Looking for the Best Auto Insurer
Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
If risks are handled correctly, the insurance business can be one of the most attractive industries to invest in. Management needs to know how to allocate capital among different investment opportunities while at the same time maintaining a healthy liquidity balance to face potential claims. This is not always easy, but if the company is well run there are many opportunities for generating juicy returns for shareholders.
Perhaps for that reason Warren Buffett has invested a big proportion of Berkshire Hathaway´s funds (NYSE: BRK-A) (NYSE: BRK-B) in different insurance companies of various kinds through the years. Companies like National Indemnity, GEICO and General Reinsurance are some of Berkshire´s biggest holdings, and in his letter to shareholders of 2004 Buffett explains why he likes the insurance business so much.
The source of our insurance funds is “float,” which is money that doesn’t belong to us but that we temporarily hold. Most of our float arises because (1) premiums are paid upfront though the service we provide – insurance protection – is delivered over a period that usually covers a year and; (2) loss events that occur today do not always result in our immediately paying claims, because it sometimes takes many years for losses to be reported (asbestos losses would be an example), negotiated and settled.
Float is wonderful – if it doesn’t come at a high price. Its cost is determined by underwriting results, meaning how the expenses and losses we will ultimately pay compare with the premiums we have received. When an underwriting profit is achieved – as has been the case at Berkshire in about half of the 38 years we have been in the insurance business – float is better than free. In such years, we are actually paid for holding other people’s money
Basically, insurance companies collect the premiums before they have to make any payment, which gives them time to invest that float and generate returns from that money. The costs for that float can be very low, and in many cases insurers actually achieve an underwriting profit, which means there is no cost at all for holding and investing the money. Low cost money in the hands of a great investor like Buffett is clearly a very compelling idea.
However, Buffett also explains in the same letter that most insurance companies achieve lackluster returns, mostly because they have no competitive advantages in an industry which has been on a path towards commoditization over the years.
Insurers have generally earned poor returns for a simple reason: They sell a commodity-like product. Policy forms are standard, and the product is available from many suppliers, some of whom are mutual companies (“owned” by policyholders rather than stockholders) with profit goals that are limited.
Building a durable competitive advantage in insurance is not an easy task, but it can be very profitable if successfully achieved. GEICO is one notable holding of Berkshire Hathaway which has been able to build a solid position in auto insurance by focusing on being the low cost leader in its industry, and Progressive Corporation (NYSE: PGR) is a another very interesting candidate in the same business.
Progressive is smaller than GEICO, but it’s still one of the biggest companies in auto insurance in the United States. This big scale has allowed Progressive to sell policies at similar prices to competitors, while achieving a higher profit margin for the company.
Innovation has been another source of competitive advantage for Progressive. The firm was the first to offer online policy quotes and comparisons, 24 hours claims service and advanced factors in premium pricing such as consumer credit scores. Many competitors have caught up with these innovations already, but Progressive keeps working on new possibilities. For example Snapshot Discount which monitors an insured´s driving behavior through a wireless device, or Name Your Price which is a system used to customize a policy around a customer´s desired price point.
The company sells insurance both directly to consumers and via a network of independent agents. Progressive targets different kinds of clients through these two distribution channels, and even offers different prices and policies trying to find the solution which better fits each kind of client. Segmenting clients and their associated risks can be an integral factor for success in this business, and Progressive implements different techniques and innovations in order to get as much information as possible about its clients and translate that information into an efficient pricing and underwriting model.
When comparing profitability ratios in the sector, Progressive has achieved superior performance thanks to its competitive advantages. Progressive has a Return on Equity of 14.5%, while competitors like Allstate (NYSE: ALL) and Mercury (NYSE: MCY) have ROE ratios of 5.4% and 11% respectively. A good business strategy usually has positive effects on financial ratios, and that´s just what the numbers are showing.
Insurance can be one of the most attractive industries in terms of profitability when buying companies with a smart capital allocation policy and solid competitive advantages. Progressive Corporation certainly seems to be a company which is moving in the right direction, and should produce above average returns for its investors in the long term.
acardenal has no positions in the stocks mentioned above. The Motley Fool owns shares of Berkshire Hathaway. Motley Fool newsletter services recommend Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.
