The year was difficult for investors, with the S&P500 index down 15% since the start of the year. Despite the weakness of the market, one industry is holding up quite well: insurance. This year the SPDR S&P Insurance ETF (WHERE 0.49%) is up nearly 5% at a time when market volatility and rising interest rates have weighed on many other stocks.
Although insurance is not the most exciting industry, it is a necessary business that can be a great source of cash. This cash flow is one of the main reasons Warren Buffett enjoys owning insurance companies, which have been a mainstay of his success for 57 years at Berkshire Hathaway.
There are other reasons to love insurance stocks. These companies are a natural hedge against inflation and can perform well in higher interest rate environments. Let’s take a closer look at why insurers can make excellent investments.
Constant demand makes insurance companies cash flow machines
Insurance is always in high demand, in part due to laws requiring insurance on cars, homes or businesses. It also has a high demand as individuals and businesses protect themselves or their assets against unforeseen events. While paying monthly premiums isn’t fun, these companies help protect individuals and businesses from disasters that could otherwise wipe them out financially.
Insurers are also excellent cash generators. This is because their cash flow is reversed from your typical business. Insurers collect their costs in advance, in the form of premiums, even before rendering service. They provide their service only if and when a customer files a complaint. The time between collecting premiums and paying claims gives insurers something called “float,” or other people’s money they can hold and invest.
When an insurance policy ends without a claim, the company keeps that money and puts it to work in longer-term investments – and that’s a big reason why Berkshire Hathaway owns several insurance companies, including Berkshire Hathaway Reinsurance, General Re and GEICO.
Why insurers can adapt to inflationary pressures
Insurers can provide your portfolio with strong inflation coverage. Indeed, as claims data flows, insurers can see if costs are rising quickly and adjust their premiums fairly quickly.
For example, last year, progressive (RMP 0.95%) found that the frequency of accidents increased by 14%, while the cost of resolving these claims increased by 9%. This is largely due to the increase in used car prices, which rose 27% last year.
Progressive was able to react quickly by increasing its premiums charged while eliminating specific policies that were causing large losses. This year, Progressive’s net premiums written have increased by 10%, demonstrating the company’s ability to adjust to inflation.
Insurers welcome higher interest rates
Besides collecting premiums, insurers invest excess cash as another way to generate revenue. Over the past decade of extremely low interest rates, insurers have struggled to generate good returns on investment. While some invest aggressively in stocks, such as marcelothers are much more conservative and invest in government bonds and other safer instruments.
When interest rates rise, insurers can invest their cash in income that generates higher interest. For example, a holding company of Warren Buffett, Globe Life, recently reshaped its portfolio, selling off riskier assets while investing that cash in higher-quality, higher-yielding debt securities.
In the third quarter, Globe Life invested $431 million in higher quality securities, and the average return on its new investments was 5.56%. This is above his portfolio yield of 5.17% and the first time his average portfolio yield has risen since 2008. If interest rates stay higher for longer, it will be another a favorable wind for insurers in the future.
Worth the investment
Insurance companies posted strong returns in a year when many other industries were in the red. The industry has done a great job adjusting to inflation, and rising interest rates are another tailwind that should benefit these companies as we move forward. Although stocks in the industry have risen significantly this year, it’s still not too late to invest in insurers that can perform well no matter what the market does.
Courtney Carlsen holds positions in Progressive. The Motley Fool fills positions and recommends Berkshire Hathaway and Markel. The Motley Fool recommends Progressive and recommends the following options: Berkshire Hathaway $200 January 2023 Long Calls, Berkshire Hathaway January 2023 Short Calls $200, and Berkshire Hathaway January 2023 Short Calls $265. The Motley Fool has a disclosure policy.
#Market #forgotten #industry #Motley #Fool