"The source of our insurance funds is 'float,' which is money that doesn’t belong to us but that we temporarily hold... The $20 million of float that came with our 1967 purchase (National Indemnity - NICO) has now increased — both by way of internal growth and acquisitions — to $46.1 billion."
— Warren Buffett
Writing insurance can be a great business. If premiums are underwritten correctly, an insurance company can use the depositor's money and draw a positive rate of return. The process is tantamount to running a bank where depositors pay you a hefty premium merely to hold their money. In most cases the depositors are quite content to accept 90 cents on the dollar in return for the right to have you hold their money for an extend period of time.
What makes the insurance business so profitable is the concept of float. Float is the amount of premiums which a company takes in long before any claims are settled. Since all insurance premiums are paid in advance, the insurer has "free" use of these funds until a claim arises. In the interim, the float can generate outstanding profits on "low risk" investments.
Of course the insurance company has to employ proper risk assessment to be sure that they are not paying out more in claims than they are making by using your cash. One can not expect to make a living by exclusively accepting large bets on the Yankees which pay 20 to 1 in the event they win the World Series. The bookmaker may be rolling in cash when the Yanks fail nine straight years but that tenth year is apt to be a killer.
Profits for insurance companies are divided into two separate pools. The first pool is underwriting profits and they can be determined by observing the company's combined ratio. The combined ratio calculates the companies' operating profits. The ratio consists of the insurance company's loss ratio (the percentage of premiums it pays back in claims) plus its expense ratio (the cost of running the business). A break-even combined ratio is 100%. Anything under that figure represents profitability; anything over that figure represents an operating loss.
The second pool of profitability is the insurance company's investment income. The amount of that investment income is a function of the company's float as well as its invested capital. The more tangible equity an insurance company possesses, the more it can invest. The same is true with the float; writing additional premiums increases the float of the insurance company. The additional float can then be used to increase investment income.
Of course the liquidity of the company's investments is paramount in the event of a large-scale disaster which requires the company to pay a huge amount of claims in a short period of time. The majority of insurance investment portfolios consists of fixed income investments which return low rates of interest. As the float and equity of an insurance company increases, so does its investment profits.
Now that I have supplied you with a rudimentary explanation of how insurance companies make their profits, I will move on to an explanation of the sizable value proposition in Everest Re (NYSE:RE).
Peter Lynch used to insist that his managers describe their investment ideas in just several sentences. In the spirit of Peter Lynch: Everest Re represents outstanding value in terms of its current, historically low price to tangible book ratio (less than .7x) and its ability to produce profits and dramatically increase shareholder equity per share over time.
The following tables clearly depict the aforementioned value characteristics of RE:
Net Profit Margin (%)
Book Value/ Share
Return on Equity (%)
Return on Assets (%)
The current price to tangible book ratio for RE is slightly under .7. In the last ten years the business has increased shareholder equity per share by over 300% while paying out a substantial amount in dividends. The current dividend is 1.92 per share, the same amount the company has paid for the four preceding years.
An analysis of the company's combined ratio reveals that Everest Re has been operationally profitable in seven of the last ten years. Underwriting appears to have been much tighter in the last five years as the company's combined ratio has averaged 93.86, with only 2010 showing a higher than 100 number.
In the last ten years, Everest Re has grown their investment portfolio size from $4.4 billion to $15.1 billion. For the trailing five years the fixed income portion of the portfolio has returned an average yield of around 4.3%. By contrast Chubb (NYSE:CB), another outstanding insurance company, has averaged about 3.9% yield on its fixed income investments in that time period.
Insurance is a notoriously cyclical business. When things are going good, premiums tend to drop and underwriters frequently relax actuarial standards. That fact generally leads to period of operational underperformance, particularly when insurance companies are hit with a series of devastating storms.
The best time to buy insurance stocks is when premiums are rising and risk assessment is tightening. Following the series of catastrophes in 2010 and early 2011, now appears to be the time to invest in high quality insurance companies.
The P/B ratios of property and casualty companies are now trading near historical lows. In the case of RE, one is now able to buy their investment portfolio at a sizable discount to its intrinsic value while getting a historically profitable operating business at no extra cost.
The main risk to Everest resides in the following low probability catastrophic events: extraordinary wind damage in Florida or Japan and extraordinary earthquake damage in California. Investors should always perform their own due diligence before purchasing a stock.
Value guru Donald Smith recently added to his position in RE.
Disclosure: long RE, no position in CB
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