Insurance is the best business in the world.

It’s not just one of the best, but the very best. After all, insurance is the only business in the world that routinely enjoys a positive cost of capital. Every other business on earth is required to pay for its capital.

[ad#Google Adsense 336×280-IA]And the cost of capital is always a consideration when starting or growing a business.

But not for insurance. A good insurance company gets all the capital it needs for free. Not only that, but it is actually paid to take it. Simply put, insurance is in a class of its own. But that doesn’t mean the industry isn’t without risks.

After all, insurance contracts are set up such that the insurer keeps the premiums even if no loss occurs. But it also means that losses could exceed the amount of a customer’s premiums.

And if too many large losses occur, an insurer could face a financial nightmare. That’s the reason insurers are so heavily regulated by governments around the world.

The Key To The Insurance Business

Thankfully, the best insurance companies mitigate these risks. They ensure the fees they charge for investing a customer’s capital exceed the risks they accept by extending insurance to them. By doing so, these companies make an underwriting profit (a loss ratio of less than one). More importantly, they maintain their underwriting discipline even during “soft” periods when premiums fall.

And it’s exactly how Warren Buffet evaluates insurance companies. He understands that the best insurers produce underwriting profits. By consistently doing so, an insurance company can grow its float and book value. In fact, history proves that companies with the best results in these metrics prove to be the world’s finest insurers.

The key here is to understand what we mean when describing “float.” Insurance float is the money insurance companies have collected in premiums, but have not yet paid in claims. As long as an insurer maintains its underwriting standards, the float becomes a permanent loan.

But unlike other business loans, float carries a negative interest rate. That is, insurers are paid to manage their customers’ capital. At the same time, the insurer keeps all the investment gains.

That’s why insurance is the perfect business.

It also helps explain why so many insurers advertise cavemen, geckos, and mayhem on TV. You see, these companies are on the hunt for people who will likely not need the insurance and who are willing to pay the insurer to hold their money.

All of which begs the central question: Why are so many investors turned off by investing in insurance companies?

Perhaps too many investors fail to understand the economics of the insurance business. Float, for example, is not disclosed in SEC filings. But whatever the reason, investors short-change their returns by ignoring solid insurance companies.

Take Assured Guaranty (NYSE: AGO) for instance…

Assured Guaranty is the leading insurer in the public finance industry. Their customers are issuers of public debt such as electric, water, and sewer utilities, and issuers of municipal bonds for infrastructure projects like airports, ports, tunnels, and toll bridges.

The company has produced strong profit margins, return on equity, and debt-to-equity ratios. But more importantly, rising interest rates and increased infrastructure spending under President Trump will dramatically increase the demand for this type of insurance.

That means AGO shares could soon experience much better stock performance. That’s because issuers and underwriters purchase insurance when spreads between credit and premiums widen. Additionally, the growth of infrastructure projects compels municipal issuers, especially the smaller ones, to use financial guaranties as a way of improving the marketability of their debt.

Assured Guaranty is positioned to write the bulk of this insurance as the dominant player in this industry. In the crucial U.S. public insurance market, Assured underwrites more than 56% of the business. And at roughly $3.8 trillion in size, that’s absolute domination. Two other firms insure the remaining 44% of the industry.

A Value Stock In A Hot Industry

But all the market domination is irrelevant if we can’t buy shares of the stock at a reasonable price. Fortunately, AGO still boasts a trailing P/E of just 6.2 while trading at 80% to its book value.

The chart below illustrates how AGO’s adjusted book value has grown at an 8% CAGR since 2004 — despite persistently low interest rates. This bodes well for the company as interest rates rise in the future.

Source: AGO Q4 2016 Investor Presentation

The Elephant In The Room

Cheap stocks are usually cheap for a reason. For AGO, that reason is Puerto Rico.

Assured Guaranty insured $4.8 billion of public financing deals for Puerto Rico. And all of it is below investment grade. So, there’s no doubt that AGO has exposure to Puerto Rico’s problems. But the risks of complete default are grossly overblown. This is backed up by Standard & Poor’s AA rating and Moody’s A2 rating of AGO. In both cases, the ratings are stable.

Risks to Consider: While the risks of a total default by Puerto Rico are unlikely, the possibility of a total default does exist. If this event were to materialize, the stock would struggle to make any new gains for 18 to 24 months. Higher future interest rates offset this potentiality to some degree.

Action to Take: Buy shares of AGO up to $42. Set your stop-loss at $30. Of course, mitigate your risk by committing no more than 1-2% of your portfolio to Assured Guaranty. The holding period is 3-5 years.

— Richard Robinson

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Source: Street Authority