5 June 2013

The Perfect Business

The perfect business. Is there such a thing at all?

Do you know of a business which might qualify as a perfect business?

Oil? FMCG? Trading?

No... these may be good businesses, but there is one which is much better.

And that business is.... Insurance.


insurance business
The Best Business to be in??

You might not subscribe to our views and say that an insurer has to pay 'Sum Assured' to everyone when they die. And it is right to assume that everyone does die. :-) You are right. But there is another thing which forms the basis of life insurnce industry. Everyone does not die together (unless and until there is an extinction-level natural calamity or something similar).

But why is it that we consider insurance to be a really good business?

Assuming that an insurance company has 1000 customers (In reality, an insurer like LIC has crores of customers). Now suppose that every year, each of the customer pays a premium of 10,000 rupees. Now these customer (generally) don't expect to recieve anything in return, till the time they are alive.

Now, if you think rationally, what insurance company is getting here is interest free loan from its customers!! Agreed that this money has to be returned when the customer dies. But as already said, everyone does not plan to die together. So most of the people will remain alive for most of their policy tenure. The insurance company keeps getting this money every year, for decades. In between, a few people might die here or there. The dependents of these people would be paid their dues and life would move on. But, most people prefer not to buy plain term insurances and go for seemingly more customer friendly policies like moneyback and endowment ones. But, if you do a simple back of the envelope calculation, you would understand that such customer friendly poloicies are only friendly for agents and insurance companies. These are the policies which effectively give returns between 4-6% in case you survive the policy tenure. But we will take this issue in another post.

So if we had to put it plainly, an insurance business keeps collecting premiums from its customers, who in return get a promise that their family would be taken care of in case they are not there. But insurance company uses this money to earn hadnsome returns (even if you consider 8.5%, it is handsome when compared to above mentioned 4-6%). Now, these premiums are interest free deposits which the company gets. Customers wont ask for it till the time they are alive. You just need to have some liquidity to pay of for few customer deaths. That anyways can be funded by new money being collected from new polcies. There is no need to liquidate the existing investments. Also, the insurance company has an enormous and ever-growing pool of funds which can be use for purchasing more money making assets.

Now tell us, which other business is so perfect? :-)

Very little capital expenditure. People hand you over their money. You dont have to pay interest on it. You can keep and invest that money for decades. When there is a need to return the money, new funds coming in continously, can be diverted to fulfill such requirements. No need to liquidate you older money-making assets. Perfect. :-)

And if you have had a little interest in Warren Buffett's life, you would know how he used this insurance business to become one of the richest person on earth. He once remarked -
“Berkshire Hathaway's insurance operations deliver costless capital that funds myriad other opportunities. This business produces 'float' – money that doesn't belong to us, but that we get to invest. The float comes into being because insurers get to collect premiums long before claims have to be paid. Its a liability without due dates attached to it."
Perfect. Isn't it?
Do you know of other such near-perfect businesses??



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7 comments:

  1. How to get a life insurance license?

    ReplyDelete
  2. It would be interesting if LIC is ever listed in the stock Market...

    ReplyDelete
  3. @Rahul
    You have got to have a lot of money dude ;)

    ReplyDelete
  4. Why did you leave out the part about the price of float, addition or subtraction to float due to not happening or happening of insured event, the initial period (2 to multiple year) of breaking even, strict discipline of underwriting business etc etc etc. If you are quoting Buffett then you must have read the part of Insurance business and why it is so damn hard to profit from it in "Snoball". Insurance business has been like airline industry for its Investors. On the face of it Insurance looks like a damn good business but when you get in the nitty gritty of it you start seeing all the entry barrier to success in Insurance business. Please tell about both sides of coin.

    ReplyDelete
  5. Banking is another business were you have tremendous FLOAT or use of free or low cost funds. As long as people keep money with banks (atleast min. balances and term deposits) they will always be flush with money. Moreover, for each service be it fund transfer, DD, debit cards, forex remittances, etc they charge a fee, and this has become a Fee income stream. If Float is not good, the Fee income serves as an alternate source of income. As long a the float or fee income pours in the bank has funds, which can further be lent or invested. When lending opportunities are less or risky the bank would invest it somewhere for better returns. If you think lending is risky there are several ways in which bank can give secure or collateralized loans. Take a simple case of a housing loan, where the loan is fully secured and collateralized and the bank also gets x% interest for long period such as 20 years.

    ReplyDelete
  6. Warren Buffett's words in 1977 letter

    "Insurance companies offer standardized policies which can be
    copied by anyone. Their only products are promises. It is not
    difficult to be licensed, and rates are an open book. There are
    no important advantages from trademarks, patents, location,
    corporate longevity, raw material sources, etc., and very little
    consumer differentiation to produce insulation from competition.
    It is commonplace, in corporate annual reports, to stress the
    difference that people make. Sometimes this is true and
    sometimes it isn’t. But there is no question that the nature of
    the insurance business magnifies the effect which individual
    managers have on company performance."

    ReplyDelete

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