Stansberry's Investment Advisory

Stansberry Data

Stansberry Data: Insurance Value Monitor Update 6-2-15

June 2, 2015 Stansberry Data

They say imitation is the sincerest form of flattery.

If that's true, the world's hedge-fund billionaires have been flattering Warren Buffett for years.

As you may know, Buffett is the multi-billionaire CEO of Berkshire Hathaway (BRK). As you may also know, Buffett has spent much of the last five decades writing about property and casualty (P&C) insurance and reinsurance… the man simply loves to explain how this particular business model propelled Berkshire Hathaway into the stratosphere.

We based our Stansberry Data scoring model largely on metrics that Buffett uses to evaluate insurers – but we're not the only ones who have paid attention to his tips and tricks.

In recent years, hedge-fund billionaire Daniel Loeb opened his own "Berkshire-style" insurance company – Third Point Reinsurance (TPRE).

When it went public in 2013, Third Point Re shot out of the gate like a dot-com rocket, soaring more than 40% in just a couple of months. Investors breathlessly bid up shares in an effort to "catch the next Berkshire" on the ground floor.

As an investor, Loeb has had a great run. In 1995, Loeb started a hedge fund with around $3 million. Today, he's worth an estimated $2.5 billion. Not a bad 20-year track record.

Loeb is not alone. Steven Cohen of SAC Capital and David Einhorn of Greenlight Capital also set up their own "Berkshire-style" insurance companies. And like Loeb, they have fortune-making, market-beating records. Since 2010, dozens of hedge funds have thrown their hats in the insurance ring. Reinsurance advisor Aon Benfield Analytics estimates that alternative capital (i.e., "hedge-fund money") in the global reinsurance market has tripled since 2008 and now represents more than 12% of the market.

This flood of alternative capital has been one of our favorite themes over the past year or so. This excess capital has sent ripples throughout the industry, putting pressure on pricing and – according to many pundits – leading to the recent rash of industry consolidation.

Buffett made it look so darn easy.

Unfortunately, replicating Berkshire's model is much easier said than done… even for guys as smart as Einhorn and Loeb. As we said last May:

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 maintain underwriting discipline is the second "head"...

(Buffett) is the two-headed monster at its finest: writing profitable contracts and investing the proceeds of those contracts for (Berkshire Hathaway's) benefit...

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.

Starting a successful insurance company from scratch is extremely hard to do. For industry outsiders, it's next to impossible. Buffett understood this, which is why he jumped into the insurance game by buying well-established insurers like National Indemnity and GEICO.

In the April issue of the Stansberry's Investment Advisory, we told you about a different insurance start-up – Allied World Assurance. Allied wasn't started by some genius hedge-fund billionaire. The CEOs of Chubb, American International Group, and Swiss Re – an all-star team of underwriting talent – started Allied. These were experienced CEOs who had already built various companies into international insurance powerhouses.

Remember, insurance is all about trust.

Imagine you have a billion-dollar skyscraper or oil tanker to insure. Who's going to get your insurance business? Yes, price matters. But with your business' survival on the line – who do you trust?

An insurance stalwart – like Travelers or Chubb – with 100 years of experience? Or maybe you could look at a smaller specialty insurer founded by industry titans a few years back – like, say, Axis or Allied World Assurance. Those are good options.

But how likely are you to put your business' most important assets in the hands of some reinsurer founded by an investment-focused hedge-fund guy? Obviously, these hedge-fund guys aren't doing the underwriting and insurance-risk assessment themselves. They bring in teams with insurance experience for that. Despite this, the numbers in the insurance market suggest that when billion-dollar risks like buildings and supertankers are on the line, it is difficult for these Johnny-come-latelies to compete, especially when it comes to the really juicy reinsurance premiums.

With limited insurance reputations to lean on, guys like Loeb and Einhorn have to compete on price. Readers who have been with us more than a couple of months know what happens when insurers "compete on price." Underwriting profits suffer… or even go negative.

As our subscribers know, the "combined ratio" is how the industry measures underwriting prowess. A combined ratio less than 100 represents an underwriting profit, while a ratio greater than 100 means your insurance business is losing money.

In the 13 quarters since Third Point began reporting as a public company, its average quarterly combined ratio has been an abysmal 113. This means by the time the float hits Loeb's hands, he's already 13% in the hole. Making matters worse, Third Point Re has yet to earn an underwriting profit in any period. An underwriting record this consistently horrible is truly hard to find. It is significantly worse than any of the 50 insurers we rank.

In the table below, you'll see a couple of hedge-fund insurers compared with a couple of other insurance "start-ups" – Axis and Allied – which were founded by insurance royalty (see the August 2014 and April 2015 SIA for more details).

As you can see, since Third Point went public, its stock has returned a ho-hum 8.5% annually to investors (it has lost 22% since that huge post-IPO gain). Greenlight Capital Re hasn't fared any better, from either a stock return or an underwriting perspective. These returns significantly trail the S&P 500 and are significantly less than what an investor would have earned by investing in an overall index of insurance companies (the iShares U.S. Insurance Fund). Meanwhile, Axis and Allied earned huge underwriting profits, nearly doubled the returns of the insurance index, and nearly tripled the returns of the hedge-fund wonder boys.

The chart above is a simplified illustration over a relatively arbitrary time period. But, over any time frame, the results would have been similar, with underwriters crushing the investors. The market has spoken. When it comes to stock returns, underwriting prowess trumps investing prowess every time.

Things may end up working out well for Third Point Re, Greenlight Capital Re, and the other "alternative capital" insurers. But, we're going to continue to focus on what works – calculating, tracking, and ranking companies based on the Buffett metrics (which, incidentally, do include a quantitative ranking for investing acumen).

As for all this alternative capital? We're content to watch those insurers from the sidelines. And, while we make no predictions, don't be surprised if you see more announcements like AQR Re's in March 2015, when the company stated that "due to consolidating market dynamics it [would] be increasingly difficult… to achieve attractive risk-adjusted returns." AQR ceased its operations one month later.

AQR Re was one of four hedge-fund-backed reinsurers to set up shop in 2011… opening its doors just days before Third Point Re. It's the first major hedge-fund-insurance casualty. We doubt it will be the last.

Insurance Insights

In this month's edition of "Insurance Insights," we address a common question we get from readers. Isn't it bad to own insurance companies while interest rates are rising? And seeing as interest rates are bound to eventually bounce off their historical lows, shouldn't we be wary of holding a portfolio of insurers?

That's certainly conventional wisdom. But, as we'll show you today, we aren't afraid of rising rates.

Let's back up for a moment and discuss the different dynamics at play here. When interest rates rise, the market value of existing bonds falls. This is a well-defined law of financial markets, because investors will obviously pay less for an existing 3% bond if the bonds issued today will pay a 4% interest rate.

Insurance companies hold massive amounts of bonds. In fact, a vast majority of insurers' valuable float is invested in fixed-income securities (i.e., bonds) whose prices are susceptible to a move in interest rates. So, as interest rates rise, won't the book value of these bond-heavy insurers collapse?

Simply put, yes. A rise in interest rates will absolutely lead to a fall – possibly even a sharp fall – in the book value of insurance companies. But remember that insurance companies count on bonds to generate income. So, rising rates will allow insurers to earn a greater return on each dollar invested in the future.

In short, rising interest rates hurt the balance sheet, but they will improve future earnings.

Think about it. The value of a $1,000 face-value June 2018 bond sitting on Acme Insurance's books would absolutely take a hit if interest rates rose. Acme's "book value" would suffer accordingly. But, if held to maturity, this 2018 bond would gradually return to its $1,000 face value (assuming the bond issuer remained solvent, of course). Bonds held to maturity always end up returning to face value. And, of course, once these bonds mature, Acme can reinvest in higher-yielding investments, assuming interest rates are still higher.

The great thing about P&C insurance and reinsurance is that management has the flexibility to invest in shorter-dated bonds when interest rates are low, which minimizes the period of diminished book value. This is a huge advantage over life insurers, who generally need to commit to long-term bonds.

This is why some of the brightest minds in P&C insurance would actually welcome a rise in interest rates, despite its impact on book value. We discussed this interesting dynamic in the April 30, 2013 issue of Stansberry Data, here.

The stock market, mainstream media outlets, and even some professional insurance analysts don't seem to fully grasp this trade-off. That's why, when interest rates finally do rise… you will almost certainly see Mr. Market indiscriminately punish insurance companies, even great companies like the ones we recommend in Stansberry's Investment Advisory.

So, if you think interest rates are going to rise… and you have a short- to mid-term investment horizon… you may indeed want to consider trimming your exposure to insurance companies. Mr. Market is scared of rising rates and will temporarily punish your insurance holdings.

But, if you're a long-term insurance investor, you'd be wise to follow the lead of Buffett and welcome rising rates and the increased earnings and cash flows they will bring. In the end, Mr. Market will catch on. He always does.

The biggest change in our rankings this month was Bermuda-based reinsurer RenaissanceRe (RNR) moving up four places and cracking our top five. RNR recently closed on its $1.7 billion acquisition of Platinum Underwriters Holdings (PTP), adding $1.3 billion of float to its balance sheet. It was a good deal for RNR… the purchase price represented a discount to Platinum's float-plus-book value of 46%. RNR now trades at a discount of 35% to float-plus-book value, up from a small 2% discount last month.

We welcome any comments or questions, which you can send here.

A Note on Our Tables: Many of you have noticed that we have altered the way we display our tables at the bottom of our weekly Stansberry Data. Unfortunately, our monitors have gotten so large, we've had to adjust our tables to fit both in our e-mails and on our website, StansberryResearch.com. We know that some of you like to have access to the raw numbers, so we have begun including a link to an Excel version of our tables below. You can download the spreadsheet by clicking here.

What Are We Looking For with the Insurance Value Monitor?

The best P&C insurance companies consistently produce underwriting profits and generate realized investment returns, while growing float, book value, and the investable asset base.

Warren Buffett became the world's most successful investor in large part due to his understanding of the insurance business. Buffett generally expects up to a 25% discount to float-plus-book value when purchasing a great insurance company. But in the current market... we believe you can do a lot better than that.

As a rule of thumb, we're looking for high-quality P&C insurers that are trading for about 50% of float-plus-book value.

We covered the opportunity in P&C insurance in detail in the October 2012 and March 2013 issues of Stansberry's Investment Advisory. For the full details, please review the analysis in the section titled "Why Your 'Safe' Money Ought to Be in Insurance Stocks" here.

We also addressed the insurance-pricing cycle in the November issue, in the portfolio review, here.

How to Read Our Insurance Value Chart and Table

We've developed our own proprietary system for evaluating P&C insurance companies, ranking each company based on:

Underwriting discipline,

How well they treat shareholders,

Their ability to generate and grow "float,"

How successfully these companies use their float to grow their investment base and realize investment gains, and finally,

Their ability to grow book value per share.

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 looked at data going back at least seven years in our evaluation… and in most cases, we go back 10 years. Our proprietary rankings consolidate dozens of data points in order to calculate each individual ranking category above. We combine the individual ranking categories to arrive at one combined overall ranking.

We then 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 current overall ranking of the top 25 insurance companies we're following. In addition, the table below also offers a small sampling of some of the data used to compile the individual rankings. Therefore, it is not possible to recalculate our proprietary overall rankings from the small sampling of data points presented here. To compile this data, we used at least seven years of history in the calculations. In most cases, we use 10 years of history. Below are explanations of some of the columns you'll find.

Avg. Combined Ratio is one of the components of our "Underwriting Discipline" ranking. Combined ratio is a measure of insurance underwriting profitability. Anything less than "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.

Float Growth helps assess how much each company has increased the money it collects from premiums.

Growth in Investments is one of the components of our "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.

Growth in Book Value per Share is a common way insurance companies measure their performance. It's the amount each company has grown the per-share value of its net assets, or book value. Book value is essentially a company's "net worth" – or the value of all of its assets less all of its liabilities.

Best regards,

Porter Stansberry with
Bryan Beach and Mike DiBiase
June 2, 2015