I've been starting to look at some reinsurance companies as potential investments as I noticed that many of them are trading at discounts to book value and have instituted fairly aggressive share buyback programs.
I'm not fully comfortable investing in this sector as it is virtually impossible for an outsider (and likely even an insider) to truly know the quality of underwriting that has been done in prior periods. It can take years to really see what sort of skeletons may or may not lurk in the closet as a result of chasing premiums that weren't worth the risk.
I noticed today that reinsurance rates are going to be dropping fairly significantly in 2011. The following article detailed this:
"Reinsurance rates have decreased by as much as 10 percent as of the Jan. 1 renewals, as two leading reinsurance brokers indicated there are reasons for concern in the marketplace.
In separate reports, Willis Re and Aon Benfield issued their views on the reinsurance market, saying that generally, reinsurance rates came in with an average decrease of 5 to 10 percent.
"Overcapitalization in the reinsurance market continues to gradually push rates downward with price reductions at the Jan. 1, 2011 reinsurance renewals averaging between 5 [percent] and 10 [percent]," Willis Re said in a statement.
"Reinsurers are now lowering rates at the same, or faster, pace than insurers are lowering rates," Aon Benfield said in its report.
The broker went on to say that both insurers and reinsurers have recovered financially from the economic crisis, but their products have "quite limited growth." Three consecutive years of declines for the United States, Germany, France and the United Kingdom mean that insurers "need to turn their efforts to generating demand from new products or innovations on existing ones."
Willis Re said reinsurers' 2010 underwriting "results are lower than the exceptional ones achieved in comparatively loss-free 2009. However, the results are "better than initially feared after the disastrous first quarter."
Reinsurance carriers may seek to "implement more aggressive capital management strategies through share repurchases, dividend payments and other similar measurers."
Among some of the factors influencing reinsurance supply, according to Aon Benfield:
Extremely light hurricane losses.
Growth in investor interest in catastrophe bonds.
Continued favorable casualty reserved development.
Declining quality of Florida homeowners insurers as they struggle to profit with inadequate rates and survive sinkholes.
Low exposure growth.
Dominic Christian, co-chief executive officer of Aon Benfield, said, "Whilst negotiations around the [$60 billion] of externally transacted reinsurance premium renewing at Jan. 1 may be fairly described as being reasoned and assured, there has been on occasion real variability around program outcomes--treaty terms have remained robust, but pricing is less homogeneous than for some time."
"The global reinsurance industry faces tough prospects for 2011," said Peter Hearn, chief executive officer of Willis Re, in a statement. "Thin investment returns and declining back-year releases provide little cover for declining underwriting returns. In such an environment, any shock to reinsurers' capital base, either through underwriting losses or other capital events, is likely to result in a sharper reaction from reinsurers than primary companies will find easy to bear.""
Seeing that premiums are dropping makes me think of Buffett. At this time I'm sure he and his main insurance main Ajit Jain will be backing away from the market and accepting a much lower level of reinsurance business in 2011. There is no better place to learn how to think about the reinsurance than the Berkshire letter to shareholders, and here is a relevant excerpt from the 2004 letter:
Since Berkshire purchased National Indemnity ("NICO") in 1967, property-casualty insurance has been our core business and the propellant of our growth. Insurance has provided a fountain of funds with which we've acquired the securities and businesses that now give us an ever-widening variety of earnings streams. So in this section, I will be spending a little time telling you how we got where we are.
The source of our insurance funds is "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, because it sometimes takes many years for losses to be reported (asbestos losses would be an example), negotiated and settled. The $20 million of float that came with our 1967 purchase has now increased – both by way of internal growth and acquisitions – to $46.1 billion.
Float is wonderful – if it doesn't come at a high price. Its cost is determined by underwriting results, meaning how the expenses and losses we will ultimately pay compare with the premiums we have received. When an underwriting profit is achieved – as has been the case at Berkshire in about half of the 38 years we have been in the insurance business – float is better than free. In such years, we are actually paid for holding other people's money. For most insurers, however, life has been far more difficult: In aggregate, the property-casualty industry almost invariably operates at an underwriting loss. When that loss is large, float becomes expensive, sometimes devastatingly so.
Insurers have generally earned poor returns for a simple reason: They sell a commodity-like product. Policy forms are standard, and the product is available from many suppliers, some of whom are mutual companies ("owned" by policyholders rather than stockholders) with profit goals that are limited. Moreover, most insureds don't care from whom they buy. Customers by the millions say "I need some Gillette blades" or "I'll have a Coke" but we wait in vain for "I'd like a National Indemnity policy, please." Consequently, price competition in insurance is usually fierce. Think airline seats.
So, you may ask, how do Berkshire's insurance operations overcome the dismal economics of the industry and achieve some measure of enduring competitive advantage? We've attacked that problem in several ways. Let's look first at NICO's strategy.
When we purchased the company – a specialist in commercial auto and general liability insurance – it did not appear to have any attributes that would overcome the industry's chronic troubles. It was not well-known, had no informational advantage (the company has never had an actuary), was not a low-cost operator, and sold through general agents, a method many people thought outdated. Nevertheless, for almost all of the past 38 years, NICO has been a star performer. Indeed, had we not made this acquisition, Berkshire would be lucky to be worth half of what it is today.
What we've had going for us is a managerial mindset that most insurers find impossible to replicate. Take a look at the facing page. Can you imagine any public company embracing a business model that would lead to the decline in revenue that we experienced from 1986 through 1999? That colossal slide, it should be emphasized, did not occur because business was unobtainable. Many billions of premium dollars were readily available to NICO had we only been willing to cut prices. But we instead consistently priced to make a profit, not to match our most optimistic competitor. We never left customers – but they left us.
Most American businesses harbor an "institutional imperative" that rejects extended decreases in volume. What CEO wants to report to his shareholders that not only did business contract last year but that it will continue to drop? In insurance, the urge to keep writing business is also intensified because the consequences of foolishly-priced policies may not become apparent for some time. If an insurer is optimistic in its reserving, reported earnings will be overstated, and years may pass before true loss costs are revealed (a form of self-deception that nearly destroyed GEICO in the early 1970s).
Portrait of a Disciplined Underwriter
National Indemnity Company Year
(In $ millions)
No. of Employees at Year-End
Operating Expenses to
Underwriting Profit (Loss) as a Per-centage of Premiums (Calculated as of
year end 2004)*