Buying insurance businesses has been key to Warren Buffett’s success. So could shares in Aviva (LSE:AV) – the UK’s largest insurance company – do the same for me?
Buffett has made no secret of the fact that he loves the way that insurance businesses work. Insurers have two separate ways of making money.
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The first is by underwriting. If I buy car insurance through Aviva, then I pay a premium and the company pays out if I have an accident or my car is stolen. The first way that an insurer can make money is by making sure that the amount that they pay out in claims is less than the amount that they bring in through collecting premiums.
In addition, insurance businesses can make money by investing. When I buy car insurance, the insurer collects a premium and then covers me for a certain amount of time. During that time, they can invest the premium that I’ve paid and make money that way.
The reason that Buffett loves insurance businesses is that it provides a float – a pot of money that can be invested, even though the company hasn’t earned that money until the insurance policy expires. The float generated by Berkshire Hathaway’s insurance businesses has allowed Buffett to buy other businesses, which in turn generate more cash.
So can Aviva shares do for me what Buffett’s insurance businesses have done for him? To start with, let’s have a look at Aviva’s underwriting.
The good news is that Aviva’s underwriting is consistently profitable. The best way to measure an insurance operation’s underwriting profitability is through its combined ratio.
The combined ratio states the amount that an insurance business pays out in claims plus expenses as a percentage of the premiums that it earns. A percentage below 100 indicates that the company’s underwriting is profitable.
Aviva’s combined ratio is currently 92.9%. Moreover, the company’s combined ratio has consistently been below 100% over the last decade, indicating to me that the underwriting at Aviva is going well.
The less good news is that Aviva’s investing operations don’t produce such spectacular results. Investment returns in 2021 were lower in both Aviva’s UK & Ireland operations and its Canada business.
In addition, investment returns account for substantially less of the company’s cash generation than underwriting profit. In other words, Aviva mostly makes its money from its underwriting activities, rather than its investments.
Warren Buffett has used his ownership of insurance businesses to get incredibly rich. But I don’t think that owning Aviva shares is likely to do the same for me.
At Berkshire Hathaway, the insurance operations provide access to cash that can be invested. The investment of that float provided by the insurance underwriting is what generates the returns.
At Aviva, the story is the other way around. The majority of the company’s profit comes from its underwriting activities.
In other words, Aviva doesn’t do what the insurance companies owned by Berkshire Hathaway do. That’s why I don’t think that owning shares in Aviva is likely to produce the same results for me that owning insurance companies produced for Warren Buffett.