"Over time, most insurers experience a substantial underwriting loss, which makes their economics far different from ours." Warren Buffett
Identifying the right company and having the intestinal fortitude to hold the stock over an extended period of time can lead to retirement prosperity. Well-managed insurance companies, with long-term growth potential, are perfect candidates so long as they are purchased at the right price. Imagine the effect on Warren Buffett's or Benjamin Graham's overall net worth without Geico Inc. The same goes for Prem Watsa without his Fairfax insurance operations.
Great insurance companies differentiate themselves from mediocre ones by their ability to achieve consistent underwriting profits. They do so by employing discipline in their underwriting as well as utilizing skilled management teams which improve the operating efficiencies of their day-to-day operations.
Occasionally an investor can learn a great deal about a company and the quality of their management team by merely listening to their conference calls. Such is the case with tiny Florida insurer, Federated National Holding Company (FNHC), which happens to be my largest stock holding. I originally profiled the buying opportunity back in 2011, when the company was trading at less than 35% of its tangible book value and was in the midst of returning to profitability. At the time, the stock was trading under $2.50 per share with at tangible book value in excess of $7. See http://www.gurufocus.com/news/145322/tchc-a-pc-turnaround-candidate. At that time, the article ticker symbol of the company was TCHC; the company name was changed to Federated National Holding Company (FNHC) a few months later.
During a recent conference call, CEO Michael Braun discussed the four pillars of a successful insurance company: disciplined underwriting, risk management, expense control and product distribution. Those pillars, along with some other observations, are the subject of today's discussion.
How Insurance Companies Record Earnings
Most insurance investors are privy to the fact that many insurance companies earn the bulk of their profits by investing the prepaid premiums which they receive (float). As Buffett pointed out in the opening quote, the norm for insurance companies is to write business at a rate below its true actuarial break-even point in an attempt to maximize their prepaid premiums which, in turn, are generally reinvested in conservative fixed-income portfolios.
In essence, many insurance companies are borrowing money from their policy holders (in the form of poorly underwritten premiums) and immediately reinvesting the proceeds into higher-paying investment vehicles.
Say I accept thousands of poorly underwritten policies that will result in a future loss of five cents for every dollar that I have insured (the company's combined ratio is ultimately 105 although current results might belie the future losses). The insurance company may still prosper as long as their investment portfolio yields rates that are substantially higher than 5%. In other words, the company is actually borrowing money from its policy holders with a 5% interest rate attached which must be paid out at some period in the future. Such a practice may be considered quite sensible if the insurance company is able to reinvest the float and secure steady returns of 10%.
In the above fictitious example, the insurance company has a 5% cost of capital and a 10% yield which results in a spread of 100%, pretax. During periods of high yields on conservative fixed-income vehicles, companies which operate with steady underwriting losses can still prosper as long as their cost of capital remains substantially under the safe yields of their investment vehicles.
The problem with such a strategy is two-fold: first of all, when fixed-income yields are excessively high so is the likelihood of inflation; secondly, during periods of relative deflation (such as we are experiencing now) fixed-income yields are excessively low and resets tend to diminish paltry bond yields even further. Subsequently, companies which perpetually write policies with combined ratios in excess of 100 begin to experience squeezes in their profitability. Further, they tend to purchase lower-grade securities in an attempt to increase yield or engage in proprietary trading in an attempt to earn profits in excess of their cost of capital.
The aforementioned companies may appear to be quite profitable on a short-term basis but many times the actuarial value of their reserves are substantially understated; furthermore, such companies frequently engage in risky investment behavior. In such cases, their current earnings yields and their seemingly impressive returns on equity are purely a mirage. As the weight of the poorly underwritten policies invariably shows up on their income statements and balance sheets, their earnings and book value can decline for a period of years. The scenario I just described was exactly the case for TCHC for multiple years prior to their recent epiphany and return to proper underwriting practices.
The Four Pillars of Insurance
The following is a brief description of the four pillars of insurance investing which result in profitable operating results. If an investor wishes to hold on to an insurance stock for an extended period, he or she had better be quite certain that the company will steadily write business with a combined ratio of under 100. Great long-term insurance investments are a function of two simple points: 1) profitable underwriting and 2) conservative and competent investment of the float and the equity of the company. The four pillars deal with the operational aspect of the insurance business.
1) Disciplined Underwriting
Poor underwriting not only results in poor operational results in the long term, it also results in excessive costs for purchasing reinsurance. Exactly the opposite is true when policies are highly scrutinized and poor risk policies are not accepted. Reinsurance companies begin to knock on your door and fight for your business when you write profitable business and refuse to purchase risky policies which can damage their profitability as well. Utilizing competent actuaries and insisting upon proper pre-purchase inspections are paramount to long-term success.
2) Risk Management
Skilled managers take into consideration all facets of risk which could affect the liquidity as well as the profitability of an insurance company. Such duties involve purchasing the correct amount of reinsurance to cover "black swan" events as well as common occurrences. Proper diversification of coverage is imperative so an extraordinary regional event does not put the company in financial peril.
The management team must also be certain that the investment teams are not engaging in high-risk behavior when deploying the company's float and equity. Ask Hank Greenberg and Jaime Dimon about the importance of monitoring the investment agents of the company to ensure that they are equipped with a proper concept of risk management.
3) Expense Control
Well-managed insurance companies are streamlined and are not laden with high fixed costs. Variable and product acquisition costs are inevitable but companies which operate on tight budgets and consolidate their operations are frequently able to provide the same coverage as a competitor with a lower cost structure.
Geico Inc. was the original low-cost provider of automotive insurance by effectively eliminating the commission cost of the agents. Through the years other companies have adopted similar business models and cut in extensively to Geico's competitive advantage. Geico's moat has now become more a function of its effective advertising campaigns rather than its low-cost structure. Again, the credit goes out to the Geico management for maintaining its operational efficiencies quarter after quarter.
Expense control is also largely a function of customer service and the ability to retain one's clients for extended periods. Policy acquisition costs are extremely expensive in the insurance business. The cost of insurance leads is expensive whether they are attained through advertising, canvassing, direct mailing or cold calling. It is imperative to long-term profits that the business handles claims promptly and have well-trained administrative and support teams to help retain satisfied customers.
Of course from a Philip Fisher perspective, the company must also operate as an effective sales organization if they are to grow their sales and continue to prosper. The key for management is to do so in a cost-effective manner.
4) Product Distribution
Outstanding insurance companies are masters of increasing their product distribution. Sales growth is largely a function of increased geographic distribution. McDonald's would have never become a behemoth if they had limited their sales to California, and Geico would be just another small niche insurance company if they still sold only to government employees.
Most investors punch their ticket to financial freedom by making a few great investments in their lifetime and grinding out small, steady gains in the rest of their portfolios. That certainly was the case for Benjamin Graham; without his extraordinary gains in Geico he would have never achieved the financial security that allowed him to live as he pleased after shuttering Graham-Newman.
Any type of business can qualify as the one opportunity which might put an investor over-the-hump. However, the very nature of insurance investing and the ability to make sizable profits off the float of the company as well as its equity is the reason that Buffett became so infatuated with Geico at such a tender age. That said, the key to a great investment is not only the dynamics of the company but also the price at which a person is able to acquire his or her shares.
In a small sense, I discovered my own little Geico in Federated National Holding Company, a little over a year and a half ago. Since I bought in at around 35% of the company’s book value, they have not recorded a losing quarter. Further, they reinstated their dividend and have raised it recently to 0.03 a share per quarter. The company is now growing like a weed and has increased their tangible book value from $7.05 per share at the time of my purchase to its current value of $8.60 per share.
I hold no delusions that the little company will become the next Geico, but I am quite confident that they can continue to grow their book value at an above average rate for the next few years. They are now writing thousands of new policies every quarter at favorable pricing and they are growing the profitability of their operating business at a rate which suggests that they are worth a considerable amount more than their tangible book value. While the company no longer holds the supreme margin of safety in the form of its former 65% discount to tangible book value, it has become a play on its rapidly improving return on equity. I have no intention of selling my shares in the near future and I expect FNHC will continue to provide me with adequate returns considering its increased dividends and its dramatic growth in revenues, book value and earnings per share.
Disclosure: Long FNHC
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