Greenlight Capital: Underwriting Has Potential to Accelerate or Damage Returns

| About: Greenlight Capital (GLRE)

In February, we purchased a 10% position in Greenlight Capital Re, Ltd. (NASDAQ:GLRE), a reinsurance company which invests its "float" in the David Einhorn run hedge fund Greenlight Capital. We wrote that when purchased at or below book value, an investment in Greenlight has the potential for substantial market beating performance due to several factors, including: (i) favorable tax treatment on corporate earnings, (ii) profitable or at least break-even underwriting and the investment of insurance premiums, and (ii) the investment acumen of Einhorn and his team. The following updates the performance of both the business of Greenlight in Q1 2009 and the stock since mid-February.

When discussing Greenlight, it's important to separate out underwriting results from investment results. While most of Greenlight's earnings will come from investment returns, Greenlight's underwriting has the potential to really accelerate or damage investment returns.

Underwriting Performance: We feel that if Greenlight can maintain a combined loss ratio of equal to or less than 100% [where net premiums earned (which represents the percentage of net premiums written (gross premiums written less retroceded premiums) allocated to the relevant period, less total expenses (which includes loss and loss adjustment expenses, acquisition costs and general and administrative expenses)) results in underwriting earnings], Greenlight will generate substantial long-term market beating results. A 100% or less combined loss ratio will essentially allow Greenlight to invest "borrowed" money interest free, expense free and tax free (subject to changing legislation of course). So both quantity and quality matter - the amount of premiums written, collected and invested as well as the performance of the underlying insurance contracts.

In Q1 2009, Greenlight wrote $71.8M in premiums, retroceded $1.2M, resulting in net premiums written of $70.6M, which compares favorably to the $61.5M in net premiums written in Q1 2008. Net premiums earned were $46.2M vs. $27.7M in Q1 2008. However, loss and loss adjustment expenses were $30.2M vs. $12.12M in Q1 2008. When loss and loss adjustment expenses are combined with acquisition costs and general and administrative costs, total expenses equaled $47.8M v. $26.5M, resulting in a combined loss ratio of 103.6% vs. around 96% in Q1 2008. Management has explained this increase due to one catastrophe contract which experienced greater than expected losses due to the combination of hurricanes Ike and Gustav as well as the large UK snow storm.

On the positive side, expenses as a percentage of net premiums written decreased to 9.5% as compared to 16.2% for Q1 2008 due to relatively flat expenses and more written premiums. While we certainly would like a less than 100% combined loss ratio, we feel it is far too early to judge the underwriting performance of the underlying contracts, especially on a quarter-to-quarter basis. We will continue to monitor performance, but at this point feel quite confident in what appears to be conservative and analytical underwriting by management.

We also note that insurance pricing has been in a multi-year downward trend, which many insurance professionals (including those at Greenlight) believe is beginning to reverse or "harden" because of the lack of capacity in the industry due to massive 2008 investment losses. Any uptick in risk pricing will benefit Greenlight's underwriting results. We are also pleased with the increase in net premiums written. Greenlight's relationships with brokers and Cayman Islands captive insurance companies appears to be developing as planned.

Two underwriting side notes to report: First, management has created a subsidiary, "Verdant", in order to deploy capital in "strategic partnerships" which appear to be investments in certain insurance companies or agencies, with the goal of investment returns, fee income and continuous reinsurance business. One such investment resulted in a one-time $2M transaction fee this quarter which partially offset the insurance losses. Second, in September 2008 the Cayman Islands Monetary Authority granted approval to Greenlight to engage in long term business (life insurance, long term disability, long term care, etc.) in addition to the property and casualty business Greenlight currently writes. These two developments will be interesting to monitor going forward.

Greenlight's Investment Performance: Greenlight's investments returned 4.6% in Q1 (investment income of $27.7M) resulting in an increase in book value per share of 5.2%, to 14.25. This compares quite favorably to a -11.7% loss in the S&P 500. In Q1 Einhorn began to focus on distressed debt as a long investment hoping to "move up the corporate capital structure," and opened a large position in Ford secured bank debt, which was purchased at roughly $.35 on the dollar. At the end of the quarter, the investment portfolio was roughly 17% debt securities. Greenlight continues to maintain a substantial investment in gold and gold related companies. At March 31, Greenlight held $557M in investment securities, compared to stockholders equity of $520M. While we see some cause for concern in the underwriting portfolio, we are pleased with Greenlight's investment returns to date.

Other Items: On March 13, several insiders made very large purchases in Greenlight stock at around $15 per share, which we consider to be a positive development.

Stock Performance: We purchased shares of Greenlight at $12.9 in mid-February, which was slightly below book value at the time. In April, Greenlight's investments returned 6.3%, which we estimate to have increased book value roughly 7% to about $15.25 per share. At the time of writing this, Greenlight shares trade for $15.9. We are more than happy to hold at a modest premium to book value, but won't be adding to our position in the immediate future.

Disclosure: The author is long GLRE.