Street Capitalist: Event Driven Value Investments

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.

According to Bloomberg:

Berkshire Hathaway Inc. has hired Todd Combs of Castle Point Capital to manage a “significant portion” of the investment portfolio built by Chairman Warren Buffett.

Combs, 39, issued a letter to partners of Castle Point announcing his decision, Omaha, Nebraska-based Berkshire said today in a statement distributed by Business Wire.

For three years, Vice Chairman Charles Munger and I “have been looking for someone of Todd’s caliber to handle a significant portion of Berkshire’s investment portfolio,” Buffett said in the statement. “We are delighted that Todd will be joining us.”

Buffett Names Castle Point’s Combs to Investment Post (Bloomberg)

Overall, I think that this decision makes a lot of sense. If you look at Berkshire over the course of its history, one of the common trends is a tendency to invest in financials. I’ve often wondered why this is but can speculate that it’s because insurance companies and banks tend to have recurring earnings and the threat of technological obsolescence is pretty low.

So who exactly is Todd Combs?

Combs (39 years old) runs Castle Point Capital, a long/short equity hedge fund focused exclusively on the financial services sector. Formed in 2005, the fund is based in Greenwich, Connecticut. Trident III provided the hedge fund’s seed capital in November 2005.

Here’s what Buffett has to say about Combs:

Buffett described Combs as an “all-American type” who is not the least bit interested in publicity, an attitude unlikely to shield him from it. Now a resident of Darien, Conn., Combs is by birth a Floridian who graduated in 1993 from Florida State University with majors in finance and multinational business operations.

Once out of school he worked for Florida’s comptroller and later moved to Progressive Insurance, where he was involved in the all-important activity of setting automobile insurance rates. Progressive is an arch-competitor of Berkshire’s GEICO.

…Buffett describes Combs’ record through the financial crisis as “pretty good.” Combs’ hiring, in fact, clearly indicates that Combs has had a performance with which Buffett is satisfied.

Meet the leading contender to manage Berkshire’s billions (Fortune)

Performance-wise, Todd Combs looks like a sharp financials investor. According to Bloomberg Castle Point’s fund gained 6.2 percent last year, fell 5.7 percent in 2008, rose 19 percent in 2007 and climbed 13.6 percent in 2006. If you look back over the same period, most financials-focused funds have not had that level of performance. Most took a beating back in 2007 and 2008 and have returns that are closer to the S&P over the same period, if not lower (about -5%).

One of the things I wondered about, back when Li Lu was discussed as a potential CIO candidate (he has since taken his name out of the running) was whether the penchant for betting big and winning huge would be an applicable strategy for Berkshire Hathaway. It’s a practice preached by Charlie Munger, but if you look out at what Buffett has done over the last 30 years, the only big bets have come via the form of acquisitions.

Some of the best plays from Berkshire’s investment portfolio have come from the preferred deals during the financial crisis and the convertible deals back in the 1987 bear market. In both cases, the investment returns had fixed-income properties, returns were capped for the most part, even though he could convert to equity or exercise warrants. These were mostly bets on survival, not on the overall ability for companies to thrive after crisis periods. An investor could have earned a much higher rate of return by purchasing common stocks near their all time lows during either period (similar to David Tepper), but it’s a strategy that Buffett did not pursue. I think that’s pretty telling.

Looking back at Todd Combs’ portfolio, we can see that he was not trying to bet big on any particular direction for financials. He was not doing a Michael Burry/Steve Eisman short the market and make 500% play. I think that is a quality that Buffett was looking for, someone who would perform well but not bet big. Maybe that’s due to the unpredictable nature of financial markets or maybe it’s because he wants the investment side of Berkshire to take a back seat to the operating businesses when he’s no longer around.

Some people have questioned whether investing in Todd Combs, someone with a short track record, makes any sense. To me, the fact that Combs performed so well during a period when most financials investors have gotten crushed is pretty telling. It’s not like we were looking at 5 years of performance during a bull market. So even though 5 years is typically too short of a short timespan, in this case I believe it’s enough to discern whether or not someone is a good investor.

You can view Todd Combs’ top 10 portfolio positions here:

For a full look at his Castle Point Capital portfolio, click this link, to view a google docs spreadsheet with his entire list of positions as of the latest 13F-HR.

Or, view his portfolio embedded in the iFrame below:

Looks like Sardar Biglari has gained an ally in his quest to acquire Fremont Michigan. Loeb Capital makes a good argument in favor of the deal. I expect the arbitrage spread to narrow:

October 18, 2010

Board of Directors (“Board”)
Fremont Michigan InsuraCorp, Inc.
933 East Main Street
Fremont, Michigan 49412

To the Board of Directors:

Loeb Arbitrage Management LP and Loeb Offshore Management LP, together doing business as Loeb Capital Management, and affiliated entities (collectively, “Loeb”) have management discretion over 160,600 shares of Fremont Michigan InsuraCorp, Inc. common stock (OTC: FMMH) (“Fremont”), or approximately 9% of the company. The recently-revised offer from Biglari Holdings Inc. (New York: BH) (“Biglari”) compels the Board to engage in a sincere process to maximize shareholder value; more to the point, Loeb thinks it is incumbent upon the Board, in keeping with its fiduciary duties to shareholders, to sell the company to the highest bidder.

Fremont, an illiquid stock, has scarcely traded at or above its tangible book value per share during its capital market history. Fremont is substantially dependant on one state for its profits. With an A- rating from A.M. Best Company (“A.M. Best”) and a premiums-to-surplus ratio of roughly 1.4x, prospects for growth, and therefore multiple expansion, are limited. The management of Fremont has put forth a strategic plan to achieve USD 100 million of direct premiums by 2013. It is not clear that the company can reach this level of premium production without an equity financing or loss of its current A.M. Best rating. Assuming everything goes according to management’s plan (a potentially unreasonable leap of faith) and assuming a 95% combined ratio, Loeb estimates that this premium level could produce operating earnings per share of $3.00. The offer from Biglari represents a P/E multiple of nearly 10x prospective 2013 earnings. Considering the earnings multiples of comparable regional insurers, Loeb thinks it unlikely that the company on its own merits would trade at a valuation of 10x P/E in the marketplace.

As a significant shareholder of Fremont, Loeb is not in favor of further tactics that put off potential buyers of the company. It is time to put aside mechanisms and campaigns such as a poison pill with a low trigger, a staggered Board and a concerted effort to secure legislation limiting shareholder rights. Again, the Board owes shareholders a fiduciary duty to maximize the value of the company, particularly in light of the current circumstances. A path has been provided for the Board to maximize value for the owners of an illiquid equity in the near term. Please note that this letter should not create the understanding that Loeb would accept an offer of $29.00 per share; rather, Loeb is simply of the opinion that Biglari’s offer is credible and that the valuation is high enough to be a springboard for a value maximization process. Loeb reserves its rights as a shareholder to take such actions to secure value maximization. Further, we hereby request a meeting with the CEO and Chairman of the Board of Fremont as soon as is practicable but in any event no later than October 29, 2010. Please contact Alexander H. McMillan, General Counsel at (212) 483-7069 to arrange such a meeting. Additionally, we request that Fremont raise the ownership threshold which triggers its poison pill, thereby allowing Loeb to increase its holdings (notwithstanding the necessary approvals from the Michigan Office of Financial and Insurance Services). Finally, please note that Loeb reserves the right to buy or sell stock.

Thank you for your immediate attention to our request.

Sincerely,

/s/ Gideon J. King
Gideon King
President, Chief Investment Officer

/s/ Blaine Marder
Blaine Marder
Vice

Yesterday, news broke that Texas-based activist value investor Sardar Biglari is bidding again for full control of Fremont Michigan InsuraCorp:

Biglari Holdings Inc. (NYSE:BH – News) today announced a proposal to acquire 100% of the issued and outstanding shares of common stock of Fremont Michigan InsuraCorp, Inc. (OTC Bulletin Board:FMMH.OB.ob – News) that it does not already own for a purchase price of $29 per share in cash. The purchase price represents a 41% premium over the closing price of Fremont’s common stock on October 11, 2010. Biglari Holdings is presenting its proposal to the Fremont Board, expecting its Board to exercise its fiduciary duties and therefore meet with Biglari Holdings to reach a mutually satisfactory transaction.

Press Release (Biglari Holdings)

To preface, I don’t own any Biglari Holdings stock anymore. Biglari’s struggle for Fremont has been well documented on my blog. Initially, Biglari offered $24.50 per share in a combination of cash and stock. At the time, many derided the offer and said it undervalued Fremont because he was only willing to pay close to 90% of book value for the company. Eventually, the management team used their political pull in Michigan to introduce legislation which would impede his ability to pursue a hostile offer against the company.

The new offer is $29 per share or about 1.1x book value, which might be fair given Fremont’s current troubles. Fremont’s underwriting has deteriorated recently and posted a combined ratio of 108 in the last quarter, which means its operations are generating losses. Combined ratios are calculated by taking underwriting expenses + loss adjustment expenses and dividing them by the amount of earned premiums. A combined ratio of less than 100 means underwriting operations are profitable. More broadly, the insurance market as a whole is feeling the pressures of the low yield environment. Most P/C underwriters have had the bulk of their profits come from their investment portfolios, not their underwriting. The problem with this is that insurance investment arms typically take a levered bond fund approach and safe bonds aren’t yielding a whole lot right now. This puts insurers who are bad at underwriting in a precarious position. They face losses on both ends and so far the soft market (weak insurance pricing cycle) is showing no signs of persisting.

So in a way, it’s possible that a capital allocator such as Biglari could be helpful. If he could adjust the company’s current allocation split between cash and bonds, Fremont might be able to generate investment gains that would offset their underwriting losses. Right now Fremont’s investment portfolio is just under $70M with about 83% of it in bonds. Biglari reportedly already has an insurance executive on staff who would be brought in to turn around underwriting operations which have so far run into losses as they’ve grown their personal lines business.

It’s easy to see why he wants Fremont. Being able to add an insurer would help diversify BH’s business from being so dependent on fast food and would also add a business line which brings recurring earnings to the table. Plus, the float from the insurance business (which is smaller because of the short-tail nature of their claims), could be used as dry powder when pursuing activist investments or takeovers. Similarly, Mark Schwarz of Newcastle Partners has taken this approach by gaining control of Hallmark Financial (NASDAQ:HALL) and using it to then gain control of Pizza Inn (NASDAQ:PZZI).

While I don’t have a stake in this situation, it’s still fun to watch given the tactics being employed by both sides.

For those of you that don’t remember – when I started this blog back in 2007 Fairfax Financial (PINK:FRFHF/ TSE:FFH) was my largest holding. It was in September and I was nervous about the potential for the sub-prime issue to spread to the rest of the economy. Fairfax represented a really unique opportunity because I purchased shares not only at 1/2 book value but also received the benefits of their credit default swap portfolio which was positioned against major Wall Street financial institutions. In a way, I had an undervalued company which also gave me the ability to hedge against the worst financial crisis in recent history.

Today, Gregory Zuckerman has a wonderful article on Fairfax Financial in the Wall Street Journal:

As more investors worry about the possibility of deflation—or a sustained period of falling prices that could cripple stocks—Fairfax Financial Holdings Ltd. has spent nearly $200 million to buy derivative contracts wagering on a decline in the consumer-price index, an inflation indicator. The trade could lead to huge profits if deflation occurs.

Fairfax purchased some of the derivative investments in the first three months of the year, when few fretted about deflation and the cost of the contracts was cheap. It added more in the second quarter.

The derivatives now are catching the attention of some on Wall Street. They have gained more than 50% in value since Fairfax made its original purchases from a number of banks, generating paper profits of more than $100 million.

The Fairfax bet, which aims to protect $22 billion of Fairfax’s investment portfolio, comes as investors grapple with a particularly challenging environment, with the economy fragile and stock indexes struggling. Few investors are willing to make big wagers on deflation, despite its potential, with many skeptical any deflationary period would last long. The U.S. hasn’t experienced an extended bout of deflation since the Great Depression.

Firm Makes Bold Bet on Falling Prices (WSJ)

With The Greatest Trade Ever and The Big Short, investors went looking for cheap insurance against seemingly improbable events. Today though, that insurance isn’t so cheap. The massive waves of CDOs that were originated in the lead up to the financial crisis helped make a market filled with inexpensive CDSs. That isn’t true for today. To me, insurance is worthless if it is overpriced. Fairfax on the other hand is once again demonstrating their shrewdness. Spending only $174M to protect a $22B portfolio sounds like a good bet:

The Fairfax team believes U.S. households have only begun reducing borrowing and increasing savings, a trend it expects will lead to less spending, higher unemployment and deflation.

Fairfax paid $174 million in upfront fees to protect $22 billion of its investment portfolio against the possibility of deflation over the next decade. In exchange, Fairfax will receive a payment amounting to the drop in CPI below 2%—the level of inflation when Fairfax bought its contracts—multiplied by the $22 billion.

If deflation averages 2% annually over the next 10 years, Fairfax’s contracts would rise in value the equivalent of 4% of $22 billion, or $880 million, each year over the next decade, according to traders familiar with Fairfax’s trades.

In that scenario, if Fairfax holds on to its investments during the 10-year period, it would reap nearly $9 billion from its $174 million investment.

The company wouldn’t get anything for its bet if inflation turns out to be higher than 2% over the next 10 years.

Right now there is a debate about whether we will experience deflation or inflation. It is my thinking that we will follow deflation briefly before inflating our way out of it — moving us into a period of inflation. That seems contrary to Watsa’s bet. But the thing to keep in mind is that Prem Watsa, Fairfax’s CEO, needs to protect his investment portfolio.

Most people don’t realize this, but investment income is what keeps most P&C insurance companies afloat. From 1975 to 2009 there have only been 5 years where the P&C insurance industry generated positive underwriting income. Over the same period insurers had an underwriting deficit of $445B. To make matters worse, we’re in a period of abnormally low interest rates. Most insurers have the bulk of their investment portfolios in fixed income securities. That income is likely to face some downward pressure given today’s yield curve. Some insurers try to chase better yields by going into munis, but I’d be cautious. Some municipalities have rather high budget deficits making the chance of default not entirely unlikely. One might find good short candidates by going through the investment portfolios of different insurers and finding the ones with the worst positioned investment portfolios that are coupled with bad underwriting.

So when I see Prem betting $174M to protect a $22B portfolio against deflation, I don’t necessarily take that as Prem betting the house. $174 million is only about 0.8% of the portfolio. I see this as a way to make sure Fairfax’s investment portfolio, which is crucial to the company’s survival, is protected. As long as their counter parties in the trade (Citibank Canada and Deutsche Bank) survive. It’s entirely possible that the team at Hamblin-Watsa will seek out other derivatives to help them hedge against other adverse macro-economic scenarios. I think that as long as the trades are cheap and offer asymmetric returns, Fairfax will probably consider them.

What does this mean for individual investors like you and me? I think that if right now, you see Fairfax as being undervalued without the derivative trade working out – you might want to consider it for your portfolio. Worst case: you have a cheap insurance company run by one of the best capital allocators in the insurance business. Best case: you have a cheap insurance company that should help hedge your portfolio against deflation. Most individual investors are unable to purchase the kinds of hedges that Fairfax employs, so this is one way to work around that. I would not buy solely on the derivatives trade because we don’t know how long it will take for Fairfax to actually realize their gains (if they realize any at all).

A lot of investors are fixated on BP plc (NYSE:BP) and Transocean (NYSE:RIG) because they are in the headlines so much. I think that part of the reason stems from the fact that investors like to be involved in the things they read about. There is a certain level of excitement.

I saw this same behavior during the financial crisis. Most people end up becoming obsessed with certain stocks just because they are constantly in the news. I can see the appeal, it gives you something that you can bring up in conversations with your friends. But often, it is not really prudent investing.

BP and RIG both face liabilities that are extremely difficult to estimate. BP has already agreed to pay for the costs of the cleanup, but as long as the oil keeps leaking, the costs will continue to rise. Credit Suisse analysts have come out saying that the costs may reach $37B or 9 times the cost of the Exxon Valdez spill. That is up from $10B a few weeks ago. With the public outraged and Attorney General investigating BP for possible criminal charges, there is a lot of uncertainty here. I just don’t think any one investor can truly figure out the risks in a situation like this with any accuracy.

Now, that is not to say there aren’t opportunities out there stemming from the oil spill.

Here are a few companies that I am researching right now. I still have a lot to read, but some of these look very interesting at current prices and all have been affected by the spill in one way or another. The benefit though is that they lack the headline risk and may ultimately be safer investments:

1. Ensco (NYSE:ESV)

Ensco is an offshore contract drilling company. As of February 15, 2010, Ensco’s offshore rig fleet included 42 jackup rigs, four ultra-deepwater semisubmersible rigs and one barge rig. Additionally, it had four ultra-deepwater semisubmersible rigs under construction. Ensco’s operations are concentrated in the regions of Asia Pacific, which includes Asia, the Middle East and Australia, Europe and Africa, and North and South America. It operates under four segments: Deepwater, Asia Pacific, Europe and Africa, and North and South America. Each of the four operating segments provides one service, contract drilling. Ensco engages in the drilling of offshore oil and natural gas wells by providing its drilling rigs and crews under contracts with international, government-owned and independent oil and gas companies.

At current prices, Ensco looks pretty cheap. Yes, a moratorium on offshore drilling would undoubtedly cause them to take a bit of a hit. But, think about it this way. You are getting a company that has been clobbered almost as bad as BP and RIG (about a 4% difference month-to-date).

However, you are also getting a company without the headline risk, substantial operations abroad to make up for any lost revenues during the drilling moratorium, and a clean balance sheet with $1B in net cash. If there really is a 6 month drilling moratorium, you can bet that some of the more leveraged players will be in for some pain. Plus, drilling rig premiums are going up, putting even more pressure on them. This might create some good bargains for a company like Ensco which could come in and buy rigs on the cheap from financially squeezed competitors.

The biggest risk with a company like Ensco is that its earnings could go down if the price of oil declines. With the risk of China’s economy slowing down, this is a possibility, but I think that in the long run the BRIC countries are here to stay and will ultimately drive energy prices higher.

Ensco looks pretty nice at around 7x earnings, 1x book, $1B in net cash, and a 4% dividend yield.

2. Tidewater (NYSE:TDW)

Tidewater Inc. provides offshore supply vessels and marine support services to the offshore energy industry through the operation of offshore marine service vessels. As of March 31, 2008, the Company had a total of 430 vessels, of which 10 were operated through joint ventures, 61 were stacked and 11 vessels withdrawn from service.

Tidewater is another company I started to look at. Again, these guys lack the headline risk, but still operate in the same industry and might take a hit from the moratorium. They operate shipping vessels for the O&G industry. A decline in drilling activity and energy prices would negatively impact their business.

On the plus side, TDW has a great record of capital allocation. When activity slows down, they have proven themselves to be incredibly adept at selling under-utilized vessels to companies in non-competing industries at prices in excess of cost.

Tidewater trades at 8.3x earnings, 88% of book value, and has a clean balance sheet with a 3% debt to equity ratio when you net out cash.

The risk here is again, if oil prices decline, rig activity slows down which also affects Tidewater. This has already happened and net income dropped from $407M to $259M YoY. In addition, the company has taken a few small charges $37M in provisions for vessels seized by Venezuela and $11.4M to the SEC for a bribery complaint related to operations in Nigeria. I can imagine that some of these may make investors nervous, but they seem quite frequent among companies in the O&G business that operate abroad.

3. HCC Insurance (NYSE:HCC)

HCC Insurance Holdings, Inc. (HCC) provides specialized property and casualty, surety, and group life, accident and health insurance coverages and agency services to commercial customers and individuals. The Company operates its businesses in three segments: insurance company, agency and other operations. It operates primarily in the United States, the United Kingdom, Spain and Ireland. It underwrites on both a direct basis, where it insures a risk in exchange for a premium, and on a reinsurance (assumed) basis, where it insures all or a portion of another, or ceding, insurance company’s risk in exchange for all or a portion of the ceding insurance company’s premium for the risk. HCC markets its products both directly to customers and through a network of independent and affiliated brokers, producers, agents and third party administrators.

These guys are expecting to take a $30 to $40M hit from the oil spill (they did $350M pre-tax last year). They seem to be running a really tight ship when it comes to underwriting, the last 3 years have been hovering around 85% combined ratio and have a good record of book value growth (15.7% CAGR since 2001). They have the lowest expense ratio in the industry, about 5% lower than peers, a nice little advantage.

The company is trading around 90% of book, historically over the last 5 years they have traded around 1.5x.

About 95% of shares are held by institutions, with 115M shares outstanding. The company just announced a $300M stock buyback, they just finished up their last buyback program ($100M, started in 2008). I think that might add some pressure to bring the stock price up, it has traded sideways the last few years.

It looks like an opportunity to get a good insurer at a good price.

Anyone who has followed this blog for a while knows that we are fans of Sardar Biglari and his work at Steak N Shake (now Biglari Holdings). One of Biglari’s goals is to add an insurance operation to the holding company. This would add a number of benefits to BH, namely the fact that its float could be redeployed into accretive investments.

Lawmakers in Michigan seem intent on curbing his efforts:

A bill wending its way through the Legislature aimed at protecting a small insurance company from a hostile takeover will have a chilling effect on investment and job creation in the state, an opponent said today.

Sardar Biglari, CEO of San Antonio-based Biglari Holdings, which owns 19 Steak ‘n Shake restaurants in Michigan, said the measure — which passed the Senate last month to block his company from acquiring Fremont InsuraCorp. of West Michigan — sends the wrong message to potential investors.

“This bill will send a signal that Michigan poses greater risks, greater uncertainty than other states,” said Biglari, who was in Lansing to meet with members of the House Insurance Committee, which is scheduled to take up the bill Thursday.

He said his holding company has no intention of moving the small insurer out of Michigan or of laying off its 75 employees. The only change in the works is to replace the company’s CEO, he said…

The legislation would require approval of two-thirds of outstanding shares of a company to elect director candidates who are not backed by a majority of that company’s board of directors. Biglari, who owns nearly 10 percent of Fremont InsuraCorp., said the bill would make it “nearly impossible to consummate the transaction.” He said the measure dilutes shareholder rights.

Biglari added he’s looking to acquire other businesses in Michigan and said the outcome of this legislation “will determine our level of interest.”

Cobb said the bill is narrowly tailored to block the takeover of Fremont and would affect only a couple other companies in the state.

“We don’t think it will have an effect on outside investment,” he said. “Shareholders will still have their say.”

Bill seen as roadblock to takeover of Fremont insurer

The really unfortunate thing here is that if a company in Michigan underperforms, with legislation like this in place, it will be extremely difficult to turn them around. Shareholders will have a say, but it will be weakened. Michigan should by now be well acquainted with how insulated management teams can run amok, after all, US taxpayers had to bailout their state when GM and Chrysler went bankrupt. It seems as if they haven’t quite learned the lesson yet.

A few readers have e-mailed me asking that I show how to analyze a P&C insurance company. I thought that this might actually make a good post series.

When I started out in investing, insurance companies seemed really difficult for me to analyze. I found out that insurance companies aren’t necessarily harder to analyze than any other company, but that there is a good deal of jargon to get used to.

I don’t know how good I am at teaching this kind of thing, so please use the comments section or e-mail me suggestions or issues you have with the post. Once I have finished this series, I’ll put all the parts into one big PDF, that way new investors can quickly grab the whole thing to study. My other goal is to eventually post guides for other industries; think banks, restaurants, retailers, and more.

The Income Statement

For the first part, we are going to look at the income statement. Now, I prefer to look at actual cases, so we will be analyzing Fremont Michigan Insuracorp (OTC:FMMH) for the rest of the series. I think it is useful to learn from companies like Fremont, because they are smaller and tend to have fewer moving parts. You can access the company’s latest 10K by clicking here.

One of the most confusing aspects of P&C insurance companies is how they make money. It is not as simple as just looking straight at the revenues line on an income statement. Instead, P&C insurance companies generate revenues in three ways: underwriting, investment/dividend income, realized gains.

Take a moment to look at the income statement line by line. One of the things that will stand out is how revenues are related to net income. You can see that each year, revenues grow, but net income actually decreased in 2008. This sometimes happens with insurance companies, they get a little loose with their underwriting standards and write too many policies without anticipating what they will do to the bottom line. As an investor though, you can sometimes use these periods to find an undervalued insurer. Say they had been writing policies for some kind of unprofitable line and decide to quit – that is an avenue for earnings to change.

Underwriting

When you think of the insurance, underwriting is probably what comes to mind. Underwriting is the act by which insurance companies take on risk. In exchange for that risk, they are paid premiums, usually on a fixed basis. The job of an insurance company is to take on the right kinds of risk, priced appropriately, so that they wont have to pay out too often or at rates that exceed their premiums.

This is why insurance is such a difficult business. In the past, Warren Buffett has noted that most insurance companies often relax their standards during a soft market (a time when insurance premium prices decline) and take on large volumes of risk that are priced too low. This narrows the margin of safety an insurance company has. If accidents happen at a higher rate than expected, an insurance company can easily go belly up. We’ve seen a lot of that in the past.

Premiums

Whenever you enter into a policy, say for auto insurance, you are paying a premium every month. That monthly premium allows you to get coverage by the insurance company. Now, to get to net premiums we have to go through a few steps.

In general, when Fremont writes an insurance policy, it goes under gross premiums written. But, as you can see, that does not appear on the company’s income statement. What happens is, most insurance companies will actually buy some reinsurance for a premium. Basically, this reduces the amount of total risk they are taking on because the reinsurance company will cover some of it — this practice is called ceding premiums.

Gross Premiums Written – Ceded Premiums = Net Premiums Written

Still, that does not get us to net premiums earned. To get there:

Net Premiums Written / 12*10 = Net Premiums Earned

A reader pointed out to me that the example I gave is a generalization, here is his approach which is better:

I think a more accurate equation, which inherently must involve the balance sheet, is:

Net premiums earned = net premiums written – increase in the unearned premium reserve (UEPR)

When an insurer writes a policy, it immediately posts a liability (the UEPR) against the cash received of 100% of the premium. Releases from the UEPR become earned revenue.

Simple example: insurer writes a 12 month policy on December 1, 2010 for $1200 and collects all cash upfront and purchases no reinsurance on this policy. The balance sheet would show $1200 in cash and an unearned premium reserve of $1200. Assuming premium is earned pro rata over the life of the policy, at 12/31/10, the UEPR would reduce to $1100 and earned premium (the top line revenue item) on this policy would be $100, the amount of the release.

The 2010 income statement on this one policy would be calculated as follows:

Net premiums earned = net premiums written of $1200 minus $1100 (the increase in the UEPR from 0 to $1100 at year end) = $100

What you are doing is assuming that the insurance company will have 10 months of the same result over 12 months. Insurance companies earn premiums pro rata over the life of the policy. Different policies have different lengths, auto insurance is generally shorter at 6 months while commercial lines may be 1 year in length.

Fremont appears to be growing by writing more policies. They recently announced a plan to expand beyond their local Michigan market, which might help propel growth prospects and diversify their risks out of just Michigan. For an insurer, this is a pretty good sign.

Loss and Loss Adjustment Expense

Accidents happen. If you write an insurance policy, you have to be ready for losses. These come under the Loss and Loss Adjustment Expense:

An insurance company will incur losses in two ways, paying claims and establishing a reserve. When you receive a check from the insurance company? That’s paying a claim. The loss reserve? That is a liability on an insurance company’s balance sheet. Basically, Fremont sets a pool of reserves for losses they think they will encounter. Premiums are often split between loss reserves and investments. When a claim is submitted, that amount is then paid out from the loss reserve.

Paid Claims + Reserve Charge = Expenses

Insurance comes in two forms, long tail and short tail. Short tail insurance has to be paid out more frequently, so the investment prospects are usually shorter. If you look at any great investor who has taken control of an insurance company, they tend to gravitate towards longer tail policies.

Besides paying out claims, an insurance company incurs underwriting expenses.

Commissions + Other Underwriting = Total Underwriting Expenses

Most insurance companies have to deal with agents and brokers who actually go out and acquire customers. They are paid commission fees for their work, typically a percentage of premiums. Other underwriting expenses are typically your administrative costs, technology, taxes, and office rent.

The Combined Ratio

Every industry has some go-to metric for figuring out how to compare one business to the other. For fast food it might be same store sales, for retail sales per square feet, but for insurance — I think it is the combined ratio. The combined ratio is this:

Expense Ratio + Loss Ratio = Combined Ratio.

Loss Ratio:

Losses and LAE incurred / Premiums

Expense Ratio:

Underwriting Expenses / Premiums

When looking at combined ratios, a 100% CR means the insurer is breaking even on their insurance operation. Below 100% means an underwriting profit and above 100% means an underwriting loss.

I can’t stress this enough – when you are examining an insurance company you really want one that is a profitable underwriter. This is not a business where you want to get yourself involved in a turnaround. You want a turnaround? They usually end badly. Fairfax endured 7 lean years as a result of picking up some very difficult to turnaround distressed insurance operations.

Overall, you can see that Fremont’s underwriting operation is profitable. Their combined ratios are coming down below 100% and are not abnormally low which would indicate that they are under-earning.

Investment Income

Most insurance companies will have a lag time between when they collect premiums and have to pay out claims. In between, insurance companies will usually invest at least a portion of those collected premiums. The idea is to beat the time value of money effect; a dollar today is worth more than a dollar tomorrow. Investment income is made up of the dividend and interest income that an insurance company receives from its investments.

Remember that discussion about short-tail and long-tail insurance? Well that affects how long insurance companies are able to hold on to their reserves and deploy them into investments. Short-tail insurance is paid out more frequently so their investments usually have less time to compound. The opposite is true for long-tail insurance. This is one of the reasons Berkshire Hathaway is involved in reinsurance is the face that they are able to write policies on events that may never happen or wont happen for a long time. This long-tail insurance allows them to deploy premiums into investments and compound for a longer period.

Unfortunately, the insurance market takes this into account and prices insurance policies accordingly. Many forms of long-tail insurance have higher combined ratios than short-tail risk insurance.

Within investments are two other components:

1. Realized Gains (Losses):

As I said, most insurance companies operate some kind of investment portfolio. When the company actually makes a sale on one of their investments, they will record a realized gain (or loss) depending on the price they originally paid and the price they sold for.

You’ll see that Fremont took some losses in 2008, most likely tied to the financial crisis. A number of insurance companies got into purchasing fixed income securities for yield without looking at their true nature. Some were involved in the dreaded toxic assets — I have not looked at what Fremont was selling back in 2008, but you could probably find out by accessing state insurance filings via the NAIC.

2. Unrealized Gains (Losses):

This is when the company’s investment portfolio appreciates or declines, without any sales actually occurring. Due to the mark to market laws, an insurance company might report changes in unrealized gains every quarter depending on the stock market’s performance. Keep in mind that changes in unrealized gains do not register in the income statement, rather, they are found in the balance sheet as a driver of shareholders equity via retained earnings.

Since many insurance companies use fixed income instruments to obtain dividend income, their portfolios are sensitive to changes to interest rates. If they are buying securities that are yielding close to current rates, and we see rates rise, the value of those securities will fall — forcing the insurance company to record unrealized losses.

Some insurers that are not profitable on their underwriting can still crank out a profit via investments. Fairfax Financial is well known for having this ability, it really requires a strong investment team at the helm. Unfortunately, the nature of investments is changing for some insurance companies. A recent article reported that many will cease to manage their investment portfolios in house. I like when insurers foster an in house investment operation because their incentives are often more aligned with the insurer. When you farm out your assets to Wall Street, you might get into products that require only a management fee (meaning performance does not matter) and the insurer will be taken for a stroll by Wall Street sales guys who only care about their commissions — not the well being of the insurer. I’d rather that insurance companies try to create a really good, value oriented investment operation in house. Guys like Tom Gayner and the folks at Hamblin-Watsa exemplify this best.

Conclusion

Hopefully, this has helped you understand some of the terminology and items that you will find on an insurance company’s income statement. Once you see how the income statement works, you can look at it from a variable perspective. One of Fremont’s criticisms is that their expenses could be lowered, this is a good point. If the company could reduce 2009 underwriting expenses by 5.9% net income would rise by almost 25%.

Let me know if I have been unclear in this walk through the income statement. My next post will focus on the balance sheet.