The business of insurance seems simple, they buy risk from individuals. Let's say, you have a house and you want to protect it against the risk of a fire. Therefore, you buy an insurance policy to protect your house against a fire and pay a monthly or yearly premium. In case, your house catches a fire, the insurance company will pay for the repairs. It sounds like the most important part of the insurance business are these premiums. Actually, it is not. It is more important how they use these premiums.
Warren Buffett likes to call insurance premiums float and he uses float from Berkshire Hathaway $BRK.B insurance and reinsurance businesses such as Geico and Berkshire Hathaway Reinsurance to invest in other companies. That's how he is able to accumulate such a large amount of cash and buy 5% of a company as huge as Apple $AAPL in a couple of years. But today, we are not going to talk about Warren Buffett and Berkshire Hathaway but rather of an insurance company, The Travelers Companies $TRV , in which, he has been investing lately.
The Travelers Companies is one of the largest insurance companies in the US and is a component of the Dow Jones Industrial Average $DJ30 . 56% of the revenues of the Travelers Companies come from business insurance, that is insuring businesses against potential risks. 9% of revenues comes from bond and specialty insurance. This means that if you are an investor, it can be retail or institutional, and you want to insure your investments, you can buy a policy from $TRV . If you invest in corporate bonds, for example, and that business defaults on the bonds, you are eligible to compensations from Travelers Companies if you insured these bonds. Another insurance company which was highly involved in such businesses is AIG(American International Group) $AIG . During the 2008 financial crisis, they were insuring many junk bonds which were backed by mortgages and when the housing market crashed, these bonds defaulted and AIG couldn't pay for the "damage" and many companies including Lehman Brothers went bankrupt. As far as Travelers companies is concerned, they are pretty safe and that part of their business is the most profitable to them with a combined ratio of 70. The combined ratio is the best ratio to access insurance companies. It is calculated as follows, combined ratio = (expenses + incurred losses)/earned premiums. The lower this number, the better but usually it is around 100. For $TRV , the combined ratio is 96.9. The third and last business segment is Personal insurance which is 38% of total revenues. This is for automobile and home insurance.
Now, let's talk about the float of Travelers Companies. 10% of their revenues comes from these investments. They use their float to invest mainly in the bond market. They currently have 48% of their portfolio in municipal and state bonds, 46% in corporate bonds and the rest in government bonds. It is important to note the quality of these bonds. 97% of these bonds are investment graded, that is, high quality bonds. In comparison, investment bank giant Morgan Stanley $MS has only 36% of its investments which are investment graded. If we look at the current valuations of Travelers companies, it is undervalued. Although, bond yields are low with the low interest rates environments, they company has been growing at a great pace over the last years. This company is pretty safe and at the current price could do well even in a bad economy. Another great thing about $TRV is that they have exposure to the municipal and state bond market. I don't own any municipal or state bond, therefore, by investing in Travelers companies, I have exposure to these markets at a discount.
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