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American International Group Inc (AIG), Travelers Companies Inc (TRV): This Is The Best Business In The World

I often find myself pondering what is the best business in the world. When I begin to weigh all the various possibilities, I usually turn to Warren Buffett for some advice on this topic. We all know that in his teachings, the sage of Omaha emphasized the importance of a wide economic moat, consistent earnings power and strong capital efficiency.

Why insurance?

I believe we can find several clues why insurance is the most lucrative business in the world.

Reason #1

Nobody knows anything about it. Seriously, try and remember when was the last time an insurance company was mentioned in a cocktail party. You see, It’s always trendy to talk about the next biotech company or the next Google, but it’s never sexy to discuss terms like “float” or “underwriting profit”. In most cases, using those words in the midst of a cocktail party will likely get you thrown out of one.

Reason #2

American International Group Inc (NYSE:AIG)Insurance is the core holding of Buffett’s Berkshire Hathaway Inc. (NYSE:BRK-A). Berkshire is famous for its branded consumer names like Coca Cola and American Express, but it’s less known for its insurance division. Through a series of acquisitions over time (notably the purchase of Geico and Swiss- re), Berkshire Hathaway Inc. (NYSE:BRK-A) was able build a massive position in the insurance sector. While we’re at it, it’s also worth noting that Berkshire’s massive cash flow (currently at $43 billion) is mostly attributed to its insurance operations. That’s contrary to the common opinion that most of the cash is from dividend payouts from portfolio companies. Just to get a little feel for the numbers – Geico’s free cash flow (FCF) equals roughly 15% of total revenue. Coke and American Express, for instance, are only able to show FCF margin of 7% and 9%, respectively. When you follow the trail of money, it will always lead you to insurance.

Reason #3

It’s the only business in the world that has a negative cost of capital. Think about it for a minute. Almost each and every company in the world is a borrower to some extent. It then must make annual interest payments on its loan. In insurance, it’s quite the opposite. Insurance companies never need to borrow money. Each and every year, they receive their insurance premiums upfront (before paying for any claims) and then, they reinvest it and keep the profits to themselves. Yes, that’s correct. Not only do insurance companies receive their annual premiums, but they also get to keep the profits from these invested funds. All they have to do is to pay for any justified claim

How to dissect the sector?

Just as in any other sector, the insurance sector has a few excellent companies, and some poorly managed, money- losing companies. In order to distinguish between the two we must use a different toolbox than the one we know. Using the standard P/E, price/sales ratio or measuring ROE simply won’t do. That’s because all of the above can be easily manipulated by a highly -creative management. In order to take a closer look at the industry, I picked 3 names – all from the property and casualty insurance segment. I chose Travelers Companies Inc (NYSE:TRV), W.R. Berkley Corporation (NYSE:WRB) and American International Group Inc (NYSE:AIG). I will elaborate on them below.

Criteria #1:Float growth

This measures the how much the company has increased the money it collects from premiums. Since collecting float is its core business, this is actually equivalent to adding new customers or increasing the amount of business from each paying customer.

Criteria #2:Growth in Investments

This shows how successful a company really is in investing its float. Receiving a lot of premiums is one thing, but increasing that float with proper money management is a totally different skill.

Criteria #3:Underwriting discipline

It’s always easy to write foolish insurance policies and sacrifice your underwriting discipline for quick gains now. Of course, these quick gains will turn into severe pain later down the road when customers will claim to be compensated by their insurance company. Maintaining a smart and balanced approach is the core fundamental of any successful insurance company

Who’s great and who isn’t?

The Travelers Companies Inc (NYSE:TRV) and W.R Berkley couldn’t be more different. Whereas Travelers Companies Inc (NYSE:TRV) is a $32 billion company, trading at a P/E of 13.5x with a 2.2% div. yield, W.R Berkley is “only” a $6.5 billion company trading at a cheaper P/E of 12x with a div. yield of only  0.8%.. But these valuation metrics don’t matter so much when it comes to insurance. The common thread here is that both are excellent examples of how insurance companies should be run. The former has managed to grow its float and its investments by about 90% in the past 10 years. The later increased its float by “only” 50% in the same time period, but it more than compensated for it with a 180% growth in the value of its investments. That’s quite a remarkable figure. Both companies have consistently shown underwriting profitability. In other words, their profits exceeded what they had to pay for claims.

On the other side of the equation we have the notoriously famous American International Group Inc (NYSE:AIG). In a striking contrast to the examples above, American International Group Inc (NYSE:AIG) has managed to decrease its float by 20% over the past 10 years and lose 80% of its portfolio of investments. In addition, all of its underwriting profit was consumed by claims. Nothing was left.

The Foolish thinks insurance

Insurance companies should be your core holding. Insurance companies never have to borrow a dime, they keep all the investing profits to themselves and they grow their book value over the years. Don’t miss out on this undiscovered opportunity.

Shmulik Karpf has no position in any stocks mentioned. The Motley Fool recommends American International Group. The Motley Fool owns shares of American International Group and W.R. Berkley Corporation (NYSE:WRB) and has the following options:Long Jan 2014 $25 Calls on American International Group.

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