Insurance company stocks have performed quite well over the past couple of years despite market volatility driven by macroeconomic issues, inflation, and tightening monetary policy. Insurance companies are well-positioned to take advantage of rising interest rates and can be good hedges against inflation.
Over the last three years, specialty insurer Markel (MKL -0.67%) has returned 59%, outpacing the S&P 500's 36% total return. It offers policies for niches that many others won't touch and boasts appealing profit margins. It also has a significant investment portfolio where it can take advantage of higher interest rates and perform well during bull markets -- a quality that has helped earn it the nickname "Baby Berkshire Hathaway." Here's what you need to know about the business.
Insurance products will always be in demand
Insurance stocks can make excellent investments -- just ask Berkshire Hathaway CEO Warren Buffett. Insurance businesses are resilient because their products "will never be obsolete, and sales volume will generally increase along with both economic growth and inflation," according to Buffett.
Markel is one of several insurance companies that Buffett's conglomerate has invested in, and for good reason. Markel writes insurance policies to cover risks that many other insurers won't touch. It focuses on hard-to-place risks that require specific knowledge in a market known as excess and surplus (E&S).
Standard policies covered by property and casualty (P&C) insurers include automotive, homeowners, and property insurance. P&C policies are pretty consistent across companies, and they're highly regulated by state regulators. As a result, P&C insurers compete largely on price and have lower margins. By contrast, E&S insurers compete based on expertise and tend to have higher margins.
Challenging market conditions benefit insurers like Markel
Insurance companies have faced challenging market conditions for several years. Rising numbers of weather-related natural disasters, high inflation, cybercrime, and other threats have all contributed to rising claims costs for insurers.
Insurance is a cyclical business that experiences periods of "soft" and "hard" market conditions. In a soft market, claims costs tend to be lower, but competition between companies is higher, raising customer premiums is more challenging, and insurers must take on higher-risk policies to grow. The opposite traits characterize a hard market. Competition is less fierce, companies can easily pass on rate increases to customers, and insurers can eliminate more risky policies and focus on the most profitable ones.
E&S insurers like Markel benefit more from hard market conditions because they can take on policies that traditional insurers pass on. Also, E&S insurers have more flexibility about increasing their prices and can concentrate on their most profitable policy areas to generate solid profit margins.
One crucial metric investors should consider when evaluating an insurance company is its combined ratio -- the sum of its claims payouts and other expenses, divided by the total premiums it collects. Industrywide, the average combined ratio is generally close to 100% -- the breakeven point on the bottom line. In 2022, according to S&P Global Market Intelligence, it was 102.6% for the U.S. P&C segment, so overall, those insurers lost money last year.
But the best insurers consistently come in with combined ratios below 100%. Over the past 10 years, Markel's combined ratio has been a solid 95%.
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Markel's significant investment portfolio
One headwind for Markel last year was its massive investment portfolio. The company has a $23 billion portfolio spread across short-term bonds, equities, and other investments. Over one-third of that portfolio is in stocks, including holdings in Berkshire Hathaway, Alphabet, Deere, Brookfield, and Home Depot.
Because a significant portion of its investments are in stocks, it has earned the "Baby Berkshire" moniker. But 2022's bear market in stocks weighed on the portfolio, resulting in a $1.6 billion loss on its income statement from its investments.
However, its investments benefit from positive market conditions, and through the second quarter of this year, it had $857 million in gains from its portfolio on its income statement. Not only that, but the company is well-positioned to take advantage of rising interest rates while taking little risk through Treasuries. In the first half of the year, its net investment income was up 74% year over year to $329 million.
Is Markel stock a buy?
Challenging market conditions due to rising claims costs and lingering effects of the recent high-inflation period continue to weigh on insurers. That puts pressure on profitability, especially for traditional P&C insurers. However, for specialty insurers like Markel, tough market conditions provide opportunities for more growth.
Markel's sizable investment portfolio also benefits it during bull markets. Since 1929, bull markets have on average lasted 3.5 times longer than bear markets. The company also benefits from higher interest rates, giving it resilience during different phases of the economic cycle.
Markel has done a solid job of underwriting profitable policies and navigating a complex macroeconomic environment, making the specialty insurer an excellent stock to add to your diversified portfolio today.
