Understanding the Financial Sector: Insurance Companies

This is a follow-up to "Understanding the Financial Sector: Banks."

Many do not understand insurance companies and even more do not appreciate their benefits until forced to buy insurance or perhaps when they experience a loss and it is too late. (Consider the people who suffered great personal losses in the wake of natural disasters like Hurricane Katrina or man-made disasters like those on September 11, 2001.)

Due to the complexity and varied product lines within the insurance business, I find insurance companies to be less understood than other financial service companies. So this installment of The Finance Professor will now take a look at this industry group.

How Insurance Companies Make Money

Think of insurance companies as big casinos. The policyholder (the insured) places a bet that something will occur -- for a payment (the premium) - with the insurance company, in return for a larger payout from the insurance company that is giving greater odds that the event will not occur.

The insurance company believes that if it makes enough of these bets and receives enough premiums, then it will be able to pay off all of its insureds and have money left over (a profit). This is achieved though a complex set of mathematical formulas derived by specially trained mathematicians call actuaries. (When I was in high school, my father actually urged me to become an actuary.)

Back to the casino. Take a roulette table, as an example. There are 38 numbers on the "felt": 1 through 36 plus 0 and 00. If the roulette ball lands on any of those 38 numbers, you will win. However, the payoff is only 35 times your bet. But if you bet all 38 numbers, the casino would win. Why? In the long run, on average, the "house" usually wins and collects more that you would.

In simple terms, insurance companies earn money according to the following formula:

Profit (or Loss) Equals Premiums Plus Investment Income Less Losses Paid, Operational Costs and Taxes

Insurance companies not only make this actuarial expected return, but will also invest the premiums they receive over time to generate further profits. Historically, this money was invested in stocks, bonds and real estate. However, recently, companies such as AIG (AIG Quote) got caught trying to increase the yield on their returns by investing in the sub-prime mortgage markets and mortgage-backed securities .

In doing so, they assumed far greater risk than in the past and are now feeling the pain of the credit crisis as they take huge write-downs on their investment portfolios.

Types of Insurers

The structures of insurance companies can come in different variations.

First we have the concept of "reinsurers." Just like a casino lays offs its risks with its peers, insurance companies can sell off some of its excess risk to specialized insurance companies call reinsurers. The worst nightmare for reinsurance companies are catastrophic events like 9/11 or Katrina.

Another variation of insurance companies comes in the form of their ownership. Most insurance companies are now owned by shareholders and can be invested in on a public exchange .

The minority of insurance companies are owned by the policyholders. These are called mutual insurance companies. While you can't invest in these companies on a stock exchange, you can do so by buying a policy from the insurer. For example, I own several policies in Northwestern Mutual Life. I earn extra dividends in my policies and in the event that Northwest Mutual Life ever went public I would be entitled to shares (at a favorable price) or other monetary benefits of "demutualization."

So, What's the Investment Landscape Look Like?

Not all insurance companies provide all of the products outlined above. Some offer more than one, while others specialize in a single type like health insurance. With that in mind, I will try to best identify and classify the largest and most popular insurance-focused companies below:

Life: This type of insurance essentially provides a large payout in the event of the death of the insured.

Life insurance is probably the most stable sub-sector of the overall insurance business. The following companies have taken less risk in their investment portfolios than other insurance companies, as the life insurance business is far more stable and cost effective, and it has less exposure to the housing, mortgage and credit problems facing the broader financial services sector.

That's not to say that these companies are totally void of such risks, but they have the least exposure to them, if any. Companies to research include ING (ING Quote), AXA (AXA Quote), Prudential (PRU Quote), Manulife (MFC Quote), MetLife (MET Quote), China Life (LFC Quote), Sun Life (SLF Quote) and Genworth (GNW Quote).

Mutual Life Companies: Again, while you cannot invest in the stocks of these companies you can benefit from ownership as a policyholder, as I outlined above. In the event that these companies demutualize and go public, you may derive some monetary windfall..This windfall could be an upfront payment, shares in the company or rights to purchase shares at a discounted rate.

Some of the companies that I would look at are Northwestern Mutual, New York Life, Mass Mutual and Penn Mutual. Of course, having grown up watching "Wild Kingdom," I have to mention Mutual of Omaha.

The key to researching a mutual life insurance company is the track record of policyholder dividends and the company's credit rating .

Property, Casualty and Liability: These types of insurance cover the risks associated with damages to automobiles, houses, boats, buildings and other property, stemming from fire, theft, accidents or other insurable risks.

This are of insurance also covers liabilities for damages due to malfeasance of a professional, such as a doctor or attorney or the actions on the part of a corporation or its board members. Liability insurance may take other forms such as title insurance for a homeowner.

Risk management at these companies has been varied. On one hand, you have Berkshire Hathaway (BRK-A Quote), which did not delve into the mortgage-backed securities and related derivative markets, while American International Group (AIG Quote) has taken huge write-downs thanks to the risks they took in the credit markets.

This is certainly a "buyer beware" part of the insurance business, but if you do your research, then you can profit wisely.