Smart Investor: why I like insurance companies

Insurers are unpopular with most people but there are good reasons why smart investors should view them more positively.

Insurance is underrated

To most people the insurance industry is of little interest. Many see it as a necessary evil, whether it takes the form of motor insurance, buildings insurance or travel insurance, it all comes down to one thing: price.

Forget levels of cover or intricate policy wording, or even where all the money goes. No, Joe Public only cares about getting a cheap deal on whichever ‘price comparison’ (or middleman to you and I) website is at the top of the search engine that day.

However, insurance is quite possibly the most underrated and impressive industry in existence. It has been around for as long as anyone can remember and will most certainly outlive us all. Moreover its participants stand to make vast sums of money from taking money and then, erm, giving some of it back.

For these reasons, the smart investor should take these insurance bods a little more seriously.

The super-bookies

The basic premise of insurance is to calculate risk and the best way to consider this is to think of how a bookie works. Insurers will look at someone wanting to take out a policy as a risk. They will then attempt to calculate this risk in the same way a bookie does; what are the odds of this person making a claim on the policy and forcing the insurer to pay out? However, in the case of insurers, this is done by a super-bookie called an actuary.

If the odds are quite low, for example a middle-aged female driver with an excellent claims history, then insurers will only ask for a relatively small sum of money. Similarly if a horse is likely to win, then a bookie will only offer to pay out a small percentage of the bet. It is the same principle.

So having calculated the risk of paying out and offered the most competitive quote, the insurer receives the premium. This is essentially an interest-free loan because insurers are unlikely to charge less than they would expect to payout. The money received is called the float and insurers are free to invest the float how they see fit, normally in stocks, bonds or whatever else takes their fancy.

The insurer then pays back some or all of the premiums received and pockets the returns made through investing the float in the interim.

Sounds like a breeze, and what makes it easier for insurers is that they have a number of tricks up their sleeve which are not available to the likes of Paddy Power and William Hill.

For starters, if the returns made on investing the float are inadequate then insurers can simply increase the price of premiums and make a bigger profit on the premiums themselves. Due to the fact that insurers normally all invest in a similar fashion, return on investments are normally broadly similar across the sector. In other words if one insurer experiences poor returns and needs to increase premiums, it is likely that it will be followed by others.

Barriers to entry

Furthermore, the insurance industry is an exceptionally difficult one to enter, mainly due to difficulties in gaining appropriate permissions but also because risk is based on probability. The more policies an insurer has, the more allowance there is for anomalous results without impacting on profitability. Therefore competition is limited to say the least, with insurers dreaming up different brands for the same company to give a more competitive look to the industry.