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Everest Re: Low Risk, High Reward

August 23, 2011 | About:
John Emerson

John Emerson

140 followers
"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 (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:



Avg P/E


Price/ Sales


Price/ Book


Net Profit Margin (%)


12/10


7.50


1.02


0.73


12.9


12/09


5.80


1.16


0.83


17.9


12/08


-280.40


1.33


0.94


-0.5


12/07


7.70


1.33


1.11


17.5


12/06


7.40


1.42


1.25


18.6


12/05


-24.40


1.27


1.57


-4.8


12/04


9.40


1.01


1.34


9.9


12/03


9.00


1.13


1.48


10.4


12/02


13.50


1.11


1.18


9.0


12/01


31.50


1.85


1.90


5.5


Book Value/ Share


Debt/ Equity


Return on Equity (%)


Return on Assets (%)


Interest Coverage


12/10


$115.45


0.14


9.7


3.3


10.6


12/09


$102.87


0.17


13.2


4.5


13.0


12/08


$80.77


0.24


-0.4


-0.1


-1.1


12/07


$90.43


0.21


14.8


4.7


11.2


12/06


$78.53


0.19


16.5


4.9


14.2


12/05


$64.04


0.24


-5.3


-1.3


-3.8


12/04


$66.65


0.34


13.3


3.3


7.3


12/03


$57.34


0.23


13.5


3.4


8.6


12/02


$47.00


0.31


9.8


2.3


5.9


12/01


$37.16


0.32


5.8


1.3


2.0


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 (CB), another outstanding insurance company, has averaged about 3.9% yield on its fixed income investments in that time period.

Summary

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

About the author:

John Emerson
I have been of student of value investing since the mid 1990s. I have continued to read and study value theory on an ongoing basis. My investment philosophy most closely resembles Walter Schloss although I employ considerably less diversification. I also pattern my style after Buffett's early investment career when he was able to purchase shares of tiny companies.

Rating: 4.1/5 (15 votes)

Comments

mcwillia
Mcwillia - 2 years ago
Everest is good, but Aflac has a far better combined ratio and has had it every year for over a decade, no exceptions. It also has a bond portfolio with durations well matched to liabilities, in the needed currency, namely yen. Its investment portfolio is only 30% in financials, contrary to popular myth, and it has nearly 30% of its massive portfolio in Japan Government Bonds, handy for a company whose liabilities are primarily in yen. Aflac has gotten a bad rap recently for its european bonds, but who has seen an insurer be more public and proactive in de-risking its portfolio than Aflac? Also, it is interesting that the entire portfolio is bonds. No real estate, no equities, no strange investments. Few insurers can say as much.

For those who think inflation is a risk, maybe for Everest, but not Aflac. Aflac bears little inflation risk on the underwriting side as it pays fixed sum benefits. Inflation risk is thus shifted to the policy holders. And U.S. investors can look forward to currency gains as the yen value increases relative to dollars (biggest net debtor nation will out-inflate the biggest net-saver country over time). There is also little of what Warren Buffett calls 'social inflation' of premiums, as the Japanese are famously averse to insurance fraud, jury trials and litigation.

Plus, Aflac operates in a country where cartel style insurance pricing virtually guarantees them fat profits. The annual collapse of the Japanese government makes it clear that the price regime is not likely to change any time soon. In fact, Aflac was given a total monopoly on so-called 'third sector' cancer insurance for nearly a decade when starting out. Nice. Also, their cushy relations with the regulators, in a country where the revolving door is very much still alive, is further assurance that the status quo will not shift against them anytime soon.

Aflac has better sales channels than its competitors, too. This is not true of Everest. Aflac has the exclusive right to sell cancer insurance through the Japan Post Office. So what? Well, that organization is something like the sixth largest financial concern in the world. Its a very big deal, and Aflac has it. Others don't.

They are the low cost provider, since they are not part of a Keiretsu where insurers must 'invest' float in the stock or debt of sluggish group members. They are also best in breed in a country famous for price-insensitive hyper brand-conscious consumers...an enviable position. Aflac's competitors in Japan are mainly under-capitalized zombies without the power to increase insurance supply. Yasuda may be the exception, but it is indeed 'the exception'.

Lastly, many may wonder what happens if Japan's government suffers more financial embarrassment. It will be forced to scale back its national health coverage, which will push people into the hands of insurers like...wait for it...Aflac.

Taking a step back, think about it. They provide supplementary heath and cancer coverage to the healthiest people on Earth. Nice gig. They insure the most honest and non-litigious. Good customers. They are the best capitalized firm and have the best brand.

Obviously, I'm long AFL.
John Emerson
John Emerson - 2 years ago


Thanks for the comment,

I am not very well versed in AFL, although I agree they have much better operating earnings and a moat which is supported by advertizing (like Geico and Progressive). What they did not have before was a margin of safety in form an extremely low price to tangible book (that has been remedied significantly) and it appears their missteps on the investment side has hurt them in the last ten years. They have not been nearly as successful as CB or RE in building shareholder equity over a ten year period. If you have read my past articles you are probably aware that I like to focus on low price to tangible book and companies which have been successful in increasing tangible equity per share for investors over a ten year period.

However I agree that the company merits a good look now with the huge drop, its change in investment approach, and its superior operating business. I hope you do well in the company I agree it appears cheap, sort of like an American Express after the salad oil scandal ie the drop in reputation does not match the drop in future earnings.

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