The Long Case for HCC Insurance Holdings, Inc.

While it could certainly be argued that HCC Insurance Holdings, Inc. (HCC) is more a "GARP" stock than a value stock, the unique business model and competitive advantage arguably justify paying a little more to own this holding. Trading at about 2.0x book value, HCC is not at the bottom of the barrell relative to other insurance companies.

With a P/E of 11x forward earnings however, it is by no way over-valued, particularly when you consider the highly visible earnings stream. Key metrics below; click to enlarge:

HCC, originally known as Houston Causualty Corp. is a small-cap multi-line P&C insurer. The company predominantly focuses on writing policies in highly specialized niche markets, where market ineffieciencies allow for high underwriting profits. For example the company may write a policy for an event cancellation by a rock band, or kidnapping insurance for a prominant political figure, basically markets where competition is low and rates are determined by convienence and level of service. Over the last 10 years HCC has managed to generate an underwriting profit 9 times. (Read Warren Buffets annual letter to shareholders to understand the importance of underwriting profit.)

Importantly the business generates revenue both through taking on risk as well as through fee and commission based agency services. This is unique in the insurance industry and provides HCC with a strong competitive advantage against its peers. In 1992 when Hurricane Andrew devastated Florida and drove "hard" pricing in the P&C insurance industry, HCC used it's strong balance sheet and wrote an abnormally large number of policies, bought less reinsurance, and relied less on its fee-based agency business, in search of above average underwriting profit. During the mid 1990's as new capital was attracted to the industry, prices (per unit of risk) came down and margins declined. Seeing this, HCC wrote less policies, bought more re-insurance, and relied on fee and commission revenues to grow the business. After 9/11, when the market recovered HCC responded....This additional lever gives HCC the ability to continue to grow through the rough times. Over the last 10 years the book value growth of HCC has strongly outperformed the industry. (see chart below)

Management owns a significant amount of stock and manages the company and the risk it accepts very prudently. Over the last several years this is evidenced by the series of positive earnings surprizes and relatively few reserve adjustments. Going forward, given the recent natural distasters, pricing is likely to improve for the policies that HCC writes and improve the profitability of the company. In my view, 2x book value and 11x earnings is a fair if not cheap price to pay for such a quality company.