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147 Billion Reasons Why Warren Buffett Loves the Insurance Industry

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The legendary investor discussed that subject again in his annual letter to Berkshire Hathaway shareholders.

Warren Buffett just released his eagerly awaited annual letter to Berkshire Hathaway (BRK.A -0.96%)(BRK.B -0.98%) shareholders. Large numbers of investors read these missives each year, not just to see how the giant conglomerate has performed, but also for the nuggets of wisdom that Buffett imparts.

In this latest letter, the Oracle of Omaha reiterated his long love affair for insurance companies -- which are cash-generating machines. Here's what Buffett loves specifically about the industry, and some ways you can put his wisdom to work in your portfolio.

National Indemnity -- a cornerstone of Berkshire Hathaway's early success

Buffett's connection with insurers began 55 years ago, when he spent $8.6 million to acquire National Indemnity, a property and casualty insurance company based in Omaha, Nebraska. The most significant benefit of this purchase was the cash it generated, which Berkshire Hathaway could then put to work.

Insurance companies collect fees before providing their service -- paying insurance claims. Because they collect premiums up front, they will have a pile of cash -- their 'float' -- that is theirs to deploy until it is depleted by policyholders claims. As Buffett notes, it's 'money we hold and can invest but that does not belong to us.'

In his shareholder letter, Buffett talks about how Berkshire Hathaway is the leader in insurance float. It has three primary insurance subsidiaries -- Berkshire Hathaway Reinsurance, General Re, and GEICO. It also owns several smaller insurers, which include National Indemnity. Since purchasing National Indemnity, Berkshire Hathaway's float has grown from $19 million to more than $147 billion -- a compound annual growth rate of 18% over five decades. This is cash that the conglomerate can and does plow into long-term investments.

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Insurers are cash-generating machines

Insurance companies need to make sure they charge the right premiums based on accurately pricing the risks in each policy. However, unforeseen things can happen, and insurers can lose money. That's the nature of the business. But over the long run, well-run insurance companies are great businesses to invest in. That's because they constantly re-evaluate risks and adjust their premiums to ensure their profitability.

For example, insurers steadily get new feedback about the parts, materials and labor costs involved in making repairs, which allows them to adjust their premiums as needed when customers renew their policies.

Four insurers you can add to your portfolio today

As an individual investor, you can't replicate what the Oracle of Omaha has accomplished, but you can learn from his example and allocate some portion of your portfolio to insurance companies. The iShares U.S. Insurance ETF (IAK -0.28%) is one way to gain broad exposure to the industry. This fund's distributions have yielded 2.22% over the past year, and it has an expense ratio of 0.42%. However, if you want to build up your own cherry-picked portfolio of insurance industry stocks, consider these four big names.

Image source: Getty Images.

Progressive (PGR -0.80%) is best known for its car insurance policies. It was the first to use telematics -- observing customers' driving behavior through its Snapshot product to price their premiums. This is one reason the insurer has excelled at profitable underwriting. For 21 years straight, it has taken in more premiums than it paid out in claims and expenses -- which is one reason why it has beaten the S&P 500 with total returns of 2,270% (versus 395% for the index) during that time.  

Progressive doesn't pay much of a dividend, but if you're looking for income stocks, several other insurers have a history of annual payout hikes. Property and casualty insurer Cincinnati Financial (CINF -0.44%) pays a dividend that at current share prices yields 2.24%, and has raised that dividend for 62 straight years  -- making it a member of the exclusive Dividend Kings club. Meanwhile, Chubb (CB 0.19%) is a member of the still-prestigious  Dividend Aristocrats, after having increased its payout for 29 years straight. At current share prices, it yields 1.57%. Finally, Travelers (TRV 0.68%) has increased its dividend for 20 years straight and yields 2.10% based on current share prices. All these companies have one thing in common -- a decade of writing profitable insurance policies.

We can take away from Warren Buffett the lesson that insurance companies can be great investments. They bring steady cash flow and stability to your portfolio -- and that looks particularly appealing in light of the current market backdrop.

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