Why I'm Rejecting All Insurance Stocks

I've noticed an interesting trend over the last several months within the Green Screens.

We are starting to get quite a few insurance stocks screening up!

As of last weekend's update, there are 3 insurance stocks on the "Hare" side of the screens, and a full 9 insurance names on the "Tortoise" side.

What gives?

We've see this phenomenon a few times before. About a year ago, the screen got littered with a ton of regional bank stocks for a few months. Oil & gas stocks started filling up the screen a few months later.

I'm immediately skeptical when a whole bunch of stocks from traditional, modestly growing industries all show up at once. It usually is because of external factors that more often that not are short-lived phenomenon. For example, the regional banks all showed up as a result of rising interest rates that provided a boon to existing loan returns - although in the medium term, we knew it would also gut originations in the future (it has - ALL of the regional banks except one quickly dropped out of the screens).

So what's going on with the insurance stocks? Let's start with a brief detour into how insurance companies make money, because it is a bit different than most businesses we look at.

The Insurance Business Model, In A Nutshell

Insurance companies make the bulk of their revenues through selling premiums - the payments you and I make to them every month for ongoing coverage. Looking at the largest insurer in our screens, auto insurance giant Progressive (PGR), close to 98% of its revenues come from premiums.

Of course, insurance companies only get to keep what they don't have to pay out in claims. Probably the most important figure in an insurer's report is the combined ratio. This is calculated by taking the amount of all claims and other expenses and dividing it by total earned premiums. A number over 100% means the company paid out more in claims than it earned in premiums. A number under 100% is the opposite - and the insurer gets to keep the excess premium.

In the latter case, the excess premiums are usually invested in safe instruments like short-term treasuries, money market funds, high grade bonds, or the bluest of blue chip stocks. Interest from these investments becomes part of future revenue.

Progressive is one of the better underwriting auto insurance firms in the U.S., with a 5-year combined ratio of around 90%. Compare that to State Farm's figure of over 120%!

This just means that Progressive has been able to ADD to its investment portfolio in that period, while State Farm has had to DRAW DOWN its investments to pay claims. Most of the remaining 2% of Progressive's revenue comes from investment income.

Why They Are Showing Up Now

Insurance is not a growth industry. Government mandates have basically required any home or auto owner to carry insurance for decades. Policy growth roughly tracks GDP. The space has low barriers to entry and competition is fierce. There's no particular reason that this many firms should be able to meet our growth screening criteria.

The insurance companies are screening right now because of one reason: the cost of premiums are skyrocketing. Auto insurance rates are up 17% in 2023. Home insurance costs have jumped over 20% each of the past 2 years!

Why is this happening? And - more to the point for investors - is it sustainable?

The answer to both are pretty simple. A combination of inflation and low supply have made cars (new and used) and homes extremely expensive over the past few years. Insurance costs are largely based on the value of the asset they cover, so naturally those rates rise as well. Repair costs have also skyrocketed as parts and labor have become much more expensive.

And, no - this isn't sustainable long-term. Which leads us to the...

Conclusion

A core tenant of Green Dot Stocks investing is that we want sustainable, organic growth - large markets that can generate high growth rates for years. What we DON'T want is growth that is driven by unpredictable, short-term, unsustainable factors.

What we have right now in insurance is clearly the latter. Inflation and supply disruptions are macroeconomic, prone to normal economic cycles, and completely outside of the individual companies control. They are also unlikely to be maintained for any long period of time. Currently, they are tailwinds to insurance firms' revenue growth. There WILL be a day - likely in the near future - where they turn to headwinds.

Given that, I'm striking all the insurance companies out of consideration from the Green Screens today. They are:

Arch Capital Group (ACGL)
Goosehead Insurance (GSHD)
F&G Annuities and Life (FG)
Kinsale Capital Group (KNSL)
Progressive (PGR)
Palomar Holdings (PLMR)
Everest Group (EG)
RenaissanceRe Holdings (RNR)
Ryan Specialty Holdings (RYAN)