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

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.