Announcer: 00:00 You’re tuned in to the Investing for Beginners podcast. Finally, step by step premium investment guidance for beginners led by Andrew Sather and Dave Ahern to decode industry jargon, silence crippling confusion and help you overcome emotions by looking at the numbers, your path to financial freedom starts now.
Dave: 00:36 All right folks, we’ll welcome to the Investing for Beginners podcast. This is episode 119, tonight, Andrew and I are going to talk a little bit about the companies that have helped Warren Buffet grow all of his wealth the most. And what we’re going to focus on today is, you guessed it, insurance companies who, who exciting. Fun. It is interesting, and it is fun. I promise you Andrew, and I always bring the fun. So this will be interesting, and we’ll come at this from a beginner’s aspects. So we’ll talk a little bit about what an insurance company is, what they do, how they make money. Maybe a little bit of accounting, not too much cause I don’t want to put you to sleep. And then we’ll also talk a little bit about some valuation metrics. So we’ll go ahead and start a little bit. Andrew, did you want to say hi?
Andrew: 01:24 I did want to say hi. I think this is a very interesting topic to me because, do you think about Warren Buffet, what makes him so great? He’s, he’s a cool people person, he’s probably a great manager, all of those things. But his biggest strength is his ability to allocate capital. And so in a lot of different businesses, you have CEOs who have to make those type of decisions with their capital. You know, we’ve talked about that before. It’s like, do I want to pay out a dividend? Do I want to buy back shares? I want to reinvest in the business in Buffett’s case. And the way that they structured Berkshire, they buy these businesses and then have the business buffets. So Buffett will buy like Geico. So I think we’ll talk about that a little bit. They’re an insurance company.
Andrew: 02:17 And so basically what Buffet and Munger do is they buy these businesses with good management, and they say, you guys take care of the business. You guys do what you do best, and then all you do is you give us the cash. And as, as the capital allocators of Berkshire Hathaway, they’re going to take the profits from each business that they own and then it’s their responsibility to invest that. And so obviously we see Buffett’s track record. We see how great he was at doing that. Buying stocks like coca-cola buying stocks, as you know, I’m blanking. Great, I’m blanking. But you know, See’s Candies and all these other businesses that they bought outright. And a lot of that was made possible because Berkshire is an insurance company. And so they have, the way an insurance company is structured, you have more capital available to allocate.
Andrew: 03:13 And so that’s, I think what makes, it’s been the underground secrets of Buffett’s success. Yeah, he’s a great stock picker. But the fact that he can take advantage of the way an insurance company is structured is something that’s not thought about as much and as just as big of a part of the key to his success as the fact that he’s a good stock picker. And so that’s why I think an episode like this is going to be so interesting because a, there can be a lot of opportunities if there are other kinds of like managements or insurance stocks were with people like buffet who are great at allocating capital. And Dave, you just recently posted one of the best guides I’ve ever seen on any investing topic, and that’s live on the blog now talking about what we are about to talk about more in-depth. So we’ll be excited to talk about that more. But it’s, it’s, it’s a very, very, very cool topic. An under underrepresented part of Buffett’s success as far as how the public perceives it. And something that I’m excited to hear because Dave’s guide is super fantastic. Helps you walkthrough as a beginner and not knowing anything about insurance and how valuable that business structure is and starting to learn about it and implementing it in your investing strategy if it’s something you’re up for.
Dave: 04:48 Yeah. Thank you. Yeah, that’s, that was my goal when I started writing that post was to help people learn the INS and outs of insurance business kind of from a beginning aspect and show you that once you get past the gobbly goop of understanding what it is that the business does. How they make money and some of the accounting terms, it’s not that far off different from investing in a regular quote-unquote business.
Dave: 05:20 I think people get scared away from insurance companies because of all those things that you start looking at the data or the information that you’re presented in the financial reports and it’s overwhelming because you have no idea what it is. So you have to flip back and forth and, and it, you know, if you’re not in accounting, if you haven’t studied finance, it can be a little bit daunting. And insurance companies you know, are, can potentially be fantastic investments because of a, they pay great dividends, which Andrew and I are both huge fans of buying large. They’re fairly stable companies, and the majority of the companies that especially that are in the s and 500 have been around for generations. And so that’s something that’s also, you know, comforting when you’re thinking about trying to dip your toe into an area that you’re not as familiar with.
Dave: 06:08 So let’s talk a little bit about insurance companies. So why did I want to talk about insurance companies? Well, Andrew kind of prefaced all that with, you know, uncles, Warren and Charlie have been huge proponents of the insurance business, and that is really kind of what has built Berkshire Hathaway into what it is now. Berkshire has, honestly, as a holding company, they don’t do anything per se. They’re more of a holding company that owns a basket of businesses. And among them are insurance companies like Geico. And that has allowed buffet to generate huge sums of money based on how the insurance businesses work that he’s been able to use to invest that money to, as Andrew said, you know, allocate that capital to create more profits and wealth for himself as well as his shareholders. And one of the ways he does that is a term that he calls the float.
Dave: 07:03 And we’ll talk a little bit more about that here going on, but know that the float is the bread and butter of, of what buffet does. So let’s talk a little bit about insurance company. So how does an insurance company works? And the basis of, of an insurance company, is what they do is they exist to spread risk around a bunch, a bunch of different customers. A great way to think about an insurance company is they take in deposits or premiums, which is what we pay insurance. And then they allow you to withdraw the money when you experience a financial loss. The best example of that would be like homeowners insurance. That’s going to be the biggest policy that most of us are ever going to own. And there’s a lot of financial risks involved with buying a house.
Dave: 07:49 You know, it could be a fire, it could be wind, hurricanes, whatever it may be. And generally, the cost of that is about one to 2% of the value of your home. And so with insurance companies, when we were looking at premiums, this is the money that we’re paying in. And there are two basic kinds of insurance companies. There are life insurance companies and their, what they’re called, property and casualty companies. So a life insurance company, think of somebody like MetLife and we think of property and casualty. You can think of somebody like all state or farmers. So think about all those ads you see on TV. That’s kind of what we’re talking about here. And how does an insurance company determine what, how much we have to pay for our premiums? They determine that by the actual cost of the damages that they know and they can vary upon different types of insurances and they have different tables, actuarial tables that they use to determine what they think the rates are going to be.
Dave: 08:50 So a car insurance rate is going to be different than a life insurance rate because of the different risks that are involved and also at the periods that you’re going to be paying that money into the insurance company as well as them possibly having to pay it back to you. So if you think about a life insurance policy, when you establish one of those, generally that’s after you get married or you have a child or something that you want to set up, some insurance money that can help cover the cost. If something unfortunate happens and you pass away. And generally the way that works is you’re going to be paying in a premium for some time, and they’ll determine that premium based on your age, your race, your sex your health. And they have tables that will determine how long they think you’re going to live based on all those different factors.
Dave: 09:42 And then what they do is they’ll determine this is how much you’ll need to pay in to guarantee that you know, you can get a hundred thousand dollar life insurance policy. And generally when you pay that is if you’re younger if you have a 25 to 30 to 40-year-old life insurance policy, what will happen is you will, that won’t, money won’t get paid out for a long, long time. So the companies can continue to take in those premiums just like a deposit in a bank and then they can use the quote-unquote profit from that to invest in. That’s how they can generate some money. So the insurance company has also used to, they try to regulate fraud. You know, people filing false claims and all that stuff. They do that to try to help keep the premiums down. Contrary to popular belief, insurance companies are not evil.
Dave: 10:33 They are not out to get us. They are trying to help us. It just feels like sometimes that we’re paying in all this money and we don’t get anything for it. But insurance companies, they distributed the money out to us in kind of three different ways to help pay for other expenses. So part of the monthly premium that we pay in is helping to pay for repairs occurred by others. So if I pay in money than Andrew has to, you know, let’s say that Andrew and I are both paying insurance and I’m paying a premium, as well as Andrew, is. And let’s say they, Andrew gets in a car accident, well part of the money that I’m paying is going to help pay for the repairs of his car and vice versa. And that’s kind of how insurance companies work as they kind of try to spread the risk it realistic label, by the way, hopefully not two rails that can hopefully not too realistic.
Dave: 11:25 The other way that they distribute the money is to cover the expense of underwriting, underwriting fees, or costs that are involved in operating in the insurance business. And that money is used to pay for taxes, state fees, salaries, all that kind of fun stuff. And then the other way that they distribute the money that they take in is invested. So to risk companies will also use the money collected from the premiums for investments. And we’ll talk a little bit about more about that. But when you think about the, that insurance companies are investing in, it falls into two categories. One is more of a fixed income type of investments, I. E. Bonds, money market funds, things of that nature. They’re a bunch more stable will very well risk and generate kind of a stable income. And then the other aspect of that is going to be equity. So they’re going to be buying stocks. And that’s the big bread and butter of what Warren Buffet does. So that’s kind of maybe how insurance companies work. Andrew, do you have any questions on that? Did that feel like that was clear to everybody?
Andrew: 12:25 Yeah, I would think maybe for somebody who’s not super familiar with insurance, maybe younger doesn’t have to think about insurance too much. If I can make like a dummy summary from, from what you said, you know, if you have like a homeowners insurance, the premiums will probably be higher if you are in a hurricane zone rather than if you are just out in the middle of nowhere. So that’s like an example of different factors affecting your premiums. And then the reason that the flow is so lucrative is that like you take a regular business like eliminate stand, I have to pay for the lemons, I have to pay for the real estate for the stand. All of those things, you pay them right away. Whereas with an insurance company, they might take all this money and have very little expenses because they don’t have to pay it out.
Andrew: 13:21 For somebody who has like a house that catches on fire or a car accident, they might not pay that out for years. So the money’s just sitting there and so they, if they invest it then a year, they’re getting like free investments because of the way that the business works. They don’t have to pay for lemons today. They might pay a claim out five years from now, but inside of all those five years is the time where that money is invested and can grow and so it’s like another profit stream and on top of their regular profit stream from the difference between premiums and claims. Is that fair?
Dave: 14:03 Yeah. That’s perfect. That’s very fair. Okay. Yeah, that’s perfect. All right, so now that we’ve explained how insurance companies work a mine in much longer winded Andrews, much more in spices and we’ll move into the, how do insurance companies make money? The way insurance companies make money as they’re betting on risk. There, they’re betting on the fact that I am going to have a perfect driving record the entire time that I pay insurance premiums on my car and that they will never have to pay me for having to repair my vehicle because I got in an accident either of my fault or somebody else’s. And there that’s how they make money as they’re betting on that happening or betting on a life insurance policy that I buy a 25-year-old life insurance policy. When I’m 30 years old, I lived at 55, and they never have to pay me out because I lived to 55 than the way I have to get a new insurance policy at that point to cover, you know, the next 25 years.
Dave: 15:04 So that’s what they’re betting on. And the way that they make them money is they have kind of twin pillars. One would be underwriting, this is one income, and the other income is going to be investment income. So let’s talk a little bit about underwriting income. Underwriting income comes from underwriting revenues from the cash collected on insurance policy premiums. Then what they do is they take the money that’s paid out on claims and for operating the business. So let’s, let’s use a kind of, everybody’s heard of Aflac, you know, the cute little duck on the radio. That’s all I was going. Aflac, Aflac, we’ll say that Aflac earn 5 million in premiums last year and they had to pay out 4 million in terms that means on the underwriting side, Aflac earned a profit of $1 million. That’s pretty simple. We can talk about that a little bit more in-depth as I do in the blog post.
Dave: 16:02 So underwriting income is, that’s one aspect of how life insurance or life insurance or property casually companies will make their money. Now we think of property and casual casualty, I’m sorry. And life insurance companies, one makes more money on one pillar than the other. Generally, companies like property and casual, so I’ll state Aflac. Those kinds of companies generally make more of their income based on the underwriting income aspect of their business. Whereas wife insurance policy companies generally make more on their investment income. That’s where their bread and butter comes from. And so how does, how does the investing income work for an insurance company? The way it works is they take in their monthly premiums, and then they take those monies, and they invest them in the fund financial markets to try to increase their revenues. A large portion of the investment income is going to be based on the bond market, either in government or corporate bonds.
Dave: 17:05 And so actually insurance companies are some of the largest investors that bond markets. And they’re very sensitive to an insurance rate, interest rates they will also use a smaller portion of that insecurities, whereas generally companies like property and casualty, they will take their investment income and a larger portion of theirs will be insecurities. So there’ll be buying stocks like Coca Cola, apple, whatever. And that’s, that’s how they do that. And so that’s the main difference of how they generate income. And Andrew asked me a question of air before that that I would thought I would kind of touch on as well. He asked me why the insurance are larger investors in the bond market, and he was a little bit surprised by that. And the reason why that is is when you think about a life insurance policy. Generally, the policy that you buy is going to be of a longer duration, and you’re going to be paying in money for a longer period.
Dave: 18:08 And the turnaround on that are going to be much, much lower. But the payout that is associated with a life insurance policy is generally much, much higher than it would be on a car insurance policy. Or, you know, something along those lines. Because you know, when Andrew gets a fender bender, and he’s got to pay six $700 out of his, you know, his insurance policy, they have to pay that to the company to repair it. That’s a much lower amount than if I pass away. And you know, my family gets $100,000. So that’s, that’s a much bigger chunk of money. So the insurance companies, when they invest, they have to think about the liquidity needs of their business. So that means how much money do they have ready, readily available to pay out any claims that may be claimed. And life insurance claims are generally slower. They take longer, and the premiums are paid in much, much longer. So they can invest in the bond market, which has much longer durations of, you know, investments. Whereas buying a security is much more liquid. You can turn it around faster. You can sell your Apple stock much faster than you can sell a bond. And having the liquidity of being able to do that is more important for a property-casualty company than it is for life insurance policies, life insurance company.
Dave: 19:33 I hope that makes some sense. So did you have any thoughts on the income aspect of it so far? No, that’s great. Thank you for you know, the, it’s a key difference. I think if you’re going to be buying insurance stocks to know that life insurance versus property and casualty, they invest their money differently. I thought that was a good breakdown to explain why. All right, thank you. All right, so let’s talk a little bit about the next aspect of sort of investment philosophy, or I guess where the money comes from for a company in the life insurance or a property-casualty insurance company to invest. And that comes from the event insurance float. This is a term that Warren Buffet has made famous. He did not invent it, but he is credited with his ability to generate a lot of wealth for himself and his shareholders.
Dave: 20:25 And what is, what is insurance float? It’s an available reserve. It’s the amount of money that we have on hand whenever there are premiums that have not been paid out in claims. So insurers generally start investing. Any money that we pay is based on how much money they can use to pay to invest. And a float is the that is, and I guess the easiest way to think of it is the period between when we pay out a premium. And when we pay in whenever a claim is made against that money. So if I pay $100 on a premium and then five years later, I ha they have to pay me out $50. They have a hundred. They have a hundred dollars they can invest in, but at some point, they’re going to have to pay the $50 back to me. And the difference is the amount that they can keep to keep investing in a company.
Dave: 21:18 And that’s, that’s what afloat is. And that is something that again, Warren Buffet is used to his huge advantage with Geico and that has been a, you know, I really, really, really huge aspect of his success. Has been his realization of how afloat works, how we can invest in companies that have been able to generate him afloat, I. E buying Geico for example, and then turning around and using that to invest in Coca-Cola, American Express, wells Fargo. All these super huge, you know, incredibly profitable businesses that have generated, you know, billions and wealth for him as well as buying somebody like see’s candy. All that money allows him to go out and buy these companies in a hole because he still has the money that he gets from these floats that are invested, he can turn around and use those to pay out any claims that that may have to be paid.
Dave: 22:13 And that’s really how an insurance company works. Any thoughts on that comment? Nope, you’re doing good. Keep going. Okay. All right. Okay. So the next thing I wanted to talk about a little bit, I’m just going to touch on this briefly, is the accounting one oh one for insurance companies. So let’s talk a little bit about insurance companies. The two main statements that are going to look at with insurance companies are going to be the income statement and the balance sheet. The cash flow statement is important, but it’s not focused on as much as what we’re going to be doing. So I’ll talk about a few, I’ll give you a few tidbits of some of the different things that you would find in an income statement. One would be revenue, which is they’re going to be terms in here that are going to be very familiar with let’s say revenue.
Dave: 23:06 So those are premiums. It can be listed as premiums, net investment income, which is mostly interest. It could be listed as net investment gains or losses in other fees. Those, that’s kind of what that’s all going to be another line item would be claims and expenses. So those are going to be anything that is going to be paid out to us. So these, this way to think of claims and expenses is something like think of the cost of, of the business, whether it’s payroll, whether it has to buy paper and pencils or whether it has to buy plastics to make whatever it is that you make. So those are the cost of goods sold. So think of that way. And then obviously we have pre-tax income, which is very familiar, pretend cause income minus our tax rate.
Dave: 23:56 So that’s kind of how an income statement is set up. And it’s fairly similar to what you’re going to see when you look at any other business. But there are going to be other differences. So let’s talk a little brief about a balance sheet as well as the assets and the liabilities. So the assets side, two of the main components are going to be investments. So again, fixed income and equities, real estate and things of that nature. And then something like non investment assets is cash, premiums receivable, which is the same thing as accounts receivable. And there are other things on there. So those are on the asset side. Now let’s talk a little bit about the liability side. Liabilities. We’re going to have liabilities, but we’re going to have a claim and claim adjustment expenses. We’re going to have unearned premium reserves. You can have debt, so you’re also going to have shareholders equity.
Dave: 24:50 You’re going to have preferred stock, common stock. So a lot of the same kind of terminology. I’ll touch a little bit on unearned premium reserves. So this is really what an unearned premium reserve is. Each year you add a premium that you’ve written for and subtract out what you recognize as revenue so that this number always reflects what you were recognized as revenue in the future. So it is very similar to deferred revenue, which means you take in $100, you look at whatever revenue you get to keep of that. Let’s say that it’s 25%. So you get to keep $25 and you’re going to defer that money as income over the next maybe two or three years because you’re going to have to pay out $75 with that $100 in premiums in either premium that has to be paid out or other costs or expenses that are associated with that revenue.
Dave: 25:46 So those are just kind of briefly some of the terms. Again, there’s, there’s, there’s not a lot, but there are some terms in here that as you start to learn more more about how insurance companies work, they’ll give you kind of a review. So when you’re looking at financial statements, I e, the balance sheet, and the income statement, you’re not going, what is this? Hopefully this will help you understand a little bit about how they work. And the way I’ve found when I’m looking at these things is to try to look at it in comparable terms of other things that you may have worked with before. And hopefully, that can help people understand that,
Dave: 26:34 Okay. Thoughts on that? Yeah. Can we on, can we flesh out the unarmed premium reserves? So okay. To summarize
Andrew: 26:44 On the income statement real quick. It’s going to look like any other income statement. The difference is underwriting. The basically the cost of goods is there, like, like that part I think is straightforward because it’s like, all right, they actually paid this money out this year and then the rest of its kind of like you know, pre-tax income and then the income, which I wouldn’t worry about how that happens. That’s kind of like with any other stock. They, they kind of make the adjustments based on taxes and some other weird accounting stuff. But basically on an income statement, you’re just thinking about whether we bring in how much do we have to pay. And that was tangible. Like this is money we actually paid out and then we have profit. Yes. But then the balance sheets confusing because now you’re starting to talk about like claims that maybe we did payout versus claims we didn’t payout. And then the deferred part I think like hearing that and having read about it a little bit, that part’s still confusing to me. So can you like flesh that out? Because like how, like if you’re looking at the balance sheet and you see the like that, that term in there, it’s like, well is this a real thing that the company eventually has to pay back or not? Or how do we think about that?
Dave: 28:10 The, it thinks you’re going to think about it as money that you’re going to get paid, but it’s going to be farther down the road. I think the easiest way that I would think about it is, is it’s a receivable that maybe you have a two or three-year payment back period on it.
Andrew: 28:27 [Inaudible] That makes sense. On the liability side. Yes. So there, that’s like an estimation then. Yes. So yes, they have their balance sheet, basically has ally has a couple of liabilities or you know, whole section of it where they’re just estimating that based on their algorithms. But they might not necessarily, oh it is that that’s correct. But it’s fair. Yep. That’s fair. So based on that could be a, a source of like as an investor, maybe you can look in there and see, Whoa, here’s a stock where it’s maybe more favorable, less favorable, and kind of find like a good opportunity based on that alone. Yes,
Dave: 29:11 Sure. I think the easiest way to think about that is, is these are reserves that they have that they may or may not have to pay back, and they hold it on their balance sheet as a hedge against having to pay out any catastrophic loss. So think about some of the largest disasters you know, in the United States recently have been more associated with things like hurricanes. So think about Katrina when that came through there, that those were considered castoff glosses because the amount of money that the insurance companies would have to had to pay out to individuals and businesses would have been staggering. And I don’t have any numbers in front of me, but they, insurance companies will have to build in reserves that they may or may not have to payout. And so it’s a liability because it’s money that they have earned.
Dave: 30:07 They have, like in, in this particular case, it’s unearned. They haven’t earned the revenue yet, but they may, they don’t know if they will or they won’t. And so they have to hold a reserve in the unforeseen possibility that there’s some catastrophic loss, you know, whatever that could be. And so that’s the best way to think about it. Does that make sense? Yeah. Okay. Cool. Okay. Okay. Alright. Okay. So we’ve talked enough about accounting. Hopefully everybody’s still awake. We’re going to move on to some of the valuation metrics. Indra and I could geek out about the accounting stuff forever. Some of the things that we’re going to talk about with evaluation metrics are more familiar. These are things that we have talked about before or you have certainly seen in your exploration of investing in companies.
Dave: 31:02 I guess the four that we’re going to talk about our price to book we’re also going to talk about price to tangible book, Return on equity. And then the last one is something that’s called the combined ratio, and that is a ratio that is more geared towards the insurance business. So price to book and price to tangible book are very similar. The main difference, and correct me if I’m wrong, Andrew, but price to tangible book versus price to book the main differences. That tangible book is going to take out intangible things like patents, goodwill and things of that nature. Is that correct yet? It’s basically like we’re going to think about the cash, maybe like the real real estate that we own. Like physical assets. Yep, exactly. Such a company like Apple is going to have a harder time. You’re going to have a harder time looking at that because a great part of their value is tied up in intangibles.
Dave: 32:07 Whereas somebody like, I’m trying to think of Walmart has their, their, their assets are much more physical I guess the best way of putting it. So yeah, like the brand, the brand loyalty for apple, I can’t say, hey, you know, Apple’s brand is worth $1 trillion. Like Dave could think, oh well it’s not that powerful. Maybe it’s 800 million. Whereas like something more tangible is like, yeah, I can see this cash, it’s $100 billion, and we’re going to, we’re going to do it as such. Right. And one of the reasons why we use the price to book versus true price to tangible book value is you’re looking; you’re spending a lot of time looking at the book value of a financial business. Because that has a much more impact on how the business is generating money when they’re trying to grow the business. And so looking at the price of book and the price to tangible book are great ways for you to determine the financial strength of these businesses.
Dave: 33:17 It’s also great to use it to compare it to other insurance companies because you can see the price to book of MetLife versus State Farm, All State, Prudential, Progressive, whichever one you want to take a look at and it helps you see a little bit more apples to apples whereas you have, you’re looking at price to earnings. That could be all over the map because there’s no, it’s not going to be quite as similar, I guess is the best way of putting it. What are your thoughts? I think because the balance sheet for both banks and insurance companies tends to include things like deposits and premiums. I think that’s maybe why the financial industry like sees that more. Yeah, you’re right about that because there are liabilities that they could have to eventually pay out to people, so that’s why they’re going to base it on there.
Dave: 34:13 Yeah, that’s, that’s perfect. W, which is, you know, it’s funny because I’m in that world, they’re thinking like that there’s going to be wild swings and earnings based on maybe, you know, in a bank how many people are, are redeeming. If there’s a year where a bunch of people takes cash out or a, for an insurance company where there’s a big catastrophe, but then, you know, that doesn’t translate on other parts of Wall Street to other businesses. But those, that same phenomenon is still there. Like you can have other business models might have large swings in earnings just based on if they’re cyclical or you know, if there’s, do you take any industry and all of a sudden if there’s a bunch of competitors that enter. And they come in with better innovations, well that’s going to shake up the industry and maybe make earnings fluctuate too.
Dave: 35:02 So I, it’s something that I find comical that price-to-book isn’t used as, as much in other industries where that could be just as valuable. But you know, good to know that for insurance stocks, this is something that you should take a look at. Yeah, absolutely. The third ratio that you want to look at is return on equity. Return on equity is used in the insurance business to help indicate the profitability of a company. And generally you want to look at your goal is to find a company that’s around 10% or better because that’s what will help you show that they’re doing a good job and it’s, and it’s a well-run company. The last ratio that we want to talk about is the combined ratio. And now this is particular only to the insurance business.
Dave: 35:55 And I’ll give you the terminology of what it means, and we’ll talk a little bit about kind of why they do it. So a combined ratio, what it does is it measures the incurred losses and expenses as a percentage of earned premiums. And I’ll explain that here in just a few minutes, but our ratio above a hundred percent means that the insurance company is losing money where a ratio below 100% suggests an operating profit. So how do we calculate this? Well, we calculate it by adding the loss ratio. And the expense ratio. We calculate the loss ratio by dividing the incurred losses, including the loss adjustment expense by earned premiums. You can calculate the expense ratio by dividing the incurred underwriting expenses by the earned premiums. So let’s Kinda Duh, I’m going to do a completely separate blog post about how all that works. But basically what that means is you the, there are two ratios that are going to look at.
Dave: 36:56 You’re going to look at a loss ratio, and you’re going to look at an expense ratio. The loss ratio is going to try to indicate how much money you will have to pay out on premiums that you have earned. So if you pay into a hundred dollars in premiums and you expected that you’re going to have to pay out in a combination of claims and operating expenses, what you’re going to have to pay out is about 65%, for example. And then you divide that by the earned premiums again, which is the money that we as insurers are paying into the insurance company. And then the expense ratio as a generality is going to be based on that ratio of expenses, which would be the expenses involved in underwriting and the cost of the business. Divide that by the earned premiums, and again that’s divided by the amount of money that we take in from insurers.
Dave: 37:56 And then you just take those two and add them together. It’s not quite as simple as that. You can’t go to the income statement and the balance sheet and find incurred losses and expenses and add them together. There is a little more detailed to that, and I will have a blog post coming out about that in the next couple of weeks that we’ll dive into that much, much more in-depth. So by the time you hear this podcast, both of these articles will be up on the website, and you’ll be able to dive into that much, much more. But just kind of keep in mind that the combined ratio is something that we look at for insurance companies. You can Google it and woke up the combined ratio of any company, and it’ll tell you what it is. And that will tell you whether they’re operating at a profit or not.
Dave: 38:41 This is a very easy way for us to find out whether a company is doing a good job with their money or not. And it’s maybe more valuable than like a price to earnings or a return on equity because it is telling you more what’s happening on the operating standpoint rather than all the other factors that go into earnings. That is absolute. Yep. Yeah, that’s, yeah, that’s very fair. Now, one thing too to keep in mind with the combined ratio is that this is it is exclusively used for property and casualty insurance businesses. So somebody like progressive Allstate state farm, those companies are all property casually, and this is something that you can use to determine the profitability of the business. When you get into life insurance policy or life insurance companies, they’re they don’t have a combined ratio because the majority of their income is based more on investment income than it is on the premiums and the amount of money they can make on the underwriting side of the business.
Dave: 39:47 Life insurance companies are going to, you’re going to look at the success of the investment for foil in addition to the expense ratio. So part of the combined ratio applies to a life insurance company, but then, the other part of it is not. So that’s something that you want to keep in mind when you’re trying to look up a combined ratio for MetLife firs. They don’t calculate it that way. And then the last thing you would do to kind of value [inaudible] company is one last thing, sorry. On the combined ratio, Another reason, another reason why it’s important is that if it’s considering the operating part then it’s kind of, cause they’re like all these insurance companies are going to have different algorithms. And kind of systems to determine how, how high their premiums are going to be versus you know, the claims and everything.
Dave: 40:42 So is that like a good ratio to evaluate how, whether it’s an algorithm or management, whatever, basically how they’re establishing that versus like maybe there’s a, an insurance company who is being too aggressive. Or maybe yeah, I guess too aggressive is the right word where they’re like, they’re trying to attract customers, so they do lower premiums, but maybe they’re not collecting enough to when there are payouts to pay it out. So a good combined ratio would kind of show you a company like that. The, I guess the easiest comparison that I could make would be to look at a company like Walmart for example, that has very little profit market margins because their markup on their products is much, much lower than some of the competing businesses that they compete against. And so when you’re buying a grocery item from Walmart versus festival, which we have in my area, I could go to Walmart and buy cheerios at $3 a box, and I can go to festival and buy it for four 50 a box.
Dave: 41:53 Walmart may be paying less because they’re buying more, but the profit margin on a $3 is going to be much more narrow than it’s going to be on the box of Cheerios from festival, which means that Walmart has a much thinner margin for error. And when you’re looking at that, you’re looking at the profit ratio of what Walmart, how, how they’re making money, and how much profit they’re making. And so the impact on that business for their costs and expenses and things of that nature, it’s going to be much, much greater than it will be for festival because they have a, they have more money to play with, I guess is the best way of putting it. And when you look at insurance companies, Andrew’s example of a company that is being super aggressive on their premiums and charging a lot lower, they, their profit margin is going to be thinner.
Dave: 42:43 So the way that they’re going to be able to have to make money is twofold. One, they either try to lower their costs so that the margin increases or they’re going to have to get a lot more people to buy their services. And that’s the gamble you take when you try to do more aggressive portions on that. But one way that you could determine how this insurance company is doing that is trying to be a low-cost provider is to look at their combined ratio. And if, let’s say that their combined ratio is coming in at 99% and their competitor that you’re trying to compete against, which has higher prices, is coming in at, you know, let’s say 87% there may be more of an opportunity for growth and the other company than there is in the low-cost provider. Does that make sense? Yeah.
Dave: 43:38 That that helps give a good context on the combined ratio. I think I understand it now. I’ve been there once you gave that example, so, okay. All right. Yeah, you’re welcome. So I think that kind of illustrates again that once you start to understand some of these terminologies, you can relate it to businesses that your I are very familiar with. Whether it’s an auto industry, whether it’s an oil industry, whether it’s tack, you know, there’s a lot of similarities. You have to understand the terminology. It’s like learning a new language I guess is the best way of putting it. And it’s just like investing in banks. You have to work in the language before you can understand it and then once you understand the language it’s a lot easier to understand. And so I think that was the, I guess the whole point of what I was trying to do with the blog post and what Andrew and I wanted to talk about today with insurance companies.
Andrew: 44:32 I think I’m done unless you, one last question and then let you go. Okay. Okay. So based on everything you’ve said and kind of some of the popular metrics, are there any examples of what we touched on it briefly, but basically opportunities to find an undervalued company.
Andrew: 44:58 You know, this insurance company looks like it’s better to run. Maybe there’s something in the financials that kind of shows that hey, we have a good capital allocator here. Or Hey, the way that they’re, they’re arriving stuff like something about the business. It gives it a competitive advantage or something about, you know, you could go either there or something about the valuation. Makes me excited about the stock. Would, would you have any thoughts on, on how you could kind of think about one way or the other?
Dave: 45:36 Yeah, I think, I think the, well, the first thing that I’m going to look at when I’m looking at companies is I’m going to look at all the same metrics that I would look at when I’m screening for any company. So all the, all the metrics that Andrew talks about in his fantastic ebook, those are all metrics that you can use to screen for insurance companies just like any other company. And then once you find one, do you think based on some of those metrics is undervalued, you can start peeling the onion so to speak. And looking at just these four metrics that we talked about will help you uncover as an overview of, of a company that has done a good job of being profitable has generated good book value, a good return on equity and you know, being a generally a good place to look.
Dave: 46:31 And you know, two companies that I talk about in a blog post that you can read to get an idea of what, how I do it. And what I think of the metrics and the numbers that I look at is just a brief overview. Our state farm and that life. And, and MetLife was, is a life insurance company. They’re both really good companies, and they have a lot of great things going for them. I noticed when I was looking at MetLife that it continues to pop up and my insurance screener, and it seems to be more on the undervalued aspect of it. Not a huge amount of, but it looks like it would be a company that would have more opportunities to grow than state farm does at the moment. And it just looks like, to me, a company that I could be interested in investing in a based on their book value versus their current price, their tangible book value, the return on equity is, is good and their expense ratio is really good. And they do a fantastic job with their investment portfolio has been able to generate a lot of income for them as well.
Dave: 47:44 So, and they’ve been around for a long, long time. They’re very, very stable. They pay a great dividend. So it’s a big company, you know, Nice, nice big market cap that we like to see and all those kinds of things. But it’s not, you know, because the market is so overheated right now, there are, especially any of the insurance companies that are in the as and p 500 is pretty, fairly valued or maybe slightly under or slightly above. So there are not huge margins of safety in a lot of them that I looked at. So that’s, I guess my kind of hedging answer if you will.
Andrew: 48:22 Oh yeah, no, that’s great. I think I can’t understand enough. If you’re going to be buying insurance stocks trying to analyze them, you have to read the guide that you wrote. An insurance epistle, if you will. You can find that where we’re going to put that on the blog. So we’ll have that. If you ever go on the blog to look at the show notes, you know, this is going to be episode one 19. We’ll put the the the blog post right next to it. So if, if you’re listening to this around the time that, that the show notes went life, then you can go to the homepage of the blog, and you’ll see this post and most likely the next post that Dave’s going to rate. Those should be very close to, to the show notes page.
Andrew: 49:16 If you’re listening to this way in the future, you can go on the blog and search insurance stocks or insurance companies. And this guide should pop up. One of the, one of the tops of you go to the investing for beginners.com search insurance stocks, insurance companies. You’ll see the title of the very, very in-depth insurance epistle that Dave Rowe is called, the best way to invest in insurance stock insurance companies, how they analyze their stocks. And so that has everything we just talked about in the episode today with those two real-life examples that they’ve mentioned. And I love how you broke down the numbers. You include screenshots so people can see where in the financials you’re pulling this from. And then you’re doing the calculations. For both of those and showing an example of here’s a stock where, you know, I look into it and based on some of these metrics it looks like it’s about value, where you’d want to see it.
Andrew: 50:16 And then here’s another example and breaking down in depth some of those other metrics that we talked about in the more granular way. So that’s a huge, huge resource I people should check out if they’re interested in this at all. And I think it’s a fantastic opportunity. I mean I have one insurance company in mind on my watch list that I’ve been looking at for months already, and I’m something that I’m gonna use this guy, the one that when it comes time, and you know, compare, you know, how is this company doing against competitors? How is, how are some of these metrics looking and do I understand whether this is likely to be a good investment for me or not based on their business model, based on the financials and based on the way that we now understand the insurance industry?
Andrew: 51:02 I think it’s a huge potential. I don’t think it’s something that’s going away. And you know, just because Buffett’s made his fortune by, I don’t think it means it’s like saturated. I think we’re going to need insurance for the rest of the time that we have business. And so I think it can be a fantastic opportunity for somebody to find maybe a stock where there’s a young buffet there or find the next insurance company where they’re just, you know, they have the the, they’re so well run like Geico was that they are going to make great returns for shareholders moving forward. And so I do think that the guide you wrote, it’s really good. It’s in-depth. I thought this episode was super interesting and educational and I hope people take that next step and check it out more cause I think it can really help a lot of the people.
Dave: 51:51 Well, thank you. It was, it was a lot of fun to write and I, I enjoyed doing it too, and I wasn’t something every time I sit down to do this kind of stuff. So it’s fascinating, and you know, Kinda like you said, there’s, there wasn’t much out there that tried to help people understand how to invest in an insurance company and how they, how they do what they do and, and all, all that kind of stuff. And so I thought, well why don’t I write one myself? So I did. So hopefully people find some value in it, and hopefully this can help them learn some more about insurance companies and find some fantastic opportunities for them to generate some wealth. Just like a Warren Buffet as all right folks. Well that is going to wrap up our discussion for this evening. I hope you enjoyed Andrew and I’s chat about insurance companies, and I hope you learned something from this and you can find a great investment opportunity for you. If you have any questions on any of this, please, by all means, let us know, and we will be there to help you any way that we can. So without any further ado, I’m going to go ahead and sign this off. You guys have a great week. Invest with a margin of safety. Emphasis on safety, and we’ll talk to y’all next week.
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