I am currently participating in opening a Property ann Casualty insurer in Florida. I have a few things that I think are pretty interesting.
First, Banks are criticized for their use of reserves. But Insurance companies have the same exact problem! In a bank you may lend a certain amount to every dollar you have in reserves. As I understand it, it is currently at 10 dollars of loans for 1 dollar of reserves (am I right?). In an Insurance company you may issue $10 worth of premiums with $1 of reserves! As a value investor, I always knew that the most profitable businesses to buy into (as a general rule) are banks and insurance companies. In fact, as horrible as banks are according to the austrian school I would say that insurance companies may be just as horrible if not more so. For one main reason, banks are not allowed to invest in equity markets and insurance companies are. Insurance companies are allowed to invest with the premiums they recieve today in the market. They shove the money in the stock market and then pay out their claims keeping the difference. So they are, in effect, inflating the prices of assets with money that has the same quality as the money lent out by banks. But as the Florida insurance market can attest to, because of their rediculous leverage, whenever a disaster, which as an insurer they were formed to deal with, happens there are massive bankruptcies. In florida there are only a few companies left that issue P&C insurance. The goverment in Florida currently insure 80% of the market! I am including re-insurance in that figure... They do so through a FED inspired entity called Citizens insurance. Semi goverment, semi private, but all evil... They do not have enough money in reserves to cover even a minor disastor...when a hurricane hits Florida, property taxes are going to go through the roof.
Second, the goverment has destroyed rational calculations in the banking and insurance markets. I am on month four of opening this insurer and we have only spoken ONCE about the qualitative aspects of an insurance company. The rest of the time we are talking about, or with lawyers, filing this type of form or asking permission to charge this type of rate or trying to get our employees approved by the state. Unbelievable! And we have not even thought about what is best for customers. It is sad indeed... I have also started taking part in the opening of a specialty bank and it looks like the same exact show just with different actors. Really makes me sick...
So I just wanted to throw that out there and see what everyone has to say... basically the Austrian school has stated that any fractional lender is already bankrupt. Well would the same be said for an Insurance company? Is any fractional insurer also bankrupt?
Further, am I doing something wrong by taking part in these businesses? Does it help at all that I am actually obsessed with whats best for customers? Does it help any more that I have recommended more rational lending standars... none of that 10 to 1 leverage? This sounds like a question for Walter Block lol.
Thanks!
I don't think this is a valid comparison. Both use the term reserves, but in completely different contexts. The key difference between a bank and an insurance company is how they realize or account for their liabilities. For a bank, it has (or should at least) have a 100% value of a liability of any deposit it receives. Meaning, at any given point, the depositor may request the money back in form of a withdrawal. Now, the fact that it is legally allowed to operate without keeping an asset equal to that liability and they are allowed to loan out at 10x that deposit, they susceptible to a run when all depositors want all their money at the same time. To combat this, banks need to borrow to have funds available to meet this demand. Now, when an insurance company writes a policy for X dollars that covers Y amount of coverage for a potential loss, it does not need or should have to book Y as a full liability, because in reality, it is unlikely that the company will have to pay out Y on that policy. Now it is likely that thte company will have to pay a percentage of those types of losses so they will book a percentage of that as a liability and keep that amount as a reserve to make up for a future loss. The insurance company does not need to rely on some government to cover up any inherent bankruptness. Since this is all privately done, there are plenty of market mechanisms to keep the reserve at a "correct" level. There are private enterprises whose sole purpose is to evaluate the soundness of the insruance company and that it is reserving realistically. Any company that doesnt reserve correctly, gets rated lower and it makes it harder for them to sell policies. Plus, since this is not a perfect world there are times when after the fact reserves are inadequate. Asbestos liability is a prime example of this. In this case the companies had to recognize losses and put additional liabilities/reserves on their books in order to look better to the rating agencies. No artifical Fed entity is needed to keep them sound. Where governments fail the insurance companies is that they will essentially price fix certain areas or not allow companies to disciriminate among risks. They will say you can't charge more than X rate in a hurricane prone area for example, thus the ins companies pull out and then the government needs to come in an insure or provide the moral hazard to the people living or operating a business there. A completely different scenario than the Fed and banks.
Thank you very much for clearning up that mental blunder I had.
Just one thing though, most insurance companies run at a deficit. I forget the exact number but conservatively they run at a .103 combined ratio. Meaning they lose 3% every year. Thats an average of the pat 30 years I think...
A fractional reserve bank's insolvency is revealed when there is a run on the bank.
A "fractional insurer"'s insolvency is revealed when a sufficiently large disaster occurs.
I don't see a difference. Basically, it's all about what level of risk a customer is willing to accept.
First I think you meant $10 worth of coverage, not $10 worth of premiums.
Banks create new money when they lend in excess of their reserves.
Insurance companies aren't creating new money. They are just engaging in old fashioned gambling.
I do not know what the real numbers are. I think most major carriers have a combined under 1. If the entire industry has operated at a loss for 30 years, that is not a good sign for long term investing in insurance companies. But, if thats also true, its not as if they are being kept in business by govt bailout (unlike banks)
True, but so does every USD based business. In some sense ins companies may be at a disadvantage as losses may come in the future at inflated amounts, higher than what they anticipated. In fact, insurance companies have to offer coverage like "inflation guard" to protect covered asset limits against inflation.
I see what you are saying. It would depend on the policy type though. Some policies have caps.<P>
It's not every USD based business that benefits from inflation though. There are two main categories of beneficiaries. Early recipients of the new money who get it and spend it before prices go up; and debtors who get to pay back their debt with money that is worth less than when they took out their loans.
And of course the biggest debtor is always Uncle Sam.
Does anyone know of studies of how free market insurance agencies work versus those trapped in the current situation (regarding profitability, efficiency etc.)?
johndolce:I do not know what the real numbers are. I think most major carriers have a combined under 1. If the entire industry has operated at a loss for 30 years, that is not a good sign for long term investing in insurance companies. But, if thats also true, its not as if they are being kept in business by govt bailout (unlike banks)
I don't know where you get the idea insurance companies are unprofitable, even with capped profits they are still making lots of money. They took a hit because of the downturn in the stock market a few years back and some major claims but they still managed to make record profits in '05 -- last year looked.
If they really were losing money every year they would be out of business...
Anonymous Coward: johndolce: I do not know what the real numbers are. I think most major carriers have a combined under 1. If the entire industry has operated at a loss for 30 years, that is not a good sign for long term investing in insurance companies. But, if thats also true, its not as if they are being kept in business by govt bailout (unlike banks) I don't know where you get the idea insurance companies are unprofitable, even with capped profits they are still making lots of money. They took a hit because of the downturn in the stock market a few years back and some major claims but they still managed to make record profits in '05 -- last year looked. If they really were losing money every year they would be out of business...
johndolce: I do not know what the real numbers are. I think most major carriers have a combined under 1. If the entire industry has operated at a loss for 30 years, that is not a good sign for long term investing in insurance companies. But, if thats also true, its not as if they are being kept in business by govt bailout (unlike banks)
There are two types of profit for insurers. There is underwriting profit (profit made from paying out less in claims than you got paid in premiums) and there is investment income (money you made while you were holding the policy awaiting a claim). The insurance industry runs at an underwriting loss almost every year, on average. But the insurance business is a fantastic business because of the investment side. If your combined ratio is .103 and so basically you are paying out 3% more than you take in from premiums every year...but you invest that money at 6 or 7% returns. You keep the 4% difference.
Insurance companies go into business because of the low cost of capital that they use to invest!!!
Thats what I was talking about above. Further, about the "goverment doesn't bail out insurers". Almost every state has a reinsurance fund. The reinusrance fund is NOT ALLOWED to say no to business at any point in time. So if there is a disaster the insurance company can turn around and buy reinsurance for that disaster at an absurdly low cost. Removing its liabilities and passing them onto the backs of taxpayers.
This sounds very very similar to the FED discount window. Big difference is that its done by the state but the federal goverment is already trying to set up a national insurance catastrophe fund. Also, I would argue that the private market forces aren't even allowed to work in the insurance industry. Why? Because you have to ask permission to the goverment before you set your prices, and they usually say no to price increases. In a business where your price is supposed to reflect your risk it is very dangerous to not allow the market to do as it pleases as it trys to evaluate this intangible.
The reason those insurers went out of business in Florida and also in Louisiana is because they were not allowed to charge enough for the risk they were taking on! So this system is planning itself for dependancy on state funds and taxpayers backs. I don't know....sounds like a bankrupt system to me...
This has been a lot of fun, but up until now I am still on the "Insurance companies and banks are both bankrupt fractional companies" side. Biggest difference is that there is no warmongering insurance federal institution. But that institution doesn't have to look EXACTLY like the FED to be part of the same demon...
Would anyone argue that insurers dont make zoning and other building regulations absurd in order to lower claims? The average home in Florida is a war bunker! I am just saying...insurance companies are going the way of banks...they are going to be fully dependant on goverment assistance in less than 30 years. And the best companies will be penalized by competitors that don't take their obligations seriously.
Ron Paul needs to be elected to start ripping leviathin to pieces.
<I>Insurance companies go into business because of the low cost of capital that they use to invest!!!</i>
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You lost me. How is the cost of capital lower if they are losing it on their underwriting business? And if their capital is all comming from their investments then how are they any different from any other type if investment firm?
DBratton: <I>Insurance companies go into business because of the low cost of capital that they use to invest!!!</i> <P> You lost me. How is the cost of capital lower if they are losing it on their underwriting business? And if their capital is all comming from their investments then how are they any different from any other type if investment firm?
Its a low cost of capital basically because a 3% loss from their reserves could be termed a 3% interest rate for the premiums they are using. So if an insurance company can have 10 dollars worth of underwritten risks (policies and their premiums) for every one dollar of reserves, they basically have a 90% "mortgage" on whatever equities (stocks) they buy for a 3% interest rate. Don't you wish you could get that on your house!? So basically its leverage to load up on stocks, bonds, and other assets. Yes it is true though that if you have an underwriting profit then you could make even more money. It would in effect be a "negative" cost of capital or what Warren Buffett calls "float". And as Mr. Buffett puts it, "Its float that makes the insurance business wonderful".
Further, yes they seem almost indestinguishable from highly leveraged investment firms. Hence, most of the best insurance companies are owned by great investors. Warren Buffett, Charlie Munger (when he ran Blue Stamps), Fairfax International, many reinsurers, and a bunch more. Thats exactly why I am getting into the business, because it is an amazing economic engine.
If you need any further clarification I could post some links up, lol too lazy to do it unless prompted.