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Property/casualty insurance provides enormous benefits to the U.S. economy by transferring financial risks that could otherwise impede profitable transactions and raise living costs.

Unfortunately, for investors, the value that property/casualty (PC) insurance products provide the U.S. economy rarely corresponds to large investment returns. Indeed, returns are often exceedingly poor. Net margins are often razor-thin, often less than 5 percent. Returns on capital are equally poor. The average PC insurance company earns a return on equity (ROE) of less than 9 percent, and over time, most insurers achieve ROEs that are half that earned by S&P 500 companies.

These poor results often make for poor long-term performance. Over the 10 years ending in 2003, PC insurers trailed the market, often significantly. However, there are a few diamonds in the rough—consistent performers that produce attractive returns over long periods. Studious investors, armed with the keys to identifying better performing insurers, can earn solid returns in this sector.

How Property/Casualty Insurers Make Money

When an insurer sells a policy, it accepts financial risk in exchange for a premium payment. By transferring many individual risks to a common pool, an insurer is able to create a diversified risk portfolio. Because most risks aren't realized (you don't crash your car every year), insurers expect to earn a small profit margin.

Insurers also enjoy a peculiar business advantage—premiums are received "well in advance of the firm's requirement to pay claims. This money is often referred to as float, and an insurer enjoys the use of this money between the time it receives a premium and the time it has to pay a claim. PC insurers exploit this by investing these premiums and keeping the money they make from the investments.

How much money they can make this way depends on market performance, the insurer's asset allocation, and how long the insurer holds premiums before making claim payments. Insurers writing long-tail insurance hold premiums longer and, hence, can invest more in equities. (The length of an insurance policy's tail refers to the time it takes for damages to become apparent. Short-tail policies are those "where damages incurred during the insured period become known quickly, such as a car accident, whereas long-tail policies cover damages that may not become apparent for many years, such as an asbestos injury.)

Let's investigate how the PC insurance business works on an income statement and balance sheet. Premium revenue (also known as earned premium) is used to fund claim payments (loss expense), sales commissions for insurance agents (commission expense), and operating expenses (OPEX). Insurers typically express each of these expenses as ratios to earned premiums. Claim ex­penses, for example, typically consume 75 percent of an insurer's net revenues.

Adding together these three ratios produces the combined ratio—an insurance company's key underwriting profit measure. A combined ratio under 100 indicates an underwriting profit. For example, a combined ratio of 95 means that the insurer paid out 95 percent of its premium revenue for losses. The 5 percent remaining is the underwriting profit. A combined ratio exceeding IOO indicates an underwriting loss. For example, an insurer with a combined ratio of 105 paid out 105 percent of its premium revenue to cover losses, meaning that it had an underwriting loss equal to 5 percent of revenues.

Companies with combined ratios exceeding 105 for more than a short time have a difficult time recouping their losses via investment earnings, and this type of poor underwriting track record suggests that an insurer's compet­itive position is unusually weak. Insurers unable to earn even the occasional underwriting profit will produce the industry's poorest returns and may be tempted to accept large investment risks to boost profitability.

Insurers also make money from investment income, which they often report as a ratio of premiums. Adding the investment ratio to the combined ratio yields the operating profit ratio. In many instances, investment income is a key profit determinant because it offsets underwriting losses.

On the balance sheet, the key asset for most insurers is investments. In addition to float, most insurers invest a large portion of their own retained earnings as well. The investments account reveals the size of an insurer's in­vestments relative to its asset base and details the asset allocation employed. As a starting point, look for insurers with no more than 30 percent invested in equities (unless the company is run by Warren Buffett).

Finally, unearned premiums represent premiums received but not yet considered revenue. This oddity reflects an accounting convention. When an insurer receives a premium, it is deemed to earn it gradually across the year. After all, if a customer cancels a policy, the insurer must refund that portion of the coverage not consumed. After six months, an annual auto policy would be JO percent earned, and half the premium would be considered revenue. Before this occurs, the premiums are held in the unearned premium account, and the insurer is free to invest them.

Nirvana for an insurer is being able to consistently earn underwriting profits on a large, growing customer base. In effect, this insurer "would be getting paid to profit from investing other people's money and could retain this float indefinitely (as long as it grows). Unfortunately, for investors, these sit­uations rarely occur.

Key Drivers for Property/Casualty Companies

Property/casualty insurers confront difficult economics. In most instances, pricing power is low or nonexistent, for two important reasons. Entry barriers are low, enabling competitors to quickly swoop in on profitable markets. And insurance products are often difficult to distinguish, except by price. Although insurers attempt to distinguish their products using tactics such as better customer service, bundling, and policy terms, these features are easily replicated by competitors.

Unpredictable Costs', The absence of pricing power exacerbates a more significant problem: An insurer's most important costs are mostly uncontrollable and unpredictable. Claims expense generally consumes more than 70 percent of an insurer's premiums. This encompasses cost items such as judicial awards, medical expenses, and repair parts over which an insurer has little or no control. These costs not only are difficult to control, but also are unpre­dictable and often grow faster than insurers are able to raise premium rates.

For example, social inflation is a particular challenge. This is the tendency of juries and judges to increase benefits and expand contract coverage, often well beyond the terms of the original insurance policy. This can make claims much larger than an insurance company could have anticipated. One study estimated that the average jury award increased 19 percent annually over the 1990s. 1 Insurers also face considerable expenses from growing insurance fraud rates. The estimated annual cost of insurance fraud is $80 billion. 1

Unpredictable cost inflation is especially troublesome for insurers because they must estimate their costs well before the costs are incurred. Insurers lack the pricing power to incorporate a margin of safety into their pricing, so variations in loss expenses can quickly wipe out profits and cause large reserving charges. Because there are few positive cost surprises, insurers are often at the whim of the forces outlined previously.

Insurers also face contamination. If one insurer prices too low—mistak­enly or otherwise—profits for all insurers can be wiped out as other industry players offer low prices in response to the perceived competitive threat. This is an especially acute problem for insurers who compete with mutual firms. (A mutual insurer is an insurance company owned solely by the people it insures, rather than by shareholders.) Mutual insurers, such as State Farm, are exceptionally dangerous competitors because they lack the profit motive of most other insurers, and they can compete on price and incur losses for long periods to build market share. For example, State Farm's enormous balance sheet— which can throw off plenty of investment income—could enable it to price below cost for many years, which would eliminate profits for listed insurers.

Cyclicality in the Insurance Business: Insurance is a mature business. We generally expect mature businesses to grow with GDP over the long term, but the insurance industry also exhibits considerable cyclicahty.

This cyclicality results from pricing decisions and investment returns. When market returns are high, such as in the late 1990s, insurers face less pressure to underwrite profitably because underwriting losses are easily offset by investment income. Consequently, premium rates decline over a period of time. This is referred to as 2. soft -,

'"The Legend of the Price-Gouging Insurer," Insurance Information Institute (November

2002) and Morningstar Analysis.

However, after many years of price decreases, insurers are often unpre­pared for a decrease in market returns or for severe losses from a large event like the terrorist attacks of September 11, 2001 . Because these losses cannot be offset by investment returns, premium rates must rise to restore profitability. At this point, prices have been too low for too long, so insurers must raise rates and reduce contract terms considerably to restore profitability. This is referred to as a hardmarket, and 100 percent price increases aren't uncommon.

Hard markets aren't sustained as long as soft markets, though. Once prof­itability is restored and investment market returns normalize, the stronger in­surers will start to lower prices again to attract customers and deter rivals, knowing they can once again start to offset losses with investment returns.

Regulation; Finally, insurers face considerable regulation. Insurance rates must often be approved on a state-by-state basis, meaning that insurers are at the mercy of the regulators in each state. In many instances, insurers are re­quired to insure less profitable customers without being able to charge them higher prices to compensate. Furthermore, in many states, insurers are re­quired to fund the losses of competitors who become insolvent.

Insurers are also highly susceptible to consumer lobbying, which can influence regulators to keep prices low or mandate price changes. A key example is California 's Proposition 103, which mandated an immediate 20 percent cut in insurance premium prices and caused the transfer of more than Si.2 billion from insurers to customers. 3 This was good for customers but bad for insurance investors.

Hallmarks of Success for Property/Casualty Insurance Companies

Economic moats are scarce in property/casualty insurance. The industry's dismal economics condemns most insurers to perpetually poor returns and ongoing price competition. However, the news isn't all bad. Intelligent strate­gies and management teams can create a narrow economic moat, thereby allowing for the opportunity of decent investment returns. Five qualities we recommend seeking in a PC insurer are:

The Foundation for Taxpayer and Consumer Rights, "Background on Insurance Reform—A Detailed Analysis of California Proposition 103." Excerpted from "Auto Insurance Crisis &: Reform," by Harvey Rosenfield, published Fall 1998 in University of Memphis Law Review .

•  Low-cost operator: In a commodity business where firms compete on price,
the lowest cost provider usually enjoys the highest profits. Insurers who
can minimize their costs are most likely to earn high returns, and insurers
who refuse to sell unprofitable insurance enjoy a special advantage in cost
containment. Two of our favorite insurers, Progressive and Berkshire
Hathaway subsidiary GEICO, employ this approach by marketing di-
rectly to consumers, avoiding sales commission expense, and underwrit­
ing strictly for profit. It's no surprise that their returns consistently lead
the industry.

•  Strategic acquirer: Profitable insurers who can continually acquire un-
derperforming insurers and return their operations to profitability can
often earn attractive returns with an above-average growth rate. Although
acquisition-driven growth can be a risky strategy, experienced manage­
ment teams can often play the insurance cycle to acquire companies at
bargain prices. White Mountains is a good example of a company that
has done this successfully.

•  Specialty insurer: Insurers who specialize in niche markets can often de­
velop relationships and underwriting expertise that can give them rea­
sonable returns. If the markets are relatively small and nonstrategic,
other insurers may not be attracted. Left to themselves, specialty insur­
ers have more leeway to set prices. Markel has made specialty insurance
pay by insuring niche markets such as summer camps, yachts, and
sports organizations.

4- A record of financial strength: Insurance is worthless if the Insurer won't survive a disaster to be able to pay the resultant claims. Insurance customers usually prefer insurers who possess the financial strength to survive a disaster (such as September 11, 2001 , or Hurricane Andrew) and still be able to pay claims. Berkshire Hathaway increasingly wins catastrophe reinsurance (insuring other insurers against large claims) business because the company is renowned for possessing the capital strength to be able to pay large claims on losses such as Florida hurricanes or an earthquake in California .

J. A rational management team with a significant portion of its personal wealth invested in the business: Poor underwriting can quickly destroy profits. Many management teams slash prices to bring in customers, but if prices are not high enough to cover losses, the company loses money. Management teams who are also large shareholders are more exposed to the potential pain that large underwriting losses can inflict, and teams like this usually set reasonable prices and produce better profits over the long term.

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