Editor's Note: In Friday Digests, Porter tries to teach important investing lessons. And while the office is closed for the holidays today, we will still share Porter's wisdom with you today. The October issue of Stansberry's Investment Advisory included a full explanation of how to invest in what he called the "best businesses in the world."
As Porter explains in the following excerpt from that issue… most individual investors avoid these stocks because they're difficult to understand. But Porter thinks it's one of the safest and best sectors in the market. And in today's Digest, he tries to help you understand why...
Why Your 'Safe' Money Ought to Be in Insurance Stocks...
Like many other professional investors, we believe insurance is the best business in the world.
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Few individual investors understand why this is so...
One of our overriding goals at Stansberry & Associates Investment Research is to give you the knowledge we'd want to have if our roles were reversed. When it comes to insurance and insurance stocks, we can only beg you to pay close attention. We believe if individuals would limit themselves to only investing in insurance companies – and no other sector – they would greatly increase their average annual returns. There's no other sector of the market where we believe that's true.
There's a simple reason for this, which everyone can understand, immediately. It's completely intuitive. But I'm pretty sure your broker has never explained it to you...
Insurance is the only business in the world that routinely enjoys a positive cost of capital. In every other business, companies must pay for capital. They borrow through loans. They raise equity (and most pay dividends). They pay depositors. Everywhere else you look, in every other sector, in every other type of business, the cost of capital is one of the primary business considerations.
But a well-run insurance company will routinely not only get all the capital it needs for free, it will actually be paid to accept it. We've seen Swiss banks offer negative interest rates on savings accounts before – but these are isolated and temporary examples. Insurance companies are all paid a fee to manage capital. All of them.
The best insurance companies make sure the fees they charge for capital are in excess of the risks they accept by extending insurance. These companies actually make a profit on their underwriting. They earn money by taking the capital of their customers. It's incredible. These firms compound their equity by simply opening their doors every morning. They don't have to do anything else. Nothing else in business is like it. As legendary investor Warren Buffett explained in his 2011 letter to Berkshire Hathaway shareholders...
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Insurers receive premiums upfront and pay claims later. In extreme cases, such as those arising from certain workers' compensation accidents, payments can stretch over decades. This collect-now, pay-later model leaves us holding large sums – money we call "float" – that will eventually go to others. |
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Meanwhile, we get to invest this float for Berkshire's benefit... If our premiums exceed the total of our expenses and eventual losses, we register an underwriting profit that adds to the investment income our float produces. When such a profit occurs, we enjoy the use of free money – and, better yet, get paid for holding it. |
The beauty of insurance is that you can get paid to use capital. That's a fantastic way to become very wealthy. And it's precisely how (along with several great stock picks) Buffett became the world's most successful investor. The downside of insurance is that there are few barriers to entry. There's no moat. Buffett warned about this in his 1977 shareholder letter...
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Insurance companies offer standardized policies, which can be copied by anyone. Their only products are promises. It is not difficult to be licensed, and rates are an open book. There are no important advantages from trademarks, patents, location, corporate longevity, raw material sources, etc., and very little consumer differentiation to produce insulation from competition. |
The basis of competition between insurance companies is underwriting. That is... to be successful, insurance companies must develop the ability to accurately forecast and price risk... and they must maintain their underwriting discipline even during "soft" periods in the insurance market when premiums fall.
Let us show you how this works in the real world by looking closely at one of Buffett's insurance companies, GEICO. The numbers in the example below are based on actual average GEICO customers and the company's results.
Let's say, back in 1999, you switched your auto insurance to GEICO. You and your spouse are average drivers, so you pay roughly $2,500 per year in car insurance premiums. In 2008 and 2012, you had accidents. (Sorry... your wife was texting.) And GEICO incurred $5,000 and $15,000 in claims, respectively.
This table summarizes your 13.5-year relationship with GEICO...
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How GEICO Profits on Underwriting |
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Premiums Paid |
$33,750 |
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Less: Admin Costs |
($6,075) |
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Less: 2008 Claim |
($5,000) |
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Less: 2012 Claim |
($15,000) |
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Underwriting Profit |
$7,675 |
Buffett and his Berkshire Hathaway shareholders made nearly $8,000 in underwriting profits off you. That is, you paid them $8,000 to hold on to (and use) your $33,750 in capital. Every other business in the world would have had to pay you interest to hold the capital... but you paid GEICO instead. That's because GEICO charged you enough of a premium to earn an underwriting profit.
That's the key to the insurance business.
Buffett, of course, has been far more successful with his insurance companies than most. Not only does Berkshire Hathaway earn underwriting profits, but Buffett also invests his customers' capital (the float) wisely. (The current size of Berkshire's insurance float is more than $70 billion.)
To understand insurance, you must understand what we mean when we say "float." Insurance float is the money insurance companies have collected in premiums, but have not yet spent on claims. As long as an insurance company has good underwriting and continues to grow, this money – the float – is essentially a permanent loan. But unlike any other kind of loan, it carries a negative interest rate. That is, good insurance companies get paid to manage their customers' capital. They also get to keep all the investment gains earned on that capital.
In 2006, for example, Buffett used Berkshire's insurance float to fund the acquisition of industrial behemoth Marmon Industries. Since that time, Marmon has contributed more than $3 billion to Berkshire Hathaway's pretax income. In 2011, Buffett used the float to buy the BNSF railroad, which contributes $4 billion-$5 billion a year to Berkshire Hathaway's pretax income.
Berkshire will continue to use its massive insurance float to buy companies. It will continue to keep these earnings streams (or pay them out as dividends to its shareholders). And the amazing thing is, not only did it get the money to make these acquisitions for free, it also makes an underwriting profit most of the time.
Now you understand why GEICO spends $1 billion per year putting lizards and cavemen on TV. It isn't looking for insurance customers... it's looking for free capital.
Insurance is undoubtedly a great business. On the other hand, few individual investors own insurance stocks. That's because it's hard to find people willing to talk about the true economics of the insurance business. "Float," for example, is not disclosed in SEC filings. The size of an insurance company's float is essential to understanding its value. Without that information, it's hard to know what the company is worth. But to calculate float, you have to know a fair amount about financial statements. You have to dig through the notes... It's time-consuming and tedious.
Even worse for outside, passive investors (individual holders of common stock, like us) are the accounting standards for insurance companies. As things stand today, it's easy for insurance companies to play games with their earnings. They're based essentially on management's estimates. After premiums are paid, insurance company managers and actuaries estimate what the eventual claims on the policies will be. The difference is what they declare to be "earned."
Of course, the actual losses might be a lot more than the estimates – and with certain insurance companies, they're almost guaranteed to be more. But since losses take years (or even decades) to emerge, it takes a long time for any aggressive accounting or actual fraud to become apparent.
This requires investors to have a great deal of trust in the managers of their insurance companies. In this way, insurance companies are more like mutual funds or hedge funds than operating companies. And unlike mutual funds, many of the assets insurance companies hold can only be valued by their managers. There's always a risk that the managers are lying... or doing dozens of legal things that inflate their track records.
These unique concerns make it difficult for investors to differentiate the bad insurance companies from the good ones, and the good companies from the great ones.
For this reason, it's not unusual for fantastic insurance companies to trade for cheap prices for extended periods. For example, two of our favorite insurance companies – Berkshire Hathaway and Markel – are trading at essentially the same levels as they were in April 2008.
In analyzing the insurance sector… Porter and his team compiled an extensive database on the major U.S.-based property and casualty insurance firms. They calculated the float and underwriting success of each. Based on that, they determined which were trading at significant discounts to their true value…
What they found surprised them… Right now, the top U.S. insurance companies are offering investors the best opportunity to buy their shares in a generation.
To learn more about Stansberry's Investment Advisory – and gain access to Porter's work on the insurance sector – click here.
New 52-week highs (as of 11/22/12): None. Markets were closed for Thanksgiving.
We hope everyone is enjoying the holiday. Please take a moment to send us a note… We always look forward to opening the mailbag when we know the drinks have been flowing. Write to us at feedback@stansberryresearch.com.
Regards,
Sean Goldsmith
New York, New York
November 23, 2012