I recently had a chance to interview Dave Carlson of Tourmaline Advisors on his investment activities in insurance stocks. I think that insurance is a really interesting business, but some value investors totally stay away from financials because they regard them as too complicated. At the same time though, Warren Buffett has been active in the insurance industry for decades — his hiring of Todd Combs seems to indicate that he believes being able to analyze and invest in financials is important.
So I thought it would be a good idea to interview Dave and get him to shed some light on how he analyzes insurers, I hope you enjoy the interview. Feel free to post follow up questions in the comments section.
1. Can you give us some background on why you got into value investing and what got you interested in insurance stocks?
I have to say that my road to value investing has been a series of unexpected turns. Despite growing up where the men on my dad’s side of the family would talk stocks at family gatherings, and my grandfather giving me a book on stocks for my 16th birthday, I had no interest initially in investing. When I started working after college, I began plowing money into mutual funds offered by the company 401K plan as my primary means of investing. When the division that I worked for was sold to another company, I had to make a decision about rolling over my 401K monies.
After spending a month trying to find the right mutual fund, I decided that if I was willing to expend this much effort on selecting a mutual fund, I might as well buy the stocks directly. A family member recommended reading the Investor’s Business Daily and from there I bought some stocks. One of them happened to be American Capital Strategies (ACAS). This was in 1999 and I had overheard people talking about Yahoo Finance message boards. So I started reading the posts on the ACAS board and found an interesting group of fellow amatuer investors. ACAS is a business development company, which not many people fully understand. We spent a lot of time dissecting how the company worked, and this led to other discussions on investing. A group of us enjoyed it so much that we decided to leave the noise of the message boards behind. Our little study group started talking about value investing and relating it to stock decisions. That mix of theory, discussion and application was powerful. From there it just clicked – I was and am a value investor.
My interest in property and casualty insurance stocks is a much simpler story. It was an occupational hazard from working in the industry and why I tend to be cynical about the industry.
2. Why do you think there is increased M&A activity in the specialty underwriting space? Fairfax has done a few of these acquisitions. Do you think they have some kind of moat that allows them to have better underwriting operations? Or are they actually more similar to the rest of the P&C insurance business which has typically relied on investment income?
There are several dynamics influencing M&A at this point. The low valuation on insurers makes it an opportune time to be a buyer. With premiums flat, catastrophes minimal and bond yields anemic, buying another insurer represents a more attractive return. The interest in specialty insurers stems from 1) they tend to have better pricing and 2) there is less overlap because their underwriting focus is narrower. In terms of moat, the property & casualty insurance is largely a commodity business with few moats.
As for Fairfax having a moat, I would say that they have an inverse moat. Sounds crazy but hear me out. They know how to get rid of business, they know how to say no. That is not a moat but a behavior – to be disciplined. Every insurance exec says that they are disciplined underwriters, they’re all from LakeWobegon, but obviously they are not. Insurance is a product sold for which the costs of goods will not be known until a later date, so people can delude themselves by assuming better loss experience. Sort of like the mortgage securitizers who assumed that home prices could only go up. Insurance companies also have a decent amount of fixed costs because you need underwriters, claims people, etc. to support the business, whether you have 50 policies or 5,000 policies. There is a tendency to write any business just to sustain the infrastructure, something you also see in the for-profit education sector.
As for relying on investment income, yes, Fairfax does rely on it more than most. In their annual report, Prem Watsa mentions the net premiums written to statutory surplus ratio, a.k.a. the underwriting leverage ratio. The ratio at the end of 2009 was around 0.5 for Fairfax whereas most insurers are well over 1.0 and closer to 1.5. Watsa has purposely structured Fairfax so that the underwriting contributes less to results. That’s a good thing because it is a lousy business! This also means that the Fairfax insurance companies are overcapitalized relative to premiums written. Once they satisfy the regulatory/rating requirements for safe investments, they are free to invest the excess capital in things besides bonds. The Fairfax business plan comes straight from Buffett.
3. Is pricing and market position maintained through client relationships (i.e. its a small expense overall for the yacht owner and they like/trust their broker)? Is it through branding and market position (i.e. “everyone know that MKL is the place to go for yacht insurance”)?, or is there some actuarial knowledge (other participants aren’t sure they know how to price the business properly so they stay away).
Branding and marketing is a diverse subject within insurance. There are significant differences between personal and commercial, distribution method and line of business. A good portion of insurance is a commodity business, particularly personal lines. Does it matter whether I buy my car insurance from a gecko or a perky sales clerk? No, but the constant bombardment of advertising will at least drive people to get a quote from them. That is important because they rely on direct marketing.
The commercial side is where you see more relationship building, not so much with the insurance companies, but with the brokers, claims administrators, etc. When you get into specialty insurance, like yacht insurance, the number of insurance companies offering coverage shrinks dramatically. It is easier for one or two companies to dominate a market and that gives them an advantage in terms of experience and distribution. The actuarial advantage is a matter of numbers. If you insure 10,000 yachts, your loss experience will be a lot more predictable than the insurer covering 100 yachts. Insurance is all about the law of large numbers. Companies that can mine their own data can create an advantage.
4. What are your top metrics to look at when analyzing an insurance company? Most people seem to hone in on combined ratios and book value — what else do you look at?
Price to book and combined ratio are good starting points. Return on equity, underwriting leverage ratio and investments to equity are other metrics that I look at. On combined ratio, it is also useful to look at the difference between what is reported on a GAAP basis and what is reported on a statutory basis. The “stat” basis is more conservative than GAAP, it’s what the regulators look at, and is a better measure.
I also look at the lines of business written because that influences the combined ratio. For short-tailed lines of business, like property and personal lines, investment income is less of a factor, so the combined ratio should be lower because the driver is underwriting profit. Long-tailed lines, like general liability, can afford higher combined ratios because the investment portfolio is larger and is held longer – the magic of compounding.
5. With most insurers trading below book and it being a soft market — are you finding a lot of opportunities or do you think this is the time to be cautious?
I am more cautious. Insurance companies are essentially levered bond funds, so the extended low bond yields have a bigger impact on earnings. My focus has turned to special situations. I bought a small insurer, Penn Millers (PMIC) after its IPO because it was trading below book value despite having a significant portion of the book value being the IPO proceeds.
Another situation arose with Donegal Goup, which has a unique capital structure. It is a mutual insurer that owns a publicly-traded holding company with two series of shares. The mutual retains control through super-voting “B” shares, which have the same economic interest as the “A” shares. There was some confusion over a deal where they offered to buy a bank, half of which involved “A” shares held by the mutual. The result was the “A” shares trading at over a 35% discount to the “B” shares, which has since narrowed. The other situation is a small specialty insurer, Seabright, which I bought at less than 50% of tangible book value. There was a lot of fear after they took a reserve hit in the 2nd quarter that seemed unwarranted.
6. When you value an P/C casuality company, how do you establish that the reserves are accurate?
When it comes to P&C insurers, reserves are a black box. Outside of being an actuary who can review their claims, there is no way to know whether the reserves are adequate. All you can do is look back over time and see how reserves have developed and whether there have been reserve additions or releases. You have to assess behavior over time. Management can play games over the short-term but eventually the claims get paid and then we find out who is covered and who is swimming naked.
7. How long do you foresee the tail before the insurers adjust their rates for the low bond yields? Do you think we will see a hard market soon?
Let me start with the last question first. Hard or soft markets are determined by capital levels. Prices will harden when capital is destroyed or removed from the space. There is no direct tie to low bond yields impacting pricing but lower investment income means underwriting results will have a greater impact on capital.
8. How do you determine if an insurer is over-concentrated?
Over-concentration is a good question. Some situations are obvious, like Universal Insurance Holdings, a home insurer with most of their business in Florida. That is a binary bet on the hurricane season. Seabright is concentrated in workers comp, with slightly less than half their business in California. The regulatory risk is known by investors, as is their ability to compensate through company-level rate changes and other rating factors. Once you get beyond regional or line of business risk, however, it is difficult to spot concentration.
Even insurers struggle with concentration in their own books. On the property side, technology has allowed insurers to do a lot more catastrophe modeling and to better monitor risk but that depends upon having detailed and accurate location descriptions. The problem on the liability side is that a relatively small segment can have significant losses, as happened with E&O/D&O coverage on financials the past three years.
9. Some insurers are limited to only a few geographic areas — do you discount these because they might face some kind of black swan risk? (e.g.: if you were to only write insurance in TX and a hurricane came, damage could be high but your operations dont have areas outside of TX to draw premiums from to offset the losses)
What I find is that most regionals are very conscious of risk and will buy reinsurance to mitigate the risk. That does not mean that a storm won’t impact earnings but it does not blow a massive hole in their capital. Plus, you do not have to be a regional to suffer major losses – look at what happened after the 2005 hurricane season. In the P&C industry, the potential for a black swan is always present, whether natural disasters, unintended coverage or legislative/judical changes. It is not limited to regionals. I have told my friends that when investing in P&C insurers, cut your normal position in half because you are betting against nature.
You may be surprised that the most that I have ever been invested in insurance was back in 2009 following the March meltdown. I had about 30% of my personal account in insurance, with P&C being about 3/4th of that. Currently, I am about 15% in insurance, all of it P&C. Did I mention that P&C is a lousy business?
10. Have you ever looked at insurance brokers? Do you think they are a better way to invest if you assume the market will start hardening?
I have looked at insurance brokers but have not spent much time looking at them. The top 5 brokers represent something like 85% of the publicly traded market cap and you have at least a dozen analysts covering them. I am not going to add any value to the discussion. Of course, that won’t prevent me from expressing an opinion! My impression is that the brokers are focusing on client needs and have moved away from pure commission fee structures to using a mix that includes flat fees. The brokers will benefit from a hardening market but not to the degree that they once did.
11. Do you ever look at reinsurance companies? How do you get comfortable with the cat risks? Are there any metrics you focus on with a reinsurer that you might look at less when analyzing a short tail P/C insurer?
I do look at reinsurers on a periodic basis. As a group, they tend to track together, depending upon which way the wind blows. As for cat risk, you can see over time how they have diversified into other lines, particularly after 2005. Still, the concern is there and is why they trade at single digit P/E ratios. When it comes to metrics, I use the same ones for reinsurers as for insurers. The only difference is that they tend to trade at cheap than regular insurers.
12. When you value an insurer, what methods or models do you typically use? Is it mostly a matter of looking at multiples and comps? Or is there more to it.
Price to book is really the first metric that I look at, followed by price to earnings. It is simple and objective, as I want to know my margin of safety and then the earnings power. If it is cheap enough that I would be a buyer, then I start digging deeper. Usually, there is a reason that an insurer is trading cheap, so then I try to determine what can change with regard to investment income, underwriting results and expenses. That part is subjective. I do look at comps as a point of reference but not as a buying point.