Insurance have been one of the favourite industries of Warren Buffett, it is not hard to see why. The industry basically sells a product that does not require any capital to manufacture or purchase. The idea is to sell you a “promise” of a possible future pay-out and it received a payment up front, called a premium. For the insurer, as long as it is able to calculate the odds of premium vs pay-out, it would be able to make a profit on its business. For example, for an automotive insurance, if the insurer knows that if it writes 100 policies, there is a chance that 10 of the policies will submit a claim. Furthermore, if the average claim is about $1,000, then the insurer can calculate back the breakeven price it needs to charge per customer.
100 x = 10 * $1000
Where “x” = price of policy
X = $100
Of course, in practice the insurance would need to add in the operational cost it would incur to obtain the business, but to simply the situation, the breakeven price for the insurer to charge is $100 per policy. Therefore, if the insurer priced its policy at $101 per policy, we know that it will make an average of $1 per policy that it written. As the company continue to write more businesses, it would have a stronger set of data to estimate a more accurate pricing policies. The $1 per policy is called the underwriting profit for the insurer.
On top of that, the insurer is able to earn profit on the float. For example, since the company received $100 from a policy, it is then able to invest that $100 to earn more profit before it needs to pay out the claim. If in this case, the insurer earns a 5% profit from the $100 by purchasing a bond with a 5% yield, its total profit for writing this one policy would be a total of $6: $1 (underwriting profit) + $5 (investment profit).
The insurer would be able to continue to earn the profits consistently as long as it maintain its underwriting discipline and is prudent in its investment. We saw that an insurer can face huge losses if it did not fulfil this two factors. American International Group Inc. (NYSE:AIG), AIG Inc, was nearly bankrupted when it mispriced the credit default swaps (CDS) it was selling, taking on a lot more risk than it first assumed.
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Insurance is a business of statistic and discipline. It is no difference to running a casino, as long as the house calculates the odds prudently and management does not fall into the gamblers’ mentality, an insurance company can be a wonderful business.
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All views and opinions articulated in the article were expressed in Stanley Lim’s personal capacity and does not in any way represent those of his employer and other related entities. Stanley Lim does not own any companies mentioned above