Thinking about investing in insurance companies?
by PlanMaestro
I made a mistake in the last post. How could I possible hide some interesting data in an inconspicuous link at the end of a boring side comment? David Merkel deserves better than this.
These are the historic reserve deficits of some large insurance and reinsurance companies with long tail risk. His main target was teflon Hank Greenberg that has been denying any responsibility in the AIG debacle. Some chutzpah given all the evidence indicating compromised underwriting standards, under-reserving, increased leverage and declining ROA under his reign. AIG Financial Products and its CDSs were the last consequence of Greenberg’s risk taking leadership and his nonnegotiable 15% ROE target: the ultimate yield hog
But that is old history, soon to be forgotten to become the foundations of the next bubble. Much more interesting for our own purposes is David’s heavy lifting in evaluating reserve practices of such interesting companies like Berkshire, Markel, and White Mountains.
I know that David has liked PartnerRe for a long time and now it is at a probably conservative 0.76x book value. Cincinatti Financial is one that I have not analyzed either but it is priced at 0.88x book value. If you are interested, I suggest to check their investment record and current portfolio; if we are taking long tail risk please tell me that at least we are doing something interesting with that float. They do not have the investment reputation of a Berkshire or a Markel but that just might be appearances.
Probably the most surprising chronic under reserving is White Mountains. For those that do not know, White Mountains has been a staple of value investing portfolios and they themselves were early investors and promoters of Michael Burry’s Scion Capital. And as David mentions, conservative accounting is something they talk about. Does anyone have absolutory or confirming evidence?
As a passive investor, I tend to avoid long tail risk insurance companies like the plague. David’s work is rear view, an evaluation of past decisions, but you can not be sure about their current ones in a soft pricing environment. Even risky banking construction and development loans have durations of just a couple of years, so many of the big bad C&D loans are probably behind us. That is not the same with long tail insurance and when things go sour, turning around an insurance ship with long tail inertia is a Titanic work.
I am also a skeptical man, how can I be at ease with an investment based on management’s pedigree when so much is at stake? It is not that I distrust them personally; it is about having seen from the inside that controlling the commercial areas is an almost impossible organizational act. If you want to know more about the gap of what is needed and what we have, you should read about how National Indemnity operates in Buffett’s letters.
Some well respected companies like Fairfax Financial had their share of problems in the early 2000s and an old standing company like Lloyd’s was brought down to its knees by the weight of asbestos claims. Bad underwriting and reserving can bring down even short tail risk companies like Lincoln General: former part of Kingsway Financial situation currently under litigation.
Not to detract from a beaten sector, but at current prices personally I am preferring other alternatives in the financial sector.
PD: If someone has done or seen similar analysis with Fairfax Financial, Montpellier RE, Greenlight RE, Aspen or others, could you be kind to share it with us mere mortals? Too busy analyzing other financials.
No position
Variant Perceptions 
No worries, friend. I am grateful for your interest.
As an aside, PRE does not discount reserves, which makes the book value understated. I need to go check the analysis that they write up in early fall of each year, but I think on an adjusted basis, PRE is below 70% of adjusted book, with the strongest, most diversified balance sheet in Bermuda — yes the P/E is higher, but that is a price to be paid for quality, and deferral of revenue.
Keep up the good work.
David
Disclosure: yes, long PRE
David, thanks for your clarifications on PRE now that you are not commenting so much on your insurance positions. Always checking your disclosures and trying to read between the lines 🙂
[…] — Apologies to PlanMaestro, Manual of Ideas republished his work, and I appreciate the two mentions from him at his blog, […]
Love your blog but never commented as banking and energy aren’t my things, but your posts have been very educational for me. Thanks for that.
I’ve owned Fairfac and CINF in the past, Fairfax recently and CINF long ago. It’s worth thinking about the sorts of risk that insurers take, and the two are very different (at least at the time I owned them).
CINF is very regional in the midwest. They expanded slowly and seemed to hav a strategy to slowly expand their geographic coverage. At the time they ceded under treaty most of their risks per policy past a rather low limit to reinsurers. Given this and the type of risk they were taking that they didn’t have huge reserving problems. On the investment side they were highly equity oriented with a huge chunk (like 50% or so at one time) of Fifth Third that they had acquired at negligable cost in the distant past. They since sold most of it I think after the bubble.
FFH has had a very different strategy. One thing that you will immediately notice is that they have a rather large book of assets that they employ aggessively against a large book of liabilities. This has given them a large per share leverage, which is either going to be wonderful such as their credit default position or terrible like in the early 2000s when thay had a large acquisition of troubled insurers that went awry and almost killed them. So as an investor in FFH you have a totally different set of risks than CINF. BTW There is a very smart community I suggest you check out if you are interested: http://cornerofberkshireandfairfax.ca/forum
Another company that I really like quite a bit is RLI which reminds me a bit of MKL but with a much more conservative investment slant. They have included charts like David’s in their reports, no need to calculate them yourslef and the CC transcripts are a joy to read with a wealth of information on the insurance industry.
BTW Weren’t you on the VSNT yahoo MB in the past? They have gotten very cheap recently. Are you following it?
Good luck.
Thanks for the good information Chris. I do not remember posting in the VSNT board, but I am following the situation. Revenues, even maintenance revenues, have been declining and the European situation can be a concern given the sales concentration. I also wonder about the technological situation on the future potential for object oriented databases. That cash pile, zero debt, stock buybacks, disciplined costs, and historic good margins looks surely tempting.
Check out QBE, an Australian insurance company. They are one of the great companies of Australia, and one of their unique capabilities is that they have been able to do dozens of accretive acquisitions. They are one of the few large companies I have ever seen do acquisitions well.
I am looking to take a position if they go below AUD $14
I remember checking QBE like 8 months ago. My main concern is their aggressive acquisition strategy. Cross-border insurance M&A is a minefield with the near impossibility of a perfect due diligence. It works until it doesn’t.
But QBE is very very good at cross border M&A. You might even call their ability to execute that a competitive advantage. They have done dozens of these cross border transactions and they manage to maintain a margin after all reserving and payouts that is amazing.
Might be right to call that a track record, but insurance M&A is one thing I am very skeptic
Hi PlanMaestro,
I am indeed thinking of investing in insurance companies recently. I saw some insurance companies trading at less than 5 times P/E, and below book. I know it is quite complicated. Would you recommend any readings? I bought ‘Handbook of Accounting for Insurance Companies’ by Clair Galloway and Joeseph Galloway. Do you think this is a good book to start learning? Are there any other books that you would recommend?
Thanks,
Zehua
Sorry Zehua, not sure I can help you with that. I learned about insurance the hard way: working for a couple of companies.
I see. So could you please tell me what are the most important factors to look at for an insurance company?
I know for banks, look at construction loan, NPA etc. But for insurance companies, do we just look at their schedule D to try to criticize it, and make adjustments accordingly to the reserves? What kind of reserve ratio would you think that would be bad?
Insurance investment analysis is even more difficult than banking:
– An important decision is mix long (catastrophic risk) vs short tail (HMOs, auto).
– Check investment port to avoid yield hogs (exotic securities)
– Check quality of reserves
– Leverage and capitalization
– There are certain insurance products that are inherently risky where diversification does not help (credit insurance was one, life insurance hybrids was another)
– Read all David Merkel’s The Aleph blog
Thank you!
They do not have the investment reputation of a Berkshire or a Markel but that just might be appearances. Is it true?
The short answer is that I do not know. Giving that I work alone I can not follow every hunch and have to prioritize resources. So at the moment I am following other financials.
Any thoughts on PNX? It is I don’t know much about insurance companies, but I am going to start learning.
Looks like this one’s trading at only 20% of book value. I don’t know where to check for the insurance companies’ investment assets, which I believe is the heart of that company?
So what are the major factors to check for an insurance company? I am going to start reading the big and old ‘Hand book of accounting for insurance companies’.
Zehua, I think I am going to put this one in the too hard pile. It seems intriguing with their excess regulatory capital but life insurance I consider a sector where you are really dealing with black boxes. It is a long tail business where you need extreme confidence in management. It would not surprise me if it is a multibagger but I would recommend you to consult it with a sector expert.
Thank you Plan. I am just started in learning insurance and it seems like on the underwritting department, they can have unrealistic low loss rate assumptions, only to get hit many years later. There are some CEO and officier insider buys so that makes it feel better about management, but still that is not sufficient proof.
On the other hand, I am wondering if there is any way to compare their rates with competitors, and if they are roughly the same, then it would be ok on this part?
On the investment part, I don’t think those guys are as brilliant as we value investors. They probably just buy some triple AAA bonds and big companies like MSFT, but since their price/book is a startling 20%, as long as they don’t lose money, that would be ok on this part. It is ok not to make 20% per year like Buffet if we can buy at this cheap price.
I will try to contact the author of Aleph blog and see what he says. Thanks again!
He is fantastic, he will probably tell you to check if they are guaranteeing minimum returns in those annuities.
Also be careful with the duration of their investment portfolio. Higher interests can hit the value of their current portfolio, but if it is short duration they can reinvest at higher interest rates. I think the main risk with life insurance companies is a deflationary environment with very low interest rates (aka Japan) that can break their backs.
Good luck with your investigations, and tell me if you find more!
[…] Insurance sector as an investment possibility: https://variantperceptions.wordpress.com/2010/06/05/thinking-about-investing-in-insurance-companies/ […]
Should investors possibly be okay with “improper reserving” at times?
I just want to play devil’s advocate:
1) If we want management to just report things where they believe they will land (at the mean) and focus on economic value, this will mean that they are theoretically over reserved 50% of the years and under reserved 50% of the years. This could be our preference because even over reserving consistently allows for reserve releases during bad years to smooth earnings. Just give the truth and move on. (That said… I’d assume most managers are focused on the bonus check closer than farther away, and so odds might be that over-reserved managers tend to be better operators)
2) What do we do if management gets the chance to write policies at good rate, but they’re somewhat similar (homogenous), and have the chance of going sour after a while? Every insurance policy has risk. Let’s say that we have a binary outcome and know the exact odds. 50% odds that expenses for it are $1 while 50% odds that they’ll be $2. They’re being offered $1.85 for the risk… obviously, the expected losses being $1.50, they take it, and they reserve for $1.50. But the catch is that it doesn’t develop for a while, because this is medical malpractice, and so in year 8, it turned out that surgeons left M&M’s inside of the body because Kramer was watching from nearby. Maybe the losses all come to $1.65, which is greater than our $1.50 expectation. It was still a good risk to take and over a lifetime of risks of this sort, they’ll do well. But this batch (vintage) of policies didn’t work out. Is it really “improper” reserving?
3) An aside… I handicap myself on reserves. I glance at them just to make sure things don’t radically blow up, but I focus more on their ability to scale premium up/down. The litmus test here is how well they deal with letting go of bad business. I’m almost suggesting to not look at reserves too much, unless you know what you’re doing. (Not *you*… but just anyone, mostly myself) I have to see a Platinum Re (PTP) type of situation where management was okay shrinking from $1.8B in premium to 500M in premium. When rates are good, I’d love for them to scale back up to $2B, but to make sure it’s opportunistic.
4) I was reading this blog post on Geico here: http://focusinvestor.com/index.php?option=com_lyftenbloggie&view=entry&id=31
Quote: Mr. Buffett (p. 430, Snowball) stated that “I looked again at GEICO and was startled by what I saw after a few rule-of-thumb calculations about loss reserves.”
I wonder what these rule of thumb calculations were. I’ve tried finding stat filings from this time frame, however the NAIC was a bit tied up at the moment. SNL doesn’t go so far back.
Any idea what he might have been looking at?
PS: I haven’t gone around your blog’s other posts yet, but I really like what I see so far. Keep up the good work. There aren’t too many asking the questions you are.
One thought on Warren’s back of the envelope reserve checks… maybe he pulled the stat filings and found 2 data points for a particular line of business:
1) Claims filed
2) Total reserves
Calculation: Reserves/claims = average loss size per claim
You then do this for 5 competitors, and see what the estimates come out to. I’m sure some businesses have different target audiences and so they should be materially different, like non-standard auto insurers, but for the most part, there might be a ballpark they land in. Well, this could help us figure out who is *obviously* under reserving.
I don’t think this method will tell you when a CEO has an evil grin because he lowered it by $1 per claim and laughs all the way to the bank with the extra $20 on his bonus check. It’s just to catch the really egregious stuff… but if it was that easy, wouldn’t the regulators spot it first for lines like worker’s comp, which seems like it blows up for amateur insurers every other day? (One potential argument is that if the DOI goes after them, then insurance rates go up, and their voters may not be happy with them… it’s the routine long term vs short term ethics question)