which they pay out losses and expenses. Written premiums refer to the amount of new business an insurance company "sells" each year. If an auto insurance company acquires 1,000 new customers in a year, with each contract requiring customers to pay $1,000 in premiums, then that insurance company's written premiums are $1 million (1,000 customers x $1,000 premiums per insurance contract).
Pretty simple, right? The total amount of premiums an insurer is entitled to receive from its customers over the life of their insurance contracts is the gross written premiums.
Net premiums
Risks come in many different shapes and sizes, and sometimes an insurance company doesn't want to take on certain risks, or it wants to transfer some of its risk to another insurer (known as reinsurance). The insurance company must pay reinsurance premiums to the reinsurer. These reinsurance costs must be subtracted from gross premiums, and the result equals net insurance premiums. Just as net sales are a better measure of a retail customer's business, net premiums are a more accurate measure of an insurance company's business.
Net premiums earned
Accrual-based accounting states that revenues and costs must be matched to the periods for which they are applicable. In other words, if a customer pays you today for a service to be rendered in a year, you cannot recognize that revenue (and the associated costs) until the service is performed. Likewise, because insurance contracts are often written for multiyear periods, the portion of the premium earned must be recognized on an accrual basis. For example, if a customer pays an insurer $10 million in premiums in order to insure its risk for 10 years, then every year it is earning a tenth of the total net premium written, so its yearly net premiums earned figure is $1 million.
Some real-world examples
Like any other type of company, the more business an insurer does, the better (assuming the business is profitable, of course). The companies that are able to generate a lot of premiums are generally more valuable. Some investors like to use price-to-sales ratios (market cap divided by sales) when judging retail companies. Likewise, it's worth taking a glance at the price-to-net-premiums-earned ratio in order to ascertain an insurance company's premium-generating ability. Keep in mind that insurers have other sources of revenue besides premiums, and the amount of premium that flows through to net income varies depending on the company.
Some of the top insurance companies are Progressive (NYSE: PGR), White Mountains (NYSE: WTM), Markel (NYSE: MKL), Cincinnati Financial (Nasdaq: CINF), and W.R. Berkley (NYSE: BER). These companies have price-to-net-premiums-earned ratios of 1.2, 1.7, 2.3, 2.5, and 1.5, respectively.
Lastly, like great value investors, great insurance companies do business only when risk-adjusted returns are favorable. In this manner, investors should look for insurance companies that grow net premiums earned when risk premiums are high (and customers are willing to pay up), which usually occurs after a catastrophe or an industry shake-out, and stay disciplined when risk premiums are low. This is the simple formula Warren Buffett has used to turn Berkshire Hathaway (NYSE: BRK-A), which owns GEICO and General Re, into the insurance juggernaut it is today.
> FloatsIn the movie Other People's Money, Danny DeVito said, "I love money more than the things it can buy ... but what I love more than money is other people's money." Warren Buffett loves other people's money, too. He built Berkshire Hathaway (NYSE: BRK-A)(NYSE: BRK-B) into one of the world's most valuable companies using it.
In the insurance industry, "other people's money" is known as float. In a shareholder letter, Buffett once said that float "has cost us nothing, and in fact has made us money. Therein lies an accounting irony: Though our float is shown on our balance sheet as a liability, it has had a value to Berkshire greater than an equal amount of net worth would have had." Translation: Float is good.
When you pay the premium on your automobile insurance, those premiums help cover operating expenses and go toward paying automobile claims from customers who get into accidents. The great thing about premiums is that the insurer collects the money up front but doesn't have to pay out claims until later down the road. In the meantime, the company "floats" these unpaid premiums. This float is invested in stocks, bonds, and other securities, and the insurance company pockets the profit.
Float is such a valuable form of capital because not only does the insurance company get to keep the investment income, but also the company's cost of capital is often low or even positive.
Calculating float
Here's how float is calculated. Ready for this?
unpaid losses
+ loss adjustment expense
+ unearned premium
+ other policyholder liabilities
- premium balance receivable
- loss recoverable from reinsurance ceded
- deferred policy acquisition costs
- deferred charges on reinsurance
- related deferred income tax
This sounds like a handful, but we can simplify it to say that float is simply cash received from customers that hasn't been paid out yet for claims and expenses.
The more float a company has, the more investment income it can generate. That's a good thing. From 1967 to until 2005, Berkshire's float increased from $20 million to $49 billion. Using Buffett's investing genius, this float has created tremendous value for Berkshire shareholders.
Short tail vs. long tail
The length of time between receiving a premium and paying out claims affects how profitable float can be. For example, Progressive (NYSE: PGR) and Mercury General (NYSE: MCY) write automobile insurance that is generally paid out quickly. If an insured driver gets in an accident, then the claim for vehicle damage and bodily injury is paid out soon. This is known as short-tail insurance. On the other hand, insurance companies used their float for as long as asbestos liabilities remained in litigation -- for years and years. In general, such long-tail insurance is preferable for the company (although not for those suffering from mesothelioma), because the float can be reinvested over longer periods of time.
However, as always, doing business makes sense only when the business is profitable. To judge an insurance company's cost of float, one has to look at the company's loss and expense ratios.
Source: Motley Fool
Labels: Stock Investing Basics
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