Insurance Stocks May Finally Pay Off

Much like the common – though oft misguided – reputation of insurance protection, investments in insurance companies have looked like a rip-off during the past few years. But a thorough look at industry and company-specific fundamentals suggest that improvements may be on the horizon.

Insurance companies make money two ways: underwriting profits and investment profits. Underwriting profits are generated determining what premiums should be charged in order for the insurance carrier to be compensated for the risk they’re assuming, plus an allowance for profits. Depending on the type of insurance, there might not be any significant losses on the policies until a few years have gone by. In the meantime, they are allowed to take the premiums they receive and invest them to generate a return that on capital.

In insurance lingo, a “hard market” is a market in which capacity has been taken out by heavy losses and insurance prices are rising. As prices rise, it eventually induces new capital to the industry, thus increasing capacity. This increased competition will ultimately drive prices back down until they no longer compensate insurance carriers for taking the risks. This is known as a “soft market.” A few years later, the losses begin rolling in and the cycle starts anew.

The insurance industry has gone through some seismic shifts in the past year. Due to huge investment losses and no help from underwriting profits, capacity has shrunk and could shrink further. Many of the top players in the industry are in a questionable financial condition. This, coupled with the fact that underwriting quality has gradually eroded since the last hard market ended in 2003, may lead to increasing insurance prices as the companies attempt to restore their balance sheets to competitive levels.

Three Criteria to Consider

There are three ways an insurance company can earn above-average returns on capital: (1) being a low-cost operator, (2) having the strength to say “no” and let premiums dwindle when the competition drives prices to insufficient levels, and (3) earning high rates of return on their investment portfolio.

The most difficult time to analyze an insurer is when the market is soft and the competition writing increasingly stupid business. The best time to analyze an insurer is immediately after the “stupid” period, when insurance companies are reeling from losses – either from underwriting of investment operations. At such times, it is relatively easy to identify the companies who have the three competitive advantages discussed above. An advantage in cost is always easy to identify regardless of market conditions. If they have an advantage in underwriting, their premium growth will have been flat or declining for a few years, when their competitor’s have grown. Underwriting integrity is probably the most important criteria to have a high-conviction assessment of, because it increases the likelihood that loss reserves are adequate and that they will be able to take advantage of profitable growth opportunities when insurance prices eventually rise again after industry capacity has shrunk. Earning good returns on float is, like cost advantages, usually easy to identify by looking at historical performance.

Word of Caution on Management

A rising tide lifts all yachts. Indeed, if market conditions do improve for insurance companies, we will likely see increasing stock prices across the sector. However, the insurance industry is fairly unique from an investment standpoint. Banking is perhaps the only other industry in which the quality of management is of such supreme importance. It is the number one factor with which investors must be comfortable.

Insurance companies have significant leeway to fiddle with the financial statements. They can be creative about finding ways to bury costs, and it is all too common for them have to restate inadequate loss reserves. Reserving practices have a huge impact on the financial health and value of a company, and there is no way for outside investors to verify the adequacy of a company’s loss reserves. Even rating agencies and auditors cannot mandate changes in a company’s reserving practices so long as the company is following accounting and regulatory rules. Thus, management’s interests should be nearly perfectly aligned with those of shareholders. You will HAVE to trust their estimates on loss reserves.

With the financial turmoil of the past couple of years, I believe there is a greatly increased risk that reserve practices have been compromised in order to maintain the appearance of financial health. So if you invest in the insurance sector, tread with caution and scrutinize management’s reputation, track record, and incentives.

An Insurer Worth Investigating – Fairfax Financial Holdings (FFH)

Fairfax Financial Holdings (FFH), through its various subsidiaries, writes property and casualty insurance and reinsurance and manage investments. Their operations are diverse and global, they have a strong financial position, and their management team has an impressive track record, large personal investments in the company, and communicate candidly with shareholders. How do they stack up against the three investment criteria that should be considered?

FFH does not appear to have a meaningful cost advantage. As with most other industries, cost advantages are rare in insurance. The primary source of cost advantages in the insurance industry lie in the distribution channel. For example, Geico, an auto insurance subsidiary of Berkshire Hathaway (BRK.A), has a cost advantage because they market directly to customers and don’t have the large costs associated with employing insurance agents throughout their markets.

Underwriting results at FFH are a mixed bag. Their modus operandi has been to acquire underperforming insurance companies and turn them around. For the most part they have been successful, but there have been a couple of notable exceptions that have dragged down their historical underwriting performance to pretty mediocre levels. However, the management team at Fairfax truly “get it” in terms of disciplined underwriting. Since they’ve recently alleviated some major headaches from poor acquisitions made in the past, and because they have an enviable balance sheet, they are very well positioned for highly profitable growth if insurance prices harden over the next few years.

Investment results at Fairfax have been nothing short of fantastic. Prem Watsa, the CEO, and his management team are very savvy investors, and their returns have slaughtered the stock and bond market averages since the company’s inception 24 years ago. Most recently, they had some grand slam investments by profiting off of the housing market collapse and stock market declines. These investments have provided them with loads of cash in an environment where many of their competitors have to scramble to get government bailout funds.

Given this information, Fairfax might be worth some research. In addition to Securities & Exchange Commission filings, the company keeps an archive of every annual report since current management took over operations in 1985. I recommend reading every Letter to Shareholders in those reports, as it will provide you with a good feeling for how management has performed given the hand they’ve been dealt.

*This is not a recommendation to buy or sell any security. Do your own thorough research before making any investment.

Comments

[eddybaby:]

Great writing. I have just begun to explore the sector (looking at companies like Aflac) and as you rightly point out it's damn hard to get a sense of the prudence of an insurers underwriting.

do you have any guidelines for evaluating company accounts that would indicate whether a company is "over writing" on it's underwriting? or is it all just too opaque?

At this time, where do you see the greatest risk fro insurers; poor quality investments, or too much cheap premium writing?

Again, congrats on a well put together piece.

May 05 11:40 AM

[Austin Roberts:]

Insurance is one of the few industries where "scuttlebutting" -- or deep research via industry contacts -- is necessary get solid information. I have a number of industry contacts that I've made through the years, and I use them extensively in my research. I suggest you do the same if you invest in this sector. Most people would be amazed just how much time and information you can obtain from executive management of publicly-traded companies. It is much easier to get quality face time with CEOs of small companies, but there are a number of large (Fortune 500) companies of which I've successfully been able to get through to executives. In this way you can get a good handle on "attitude," towards both the business itself and towards shareholders. Without compromising insider information, a persistent and clever investor can talk to executives and come away with knowledge that will put you leaps and bounds ahead of the general investing public. You'll have a big "edge" if you know management is working to make money with shareholders, and not off of them.

You can look at historical financials to see if any advantage in underwriting exists, but to find the source of the advantage, you'll have to scuttlebutt. What kind of reputation does the insurance company have with their brokers? With retail agents? With insureds? What is their reputation for claims handling?

Insurance is a research-intensive industry, but it can pay off big if you do your homework.

The greatest risk for insurers right now is two-fold: solvency and liquidity. To play it relatively safe, I only consider investments in companies that have strong financial positions, good cash flows, and savvy, shareholder-friendly management teams. On top of that, if you can find an insurer with the ability to earn above-average return on capital, you may do very well over time.

There are lots of insurers out there with questionable books of underwriting business and and questionable investments, and they're all working hard to instill confidence in their investors even if they know they're on shaky ground. So if I were you I'd be picky about which companies you invest in.

May 05 09:24 PM

[ubuy2w:]

Excellent article, I am a long term fan of the mgmt. of FFH I recently purchased some more shares of FFH I expect that I will be sitting on a 300% profit on these shares in 5 short years if the market hardens and Prem works his usual magic. This company looks more and more likely an extremely well managed hedge fund disguised as an insurance company without the 2 and 20 vig.

May 15 05:41 PM