A glance at the insurance industry

The insurance industry is a fascinating business as is its function is basically to absorb risk. The apealing aspect of insurance companies to investors are their ability to generate cash. In the words of Warren Buffet:

The fountain of funds we enjoy in our insurance operations comes from “float,” which is money that doesn’t belong to us but that we temporarily hold. Most of our float arises because (1) premiums are paid upfront though the service we provide – insurance protection – is delivered over a period that usually covers a year and; (2) loss events that occur today do not always result in our immediately paying claims, since it sometimes takes years for losses to be reported (think asbestos), negotiated and settled.

Float is wonderful – if it doesn’t come at a high price. The cost of float is determined by underwriting results, meaning how losses and expenses paid compare with premiums received. The property-casualty industry as a whole regularly operates at a substantial underwriting loss, and therefore often has a cost of float that is unattractive.

– Warren Buffett, Letter to Shareholders 2003

David Merkel wrote a very informative summary of the insurance industry recently on SeekingAlpha.com called Flavours of Insurance.

“I view the insurance industry as a loosely related group of sub-industries, where knowing something about one sub-industry tells little about any other sub-industry. Even within each sub-industry, companies can be very different from each other.”

It is a highly informative reading. You can read the articles here:  Part I, Part II, Part III.

The current market
Insurance companies seem very attractivly valued at the moment. Here´s a presentation from Alterra Capital on the current P&C insurance market. As they note the industry is trading at valuation that are at a 25 year low, with the averege being less than book value. The same holds in other other sectors.

Here is a link to the Alterra presentation: Alterra presentation

I asket Tom Armistead, an active contributor at Seeking Alpha who used to work in the insurance industry, about his thoughts on the low valuations. Here are his comments:

I’ve been puzzled by the way insurance stocks are trading under book value. I own (or control by options) a lot of them – ALL, CB, TRV, UTR, MET, PRU, MFC, FNF, MBI, RDN, AGO…

I think investors fear that operations of some of these companies will continue to develop losses for a number of years going forward, that would be RDN,MBI and AGO. So for those cases its a waiting game, to see how much book value remains when all the losses are in.

For the Life insurers – MET, PRU and MFC, investors are afraid of their exposure to equity markets via the guarantees they have written on variable annuities. Also, it is difficult for them to earn good returns in a low interest rate environment and Canadian GAAP and regulatory requirements exacerbate the problem for MFC.

Then for most of them there is the fear that their investment assets are not good. That can be researched, they typically disclose the mix of assets and discuss the quality of them in various presentations. SO investors who take the trouble can find out how much RMBS or CMBS they hold, sometimes the ratings, how much loans have they made on commercial real estate, what are the vintages of that, etc.

I’ve been investing on the basis that P/B will revert from the present 1.0 or less sometimes to something more like 1.2 or even 1.4 which would be more in line with historical averages before the financial crisis.

My first career was in P&C insurance and I find if very difficult to understand current valuations, many of these companies are a steal in my opinion, you could for example add CINF to the companies listed and there are others.

Insurance companies are hard to value as they have a ‘black box’ element and because of the importance of quality management.  None the less, I am very interested in this industry as I think it might hold opportunities at currently that come only on very rare occasions.

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