Stansberry Data Weekly Update 5-6-14

It was only a matter of time until Berkshire Hathaway's Warren Buffett attracted imitators.

Buffett built the foundation of his legendary holding company on investments in insurance companies. He has written extensively in his annual shareholder letters about what makes property and casualty (P&C) insurance such an outstanding investment vehicle…

His work formed the basis for our investments in the sector. But it's not just us…

We've been calling P&C insurance "the best business in the world" since at least 2007. If you want validation of that point, look no further than Wall Street's best and brightest. They've been plowing capacity and capital into the markets at an unprecedented rate.

David Einhorn and his Greenlight Capital hedge fund were among the first to enter the P&C market in the middle of the 2000s. Daniel Loeb (Third Point Reinsurance) and Steven Cohen (SAC Reinsurance) followed in 2011 and 2012, respectively. These days, you can't be a billionaire hedge-fund wunderkind without having your own Bermuda-based insurer. It's like a rite of passage.

So what we're seeing is a bunch of new companies that have not participated in the insurance business suddenly throwing their hats into the P&C/reinsurance ring. According to the risk-focused publication Business Insurance, an incredible $10 billion of "alternative capital" flowed into P&C and reinsurance from the end of 2011 through June 30, 2013.

"Alternative capital" is a euphemism for "hedge-fund money"… and all of these dollars are now looking for risks to insure. All of this money has created what's called "excess capacity"… which basically means that the number of insurance companies looking for customers – or "insurance capacity" – exceeds the number of customers looking for insurance. In short, insurance supply is bigger than insurance demand.

But here's the thing. The insurance business is a two-headed monster. Deploying the excess capital generated by insurance premiums received is the first "head." But knowing how to underwrite and maintaining underwriting discipline is the second "head." If you do it right, over time, you will collect more in premiums than you pay out in claims. This is called an "underwriting profit," and it requires a discipline that few firms have.

Buffett only takes on a new business if he is adequately compensated for the risks. This often means turning away business and decreasing revenues if the market gets hyper-competitive. But Buffett understands that if his underwriting is consistently profitable, then he is essentially paid a fee for investing other people's money. He can keep for himself whatever proceeds he generates by investing that money.

This is the two-headed monster at its finest: writing profitable contracts and investing the proceeds of those contracts (known as float) for your own benefit. Porter explained this "Buffett model" in the March 2012 Investment Advisory:

For much more on this strategy, refer to the March 2012, October 2012, or March 2013 issues of Stansberry's Investment Advisory. For more on how this P&C model is vastly superior to the life-insurance model, read the April 30, 2013 edition of the Insurance Value Monitor.

Some companies – like our W.R. Berkley (NYSE: WRB) holding – are fantastic underwriters, but relatively conservative when it comes to investing the float. Conversely, hedge-fund geniuses are really good at investing excess capital – that's how they became billionaires in the first place. But they are unproven as underwriters. It's hard to find companies, like Berkshire Hathaway, that are equally good at underwriting and investing the float.

It's possible guys like Cohen and Loeb will hire the right people and end up leading first-class underwriting organizations. But we won't even rank a company with less than 10 years of underwriting results because it takes at least that long to develop a reliable track record. Buffett bought his first insurance company in 1967. It took him about a generation to develop his underwriting chops and recognize underwriting prowess in others. Should we assume Einhorn, Loeb, and Cohen were born with this ability?

By leaving the newer firms out, we will miss some overnight home runs and up-and-coming stars… but we will also avoid some disasters. We like overnight home runs as much as anyone, but we don't expect the P&C portion of our portfolio to produce them.

Some of these hedge funds and their "alternative capital" will certainly succeed in P&C insurance. But whether they succeed or not, the market is feeling their presence. The capital influx from 2012 and 2013 is just now beginning to drive down pricing on 2014 insurance contracts. For example, Axis Capital (our top-ranked insurer) and Berkshire Hathaway have already acknowledged that the industry's excess capacity has begun to eat away at the top line.

Last week, the P&C insurance industry descended on Denver for the Risk Management Society (RIMS) annual conference. AM Best – the source for rating and covering the insurance industry – had a large presence at the conference. The company reported:

As Liberty Mutual's general manager Michael Martin put it: "I don't think there's any secret [that] there's just a large abundance of capacity in the market."

Note… Buffett himself has played a significant role in the current state of over capacity. Berkshire Hathaway launched "Berkshire Hathaway Specialty Insurance" in June 2013 to compete in the "excess and specialty" (E&S) insurance market. E&S is a small corner of the P&C market that insures hard-to-price risks, like the arm of a professional quarterback or a company's potential exposure to sponsoring a contest, for example.

Berkshire Hathaway Specialty Insurance made an immediate splash by insuring the famous $1 billion Quicken Loans March Madness contest. Less than a year since launching, Buffett's new business has already grabbed 2% of the market. David Bresnahan, an executive vice president of the new Berkshire segment, made no apologies for his company's impact at the RIMS conference:

So what does all this mean?

We write all the time about how pricing cycles play into the P&C and related reinsurance markets. Check out the Portfolio Update of the November 2012 Investment Advisory or the November 13, 2013 Insurance Value Monitor for a refresher. Obviously, as more insurers enter the market, less disciplined insurers will be tempted to lower prices to compete… a tactic that will inevitably lead to costly underwriting losses in the future. Not everybody can be an "above average" underwriter.

Insurance pricing is still strong, but these pressures are definitely making the market softer. So now, more than ever, we will be focused on the "underwriting" component of our rankings. Remember what we said in November 2012:

This is a great time to invest in P&C insurance. Excess capacity may very well keep results low as the pricing cycle softens… which means we will be able to buy our favorite companies for great prices.

There was very little movement in the valuation component of our rankings this month. And the updated quarterly performance rankings will be released in next month's Monitor. At that point, you can expect an update on Axis (AXS) and PartnerRe (PRE), two brand-new entrants in our coverage universe that we've been monitoring for the past few months.

For now, WRB, Travelers (NYSE: TRV), and Alleghany (NYSE: Y) remain Buys. We continue to advise you to hold Chubb (NYSE: CB), American Financial Group (NYSE: AFG), and Navigators (Nasdaq: NAVG).

How to Read Our
Insurance Value Chart

We've developed our own proprietary system for evaluating all these companies, ranking each company based on underwriting discipline, how well they treat shareholders, and the ability to generate and grow "float." Finally, we evaluate how successfully these companies use their float to realize gains, grow book value, and increase the investment base. Of these factors, underwriting and float are the least understood.

• Underwriting is the ability of a company to accurately forecast and price risk.
• Float is money that is temporarily held by the insurer, but does not belong to the insurer. Float arises because premiums are received before losses are paid... and until the losses are paid, the insurer gets to invest the proceeds of these premiums for their own benefit. If insurers exercise a disciplined (and profitable) underwriting policy, then they are essentially paid to invest other people's money for their own benefit. See the March 2012, October 2012, November 2012, and March 2013 issues of Stansberry's Investment Advisory for more details.

It's hard to find people willing to talk about the true economics of the insurance business. "Float," for example, is not disclosed in Securities and Exchange Commission filings. To calculate it, you have to know a fair amount about financial statements. Then you have to dig through the notes and financial statements to calculate it yourself...

We've calculated the floats and the book values. We've researched the underwriting successes (or failures). We know each company's investment track record.

We compare the P&C companies' valuation to their respective insurance rankings. We define "valuation" as the premium (or discount) of its market cap to the combination of its book value and its float.

If you look back to the quadrant chart... you can see at a glance which insurance companies are mispriced. We are looking for stocks that land in the lower-left quadrant... Those are the cheapest stocks with the best rankings. We've circled the ones trading at the greatest discounts.

Turning to the table below, we've displayed our ranking of all the stocks we're following. Here is an explanation of some of the columns you'll find below:

• Combined Ratio is one of the components of our "Underwriting" ranking. Combined ratio is a measure of insurance underwriting profitability. Anything under "100" represents an underwriting profit. Some companies sacrifice underwriting discipline to meet their revenue goals. Over time, this can lead to sky-high combined ratios.
• 10-Year Float Growth helps assess how much each company has increased the money it collects from premiums.
• 10-Year Growth in Investments is one of the components of our "BV/Investment Growth" ranking. It shows which companies are doing the best job growing their investment base. The "Growth" in these accounts represents unrealized gains – that is, they are paper gains that will be realized when the underlying securities are sold.
• 10-Year Realized Investment Gains is one of the components of our "Investment Returns" ranking. Realized Gains include dividends and bond interest received on investments, as well as capital gains/losses on stocks that the company sells.

Regards,

Porter Stansberry with
Bryan Beach and Brett Aitken
May 6, 2014