Warren Buffett has been a huge fun of the insurance industry. He used his insurance business in Berkshire Hathaway to generate significant cash to invest in other businesses.
In fact, Berkshire Hathaway has recently invested $500 million into Insurance Australia Group Ltd (ASX: IAG) for a 3.7% stake. You can read here for more about that deal.
Berkshire Hathaway gets 20% of IAG's consolidated gross written premiums and will pay 20% of claims.
This shows that there was something extra in it for Berkshire Hathaway to invest, as well as the normal share ownership and dividends. Without these added perks is it worth it for normal investors to buy into the insurance industry?
The big 2 players
IAG and Suncorp Group Ltd (ASX: SUN) are two of Australia's biggest insurance companies. Suncorp has a market capitalisation of $15.9 billion and IAG's is $13.6 billion.
Each company has a list of recognisable brands; Suncorp owns brands like AAMI, GIO, Bingle, Apia, Shannons, Terri Scheer and Vero. IAG owns brands such as NRMA, CGU, SGIO, SGIC, Swann Insurance and WFI.
By having a number of different brands, they can appeal to a number of different insurance market segments with their specific brand, for example, Suncorp uses Terri Scheer to focus on landlord insurance.
Big dividends
The insurance sector is known for paying a big dividend yield – IAG and Suncorp are no different. IAG has a grossed up yield of 6.83% and Suncorp's grossed up yield is 7.84%.
Both yields are appealing in this market of low interest term deposits, Suncorp is the clear winner based just off the dividend.
Re-occurring revenue, volatile profit
Everyone insures their cars and homes. This provides a good regular income for the insurers.
However, insurer's profits can be quite volatile from one year to the next. Large storms can wreak havoc on cities – Brisbane and Sydney have endured big storms in recent years, which have caused big hits to Suncorp and IAG's profits.
Insurance is becoming more like a commodity
With so many players in the insurance market, premiums have to be competitive by competing on price.
Over time, this will narrow every insurer's margins – not only Suncorp and IAG, but QBE Insurance Group Ltd (ASX: QBE) and AMP Limited (ASX: AMP) among others.
Automated cars are widely expected to reduce premiums
We aren't too far away from automated cars being available for purchase. Most commentators are expecting automated cars to reduce insurance premiums fairly significantly.
It will take time for the effects to be fully realised, but it will make raising revenues with motor insurance a lot harder for insurers in future years.
Valuation
Suncorp is trading at 14.5x FY16's earnings and IAG is trading at 18.82x's FY16 earnings. Both are trading at a reasonable level to the market's P/E ratio of 17.1, though Suncorp is cheaper using this valuation method.
Is either worth a buy?
For investors looking for cheaper stocks with big yields, both these insurers are worth considering.
Out of the two, I prefer Suncorp because it has a much more diverse earnings base with its banking business. Suncorp also has a bigger yield.
With such big yields on offer, it's easy to be tempted. However, insurance companies are quite cyclical and don't consistently grow like some of the more dependable businesses on the ASX.
