I’ve been around insurance companies most of my professional life.

Of course, it helps that I think insurance is interesting. I mean, have you ever read a policy that indemnified and insured for causes of loss to satellites in space? Or policies covering jumbo jet aircraft? They’re simply amazing.

Now, one of the things I learned early on is that well-run insurance companies have a common denominator. It’s a simple concept: profitable insurers receive more in premiums than they pay out in claims. 

Seems easy, right?

#-ad_banner-#But in the real world, it isn’t as easy as it sounds. You see, insurance pricing is cyclical. Prices go up and down with the changing levels of supply and demand in the market.

This is especially true after hurricanes and other large loss events. These large losses force many insurers to flee the market until they can build up their loss reserves. But that leads customers to lose faith in an insurer, making any future return to the market more difficult.

That’s why it’s so important for insurers to underwrite their policies profitably every time. 

To do this, insurers look at two metrics to calculate profitability. The first is their expense ratio. This metric measures a company’s underwriting expenses like marketing and overhead. A well-run insurance company, like GEICO, typically spends 15% of its total premiums on overhead. This compares favorably to less efficient insurers like State Farm at 26% and Allstate (NYSE: ALL) at 29%.

But a company’s loss ratio is even more important. This measures the amount of claims against total premiums, and includes the costs associated with paying the claims themselves. Here, GEICO spends roughly 75% of its premiums on claims (which is about average). 

Adding the two ratios together, we get the combined ratio. The combined ratio tells us if the insurer is profitable. GEICO recently posted a combined ratio of 93.7, which is relatively strong (and profitable) when compared to its peers. At the same time, it shows that, with an operating profit of 6.3 cents for every premium dollar collected, insurance is not a high-margin business. 

But that doesn’t mean insurance can’t be more profitable…

Lancashire Holdings (LON: LRE) operates in Bermuda and London. The company focuses on direct, short-tail risks in five categories: property, energy, marine, aviation, and Lloyd’s.

The company sells coverages for specialty niche markets like war-related commercial aircraft liability, satellites, cruise ships, Gulf of Mexico oil rigs, terrorism risk, political risk, and retrocession (reinsurance for reinsurance companies). Their policies are short-tail policies, which mean there is very little time between a loss and the payment of that claim. This eliminates costly claims long after a policy expires. 

But what really sets Lancashire apart from other insurers is that they have perfected the art of underwriting profitability.

The table below illustrates Lancashire’s incredible ability to destroy their competition when underwriting insurance:

It takes discipline to achieve this level of underwriting profitability. There isn’t another comparable company on earth that can reproduce these results. The average profitability for Lancashire is an incredible 35.7% since 2009! Just imagine what Warren Buffet could do if GEICO had a margin of 35.7% with which to work.

So, how does Lancashire do it?

It does it by refusing to insure any business that’s not priced high enough to make a profit. You see, if a risk doesn’t produce a big enough return, the company simply refuses to insure the risk. Simply put, the company is exchanging fast growth for great underwriting profits. It’s the perfect compromise.

Float Counts…
Up to now, we’ve only looked at the company’s underwriting standards and practices. But like all insurers, Lancashire has the use of its premiums to invest (float) and increase its profits. In 2016, the company earned an investment return of 2.1% on its float.

The company invests its float rather conservatively, too. At the end of 2016, the company’s total investment portfolio was $1.5 billion. Of that, about 15% of that is in cash and other short-term securities. Roughly 35% is in corporate bonds and another 40% in government-backed securities. The balance consists of other minor holdings.

Dividends Count, Too
Lancashire earns a profit by being a great underwriter and conservative investor. But the company is investor-friendly, too. In fact, LRE handsomely rewards its investors with a 10.5% dividend yield.

But this isn’t a gimmick to attract income investors. The company has returned more than 240% of the capital raised since it began operations. The company’s total return since 2006 is more than 400%.

By every measure, Lancashire is making its shareholders wealthy. It can do the same for you, too.

How To Buy Shares
Shares are traded on the OTC market — but do NOT buy these shares, they are much too illiquid. Instead, buy shares on the London Stock Exchange where the stock trades more actively. 

Risks To Consider: The stock trades narrowly, even on the London exchange. This could make the stock hard to sell in an emergency or major market selloff. In addition, the company dominates small, niche markets. This helps them set profitable rates, but opens them to competition from other insurers looking to capitalize on high-margin underwriting.

Action To Take: Purchase shares in small amounts over time, taking advantage of periods of weakness. Because the stock is narrowly traded, large orders can and will cause spikes in the stock price, potentially giving an investor a higher cost basis than necessary. Use market orders to buy into a position to avoid attracting momentum investors, which will drive up the stock price. Mitigate your risk by limiting your exposure to LRE at no more than 2% of your portfolio. 

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