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The risks and rewards to understand before investing in insurers

Many investors are attracted to companies like QBE Insurance Group Ltd (ASX: QBE) and Insurance Australia Group Ltd (ASX: IAG) for the perceived reliability of their earnings and income.

But how does insurance actually work?

What kind of risks are investors taking with these companies?

Let’s use a simplified motor vehicle insurance example. Insurers sell you the right to have your car repaired or replaced if you crash, in return for a cash payment (the ‘insurance premium’). However, insurance premiums of $1,000 per year , for example, won’t cover the costs of repairs if you crash your car every year.

This means the insurer must find a group of customers, estimate their likelihood of crashes and expected repair costs, and price the insurance policies in a way that lets them pay all expected claims, as well as make a profit for the business and shareholders.

With car insurance, or health insurance like that of Medibank Private Ltd (ASX: MPL), this is usually a straightforward process as these companies sell ‘short-tail’ insurance liabilities.

This means that most claims are incurred and paid quickly. If you buy car insurance, crash your car 3 months later and notify the company, they will usually pay the claim within 90 days. Additionally, in this example, the maximum risk is generally limited to a reasonable and knowable level – for example the cost of repairing or replacing 2-3 cars.

However, if you own shares in a company that provides ‘long-tail’ insurance, like CBL CORP FPO NZX (ASX: CBL) then the insurance business becomes fiendishly complex. CBL, for example, sells 10-year builders insurance against defects in buildings. Long-tail insurance can be a risky area for several reasons:

  • The total claims expense won’t be knowable for more than 10 years in CBL’s case, or longer if litigation is involved. This means it is hard to know for certain if the company is profitable before then.
  • With some types of long-tail insurance (natural disaster insurance, for example), there is no real limit on the claims expense.
  • The risk conditions of the business can change drastically in the long term. QBE Insurance was stung by this a few years ago with its Argentine workers’ liability insurance. Policies written at X time can become much more risky than was apparent at the time it was written.
  • Inflation can result in big changes in the cost of meeting insurance obligations. The cost of repairs and wages can rise significantly in a few years, resulting in higher claims costs and hurting profits if expenses were not correctly forecast.
  • Interest rates can result in huge shifts in the returns from investments, hurting a company’s ability to meet its future claims.

This sentence from a 2015 Fairfax media article about QBE neatly sums up the possible problems with long-tail liabilities:

“QBE, which in 2014 controlled about 6 per cent of the sector, had to reprice their policies on a monthly basis to keep up with raging inflation while lawsuits exploded across the sector relating to workers’ compensation cases.” (emphasis added)

An additional risk is that most household investors don’t have the means or the inclination to establish exactly what kinds of policies their insurers are writing. Insurance reports are turgid and difficult to fathom, and many investors bought shares in AIG at the height of the financial crisis, when it was selling credit-default swaps, insurance policies that cost it billions.

While this all sounds very negative, the plus side is that if insurers correctly price their risk – and most of them do a good job of this, over time and on average – they get to keep any cash that is not paid out as claims. This builds up into a warchest that itself becomes a significant contributor to earnings, via returns on bond investments. Owning insurers can be rewarding, as long as you understand what the company is insuring against and how it makes money.

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Motley Fool contributor Sean O'Neill owns shares of CBL Limited. The Motley Fool Australia owns shares of Insurance Australia Group Limited. 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. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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