It’s no secret that many great fortunes have been built by smart insurance operators.
A good example is Berkshire Hathaway, which has interests in several insurers and reinsurers covering a variety of property and casualty (P&C) risks including vehicles, medical malpractice, workers compensation, marine vessels and others.
What is it about the unglamorous business of underwriting personal and commercial P&C risks that attracts the best minds in the investment business?
Profit potential, that’s what!
At its heart, the P&C insurance business is one of shared risk. Insurers (or carriers) collect premiums from customers (insureds) and in return agree to pay any covered claims that may occur during the policy year.
Before a policy is proffered, the customer typically undergoes an “underwriting process” to assess their level of risk. Once determined, the policy is priced and, if acceptable to the customer, signed. Generally speaking, the higher the risk, the higher the premium (price).
As a wise person once said of P&C insurance, “There’s no such thing as a bad risk, only bad rates.”
Insurance companies can be mutual companies owned by policyholders (for example, State Farm) or stock companies owned by shareholders (for example, Allstate).
Regardless of their ownership structure, insurance firms generally make money three ways:
Lots of float can be good, if the cost of the float is not too high. The cost is the underwriting results: Do the premiums collected cover the losses and expenses ultimately paid?
When an underwriting profit is achieved, the carrier is actually “paid” to hold other people’s money. When there is an underwriting loss, the carrier is “paying” to hold other people’s money. This can still be acceptable if the return on the float (dividends, interest, net capital gains) exceeds the amount of the underwriting loss.
Property and casualty insurance can be a good business for several reasons.
First, profits can be generated multiple ways, as we have seen.
Second, capital requirements are usually minimal, with no major outlays required for fixed assets or working capital such as inventory.
However, the business is highly dependent on human capital: Capable underwriters, claims handlers, and marketing, sales and investing personnel are essential. While a portion of this can be automated, the human touch is still required to control risk, enhance returns and maintain a high level of customer service.
Finally, most insurance businesses are highly scalable once the infrastructure is built, allowing existing people and technology to handle a multiple of premiums, transactions and claims with little or no increase in costs.
This is known as operating leverage: Revenues rise faster than expenses, causing margin expansion.
Insurance can be a challenging business.
For one thing, the key assets walk out the door every night. Properly structured incentive compensation is essential to retaining good talent.
In addition, the product itself is a commodity available from many firms via fairly standard policy forms—anyone can copy another’s product. There are no proprietary assets—like manufacturing know-how, entrenched distribution, patents or critical supply relationships—to protect one’s competitive position.
Another challenge is that competitors are often mutual companies with minimal or no profit requirements. The result is often low prices that make it difficult for public companies to earn adequate returns for their shareholders.
Finally brand recognition is minimal and price competition is often high. Consequently, most P&C companies experience underwriting losses, not profits, over the long term.
Here’s a brief description of the winning characteristics that the best P&C insurers exhibit.
As regulated entities, insurers must meet certain net worth requirements to allow them to absorb the impact of claims (expected and unexpected) that inevitably occur.
As a basic means of assessing balance sheet strength, we look at common equity divided by total assets, which should be at least 20% or better.
If the capital structure includes convertible preferreds or debt, count each towards equity if the conversion/strike price is less than the stock price. For an extra margin of safety, many analysts exclude goodwill and other intangibles in making this calculation.
Capital also affects the amount of insurance a carrier can write. State insurance regulators usually limit the amount of premiums a carrier can write to twice (2×) its capital.
The larger the capital base, the greater the underwriting capacity.
Virtually all insurers have ratings attesting to financial strength assigned to them by third parties like Standard & Poor’s and A.M. Best.
A high rating is critical to maintaining policy renewal rates and keeping pricing firm. A rating of AAA conveys greater financial strength than a single-A rating, allowing a firm with the former to charge higher prices for the same coverage or provide lower coverage for the same price.
The best carriers are unwilling to take on even small exposures at prices that don’t properly reflect loss probabilities. They stay within their area of expertise and accept only risks they are qualified to evaluate.
The best carriers price for profitability and are willing to lose customers and business to competitors that offer insufficient rates or policy conditions. They will also limit exposures so their solvency is not threatened by the aggregation of losses from a single event (flood, fire, earthquake, explosion, windstorm, etc.). They always want to understand possible correlations among seemingly unrelated risks.
After losses or claims, the next largest expense for most insurers is operating expenses including selling, general, administrative, litigation and actuarial costs.
When selling a commodity product, it’s essential to be a low-cost operator.
This is the black box of the insurance business.
A reserve is a liability that must be established to cover losses that have been incurred and reported (but not yet paid), as well as losses that have been incurred but not reported (IBNR).
Estimating reserves and maintaining reserve adequacy is one of the trickiest parts of the insurance business. Being too optimistic (not reserving enough) overstates earnings, which can continue for years until the day of reckoning when the shortfall becomes evident.
Conversely, a carrier is said to have excess reserves when the money set aside years ago to pay claims is more than enough because the claims weren’t as costly as expected.
Ultimately, excess reserves are recaptured into earnings, which can provide the illusion that current earnings are better than they actually are.
The best operators are both consistent and conservative in their reserving.
The 10-K (the report of the company’s performance that must be submitted annually to the SEC) of many property and casualty insurers includes a loss development chart showing the development of losses for a given policy year and how reserves have tracked those losses. From this chart, one can gain a better understanding of whether a firm is under- or over-reserved.
Instead of selling thousands of small policies to drivers and homeowners, a reinsurer sells a few big policies to other insurers, thus assuming a portion of the risks that its customers have underwritten.
It is essential for reinsurers to be well-capitalized, so that when losses hit their primary insurance customers they can meet their obligations.
In the early 1980s, many reinsurers were not well-capitalized, leading many to go bankrupt and saddling the primary insurers with unrecoverable reinsurance to cover their losses. Eventually the absence of capacity caused prices to rise, at which point profitability rose and capacity returned to the marketplace.
Most reinsurers today are large, international, well-capitalized publicly traded players, but make sure you know which reinsurers a primary insurer has relationships with.
Reinsurers can also be considered potential investments. The analysis mirrors that of primary insurers.
Most property and casualty claims are settled in a short amount of time. These are known as “short tail” liabilities, since the time between the loss event and the claim settlement is relatively short. This requires that most of the investments be fairly liquid.
Claims that are settled over a longer time period are known as “long tail” liabilities, and allow the carrier to make longer-term investments.
Regardless of an insurer’s book of business, asset maturities should always match liabilities.
Many observers are predicting inflation given the tremendous fiscal and monetary stimulus we’ve seen.
Higher inflation is usually accompanied by higher interest rates, which destroy bond portfolios—the bedrock of many P&C insurers. So if you’re expecting inflation, make sure the bond portfolios of insurers you are interested in have short duration.
To assess how the core business is fairing, many analysts exclude capital gains and losses from their analysis, as these are highly unpredictable and often non-recurring.
As with other industries, we’re encouraged when insiders have large positions that align their interests with ours.
Insider buying on the open market is usually a sign of bullish prospects.
1) Strong Balance Sheets
One basic measure is the capital ratio (common equity divided by total assets), which should be at least 20% or better.
2) High Financial Ratings
A high financial strength rating from a third-party rating agency such as Standard & Poor’s, A.M. Best.
3) Disciplined Underwriting
4) Astute Expense Management and Operating Efficiency
5) Adequate Reserves
The black box of the insurance business. The best operators are both consistent and conservative in their reserving.
6) Reputable Reinsurers
Instead of selling thousands of small policies to drivers and homeowners, a reinsurer sells a few big policies to other insurers, thus assuming a portion of the risks that its customers have underwritten. It is essential for reinsurers to be well-capitalized, so that when losses hit their primary insurance customers they can meet their obligations. Most reinsurers today are large, international, well-capitalized publicly traded players. But make sure to check which reinsurers a primary insurer has relationships with.
7) Adequate Liquidity
Regardless of an insurer’s book of business, asset maturities should always match liabilities.
8) Stable, Consistent “Operating Earnings”
Focus on core operating earnings.
9) Insider Ownership and Insider Buying
Investors are well-served when insiders have large positions that align their interests with shareholders’ interests.
Return on Assets: 4% or higher is strong
Return on Equity: 12% or higher is strong
Combined Ratio (the loss ratio plus the expense ratio): The lower the number, the better. The industry ratio is usually above 100%; combined ratios above 120% are unsustainable.
Capital Ratio (common equity divided by total assets): Should be 20% or greater
These are the key financial ratios that you should spend a considerable amount of time analyzing when evaluating these firms:
Assets are to financial firms what sales are to non-financial firms. The amount of income those assets generate is a primary indicator of an insurer’s profitability.
Generally, ROAs of 4% or higher are considered strong.
Return on equity—net income as a percentage of average shareholder equity—is an important indicator of financial profitability.
ROEs of 12% or higher are strong.
The combined ratio is calculated by adding two factors:
A combined ratio of 100% or less indicates an underwriting profit, while over 100% indicates an underwriting loss.
The lower the number, the better. The industry ratio is usually above 100% because of the competitive nature of the business.
Combined ratios above 120% are unsustainable, and usually result in the cessation of underwriting and a subsequent hardening (rising) of rates that enhances profitability.
The capital ratio is simply common equity divided by total assets.
This number should be 20% or greater.
The current P&C insurance market may merit a closer look. Many of the stocks of these firms are well off their highs. Investment losses for many were significant in 2008, eroding net worths.
Despite two significant hurricanes in 2008 (Ivan and Gustav), pricing remains soft.
Low interest rates continue to reduce the returns on fixed-income portfolios.
Finally, many stocks are trading at discounts to book value, making it difficult for them to raise additional equity without diluting existing shareholders.
|5Yr Avg (2004–2008)||
|Amer. Phys. Cap. (ACAP)||330||4.3||16||92||38||9||1.4||1.1||Med Mal|
|Baldwin & Lyons (BWINB)||290||3.6||8.6||95||42||13||0.9||5.1||Trucking|
|CNA Surety (SUR)||600||5.3||12.6||84||42||8||0.8||0.0||Surety|
|Donegal Group (DGICA)||360||4.3||11.4||92||38||15||1.0||2.8||General|
|Hallmark Financial (HALL)||150||4.9||13.6||87||36||6||0.8||0.0||Specialty|
|Infinity P&C (IPCC)||500||4.1||13.2||92||31||10||1.0||1.3||Auto|
|Investors Title (ITIC)||70||7.1||11||100||65||12||0.8||1.0||Title|
|Montpelier Re (MRH)||1,100||11.1||26.4||98||42||7||0.8||2.2||Reinsurer|
|ProAssurance (PRA)||1,500||3.3||13||90||25||11||1.0||0.0||Med Mal|
|State Auto (STFC)||60||4.2||12.3||95||35||16||0.9||3.6||Auto|
|Zenith National (ZNT)||790||7.4||23.2||77||32||14||0.8||9.5||Wkrs Comp|
*The combined ratio is the loss ratio (losses and loss adjustment expenses divided by earned premiums) plus the expense ratio (sales, actuarial, litigation, general & administrative expenses divided by earned premiums).
Data as of June 25, 2009.
All of this may set the stage for an increase in rates that could result in higher earnings per share and rising share prices.
Stay with insurers that have high ratings and a history of rock-solid balance sheets, low combined ratios, above-average returns on equity and assets, and large insider ownership.
Table 1 provides the current characteristics of a number of high-quality property and casualty insurers.
Start your search now using the metrics we discussed above. Long-term followers of the P&C industry know the stocks always move ahead of the underwriting cycle.
You can’t wait to see the whites of their eyes before investing. Be ready.