The Greeks can give assurances that they will repay their debts once the current ones are forgiven, really they will. The EZ’s troika can give assurances that they will stand firm. And Putin can give assurances that there are no Russian troops in eastern Ukraine and all those mothers losing their sons are losing them to “training accidents” deep in Mother Russia. Assurances are a dime a dozen.

But insurance — that’s something that is real. Every now and then, the insurance industry is at the sweet spot of claims, premiums and interest rates. I believe we are at one of those times.

While we select very different ways to invest in this industry, I am indebted to my friend Bob Howard of Positive Patterns for pounding the table about insurers this month — and to Warren Buffett and his top lieutenant, Ajit Jain, for discussing the changing dynamics of the reinsurance industry a couple days ago. These viewpoints, and my certainty that financial services firms will benefit from rising interest rates, leads me to discuss the best ways to invest in this industry.

By the way, rates will rise in “anticipation” no matter when the Fed actually raises short-term rates, and financial firms will universally benefit. I should explain briefly why this last item is true. Insurance companies make their money in two ways. First, they are smart (or dumb) about the clients (risks) they accept. That is to say, if they’re good, they take in a lot more money in premiums than they pay out in claims. But probably the more important way they make money is through the float they get on the premiums paid before some of them be-
come claims. In this they are no different from the big banks and brokerage firms.

The reason online / discount brokerages can afford to give you $8 commissions is because they make more money on the spread between what they pay you to keep your cash / stocks with them and what they can loan those to what they pay you (usually as close to bupkus as possible) and what they can lend at is always good. But when rates rise, they do even better: they can still pay you close to bupkus but the rate they are charging for margin lending, etc., has increased, increasing their spread considerably.

It’s no different with the insurers. They have this pile of cash they get up front every premium period. They can then invest that pile in (primarily) stocks and bonds. They have to keep x amount in bonds, especially short term bonds, because that allows them to let their stock-pickers select great investments without having to sell them off when there are too many claims. The short term bonds are there to sell when they need claims cash. If they are only making 1% on the short bonds, they have to keep more in bonds in order to make enough to pay claims without eating the seed corn that is their stock portfolio.

But when rates rise, they get more income from their fixed income portfolio and can redeploy some of that to their more profitable equity investments. As rates rise, they need fewer bonds held to pay claims and can either pocket the extra interest or switch some additional funds to their equities portfolio.

There have been a number of legendary investors in the insurance business who ran their investing and float side so well that they increased the revenue, earnings and book value of their companies many orders of magnitude more effectively than their lesser counterparts. The best known in the public mind, of course, are the team of Warren Buffett and Charlie Munger (NYSE:BRK-A). By being such great stockpickers, these gentlemen earn more on what they invest (on your float, but placing the results in their pockets, not yours!) which means they have more regulatory capital and they can therefore write more insurance and get even more premium income to invest. In this business, size matters.

Mr. Buffett uses the analogy of his business model as creating a snowball that, as it rolls downhill, picks up more and more snow. This snowball grows and grows as “reserves” against which they can write ever more business ever more competitively or lend it to others (sometimes on amazingly favorable terms, as they did with their loans complete with stock kickers to Goldman Sachs (NYSE:GS) and General Electric (NYSE:GE) at the bottom of the financial mess that Goldman and GE helped create.)

The other side of the insurance business cannot be ignored, of course. Consistently take in more money in premium income than you pay out in claims and you will have a steadily increasing revenue stream. Even the best insurers can be quite parsimonious in how they decide to pay or not pay a claim — and what the repercussions might be after they do.

Case in point:

I think USAA is a pretty good company. I’ve been with them 44 years and they’ve made buckets of money off me in that time of many premiums paid and only a couple claims filed. I had a minor fender bender as I backed into a concrete abutment on private property. On any car made of real metal, the dent would have been dinged out for a couple hundred bucks but I dutifully reported it as my policy stipulates and said, “I’ll fix this myself.” The claims rep suggested I at least let the USAA adjuster look at it. He did. The bill was $1200 since the entire quarter-panel was one piece of fiberglass and had to be replaced for this one ding.

I still said I’d pay, with the question, “Won’t you just raise my rates if I let you pay?” I was told that was a different department but, given my stellar record all these years, it was “likely” they wouldn’t raise my rates.

You know where this is going by now, don’t you? They paid and I am now paying an additional $400 in premiums for three years. I can complain about it but, with no respite, I can fight ’em or join ’em. I aim to get my money back by at least the capital gains and dividends I plan to receive by investing at this sweet spot in the financial services cycle.

My bias is always to buy the best and, if not the biggest, then at least the top tier of big in most any industry: in the energy business XOM, RDS-B, TOT, CVX, BP; in tech AAPL, GOOGL, CSCO, IBM; etc.

Ordinarily, that’s particularly true in the insurance business. You want Big because the big boys have enough breadth and depth of policy-holders to enjoy a more consistent and profitable claims cycle. If you are smaller geographically or demographically than the competition, you may have too many New Yorkers or San Franciscans, too many 20-25 year olds or 60-65 year olds. The idea is to spread the risk among the most diverse group you can. This is of course the economic downfall of Obamacare, clearly understood by the insurance industry but ignored by its proponents: if you overload the system with more (in this case, elderly) potential claimants with huge claims than you have in premium income from those who make fewer claims, you must rob from Peter to pay Paul via subsidies in order to get the number of total policyholders up to a breakeven point.

No insurer would remain in business for a year if they ran their business solely by expecting a third party to willingly pay the premiums for their policy holders. That’s the difference between a business and our government. The latter has considerable experience at spending other people’s money whenever the administration in power begins to run short!

I said I normally go for big and efficient — but this time around I’m thinking differently. I believe there is more money to be made in the intermediate term by buying the second tier firms that are slightly less efficient. I anticipate a huge wave of consolidation in the business. I see great returns among the potential acquirees in this melee.

The SPDR Insurance ETF (NYSE:KIE) is an equal-weighted ETF so it didn’t jump as much on the news that ACE (NYSE:ACE) extended a takeover offer for Chubb (NYSE:CB) on July 1st. (Those ETFs with these two in their top 10 shot up, but there is no guarantee this deal will happen, so I am willing to wait to see if they settle back down.) KIE holdings in the aggregate have a PE of 12, well below the S&P 500; a Price/Book of just under 1.00; a Price/Sales of 1.08, and that all-important-in-this-industry annual Book Value growth of 7.71%. KIE holds 102 equal-weighted positions and has an expense ratio of just 0.35%.

With Chubb as its largest position, market-cap weighted Powershares KBW Property & Casualty Insurance ETF (NYSE:KBWP) did get a nice bump. But I like their portfolio enough to consider owning it if it settles back just a little. None of its top 10 holdings are reinsurers and, given the Buffett warning on reinsurance as becoming less and less attractive (he should know; that’s where he made some of his biggest returns over the years) I think this is a good thing. KBWP’s aggregate holdings have a combined PE of 12.2; a Price/Book of 1.15; a Price/Sales of 1.20, and Book Value growth of a very attractive 8.75%. With 99 positions, KBWP also has an expense ratio of 0.35%.

Finally, since I believe all financial services firms (banks, brokers, insurers, payment firms, etc.) will benefit from rising rates, I’ll recommend for your due diligence one more ETF that covers all these areas. The First Trust Financials AlphaDex ETF (NYSE:FXO) is equal-weighted but provides a much broader exposure to the entire financial services sector.

The aggregate PE here is higher, at 15.5, as are the P/Book at 1.42 and the P/Sales at 1.92. The Book Value growth is a respectable 7.15%, and you are getting much better diversification with FXO than the other 2 ETFs.

For a free trial of my friend Bob Howard's newsletter, send an email to positivepatterns@prodigy.net.