Loss reserve provisions generally represent the largest liability item on any insurer’s balance sheet and the biggest expense item on the earnings statement.
Furthermore, these loss reserves are simply a management estimate, as Warren Buffett alluded to in Berkshire Hathaway (BRK-A) (BRK-B) Chairman’s letter for 2007 …
“In every report we make to you, we must guesstimate the loss reserves for our insurance units. If our estimate is wrong, it means that both our balance sheet and our earnings statement will be wrong. So naturally we do our best to make these guesses accurate. Nevertheless, in every report our estimate is sure to be wrong”
So how can an investor get comfortable with an insurer’s loss reserve provisioning and be sure there are no hidden dangers lurking and that the numbers are generally conservative.
It is reasonable to argue that insurers that have a limited operating history should be avoided by investors because there is insufficient time to gauge quality of the insurance management’s ability to adequately reserve over time.
A good example here is Montpelier re, a Bermuda reinsurer which began life in 2001 as a reinsurance company. Montpelier re was very profitable from 2001 onwards until Hurricanes Katrina, Wilma & Rita struck in 2005 and caused Montpelier over $1.1 billion in losses. As a result Montpelier re was forced into a large dilutive capital raising. All told, Montpelier re lost 56% of its book value in 2005.
Reading through the annual reports of Montpelier re prior to these events would have given an investor no hint as to Montpelier Re’s potential exposure. On the eve of the disaster, in Montpelier Re’s 2004 annual report Anthony Taylor, CEO, said
“Rest assured that our principal aim is to be prudent stewards of your capital throughout the underwriting cycle. As that cycle now softens, we are particularly aware of the importance of exercising strictest discipline in the underwriting and risk management of our business.”
Montpelier Re were confident enough of their risk exposure that they took the unusual step of making a large capital return to shareholders amounting to $390 million plus a large dividend in 2004.
Where an insurer such as Montpelier Re has a short operating history, an investor may be tempted to rely on annual reports and reported financials to assess the conservatism of management. Montpelier’s shareholder returns had been excellent since 2001, growing nearly 50% from 2002 to 2004, so everything looked positive on the surface.
What was lacking with Montpelier Re was a long history of operating successfully as a reinsurer over time? This was the decisive risk variable for any investor looking at the company and why I believe investors should look at new insurance start ups in Bermuda, amongst other places, with a skeptical eye.
Loss reserves will be conservative if management are disciplined underwriters and setting their reserves prudently. So what can we look for to tell if management are being conservative?
1. Track record of management – if an insurer has a track record of disciplined underwriting and conservative reserving over a 15-20 year period then it is a fair bet that management are setting loss reserves at appropriate levels through multiple cycles of soft and hard markets.
2. Actuarial estimates - the management of Markel Corporation (MKL, Financial) maintain that they set their loss reserves with the expectation they will more likely prove redundant than deficient. Examining Markel’s actuarial estimates, it is clear Markel’s loss reserves sit well above the mid point of actuary estimates of loss reserves.
3. Distinguish the cause of large loss reserve increases – contrast two situations
1st situation
Insurer A with an excellent history of loss reserving acquires another insurance company B with legacy loss exposures that turn out to be far worse than expected. Insurer A sustains large loss reserve increases as a result Insurer B’s problem loss exposures, which in turn depresses Insurer A’s share price. Insurer A will ultimately take steps to resolve Insurer B’s problems and this will often present an excellent opportunity for investors to opportunistically buy Insurer A’s shares at discounted prices. Examples of this include Markel Corporation’s (MKL) acquisition of Terra Nova, Berkshire Hathaway’s (BRKA/B) derivative losses on acquiring General Re, Fairfax Financial’s (FFH, Financial) legacy loss problems sustained after acquiring TIG & Crum & Foster.
2nd situation
Insurer C with a history of poor underwriting and loss reserving sustains large loss write offs on new product lines written. Insurer C announces large write downs and its share price falls. This is generally a situation which arguably does not present an attractive investing opportunity. Poorly run insurers, absent some transforming event or significant management changes, are destined to repeat their same mistakes.
Disclosure: I own shares of MKL,BRKB & FFH
_________________
Source: Insurance Stock Investor
Furthermore, these loss reserves are simply a management estimate, as Warren Buffett alluded to in Berkshire Hathaway (BRK-A) (BRK-B) Chairman’s letter for 2007 …
“In every report we make to you, we must guesstimate the loss reserves for our insurance units. If our estimate is wrong, it means that both our balance sheet and our earnings statement will be wrong. So naturally we do our best to make these guesses accurate. Nevertheless, in every report our estimate is sure to be wrong”
So how can an investor get comfortable with an insurer’s loss reserve provisioning and be sure there are no hidden dangers lurking and that the numbers are generally conservative.
It is reasonable to argue that insurers that have a limited operating history should be avoided by investors because there is insufficient time to gauge quality of the insurance management’s ability to adequately reserve over time.
A good example here is Montpelier re, a Bermuda reinsurer which began life in 2001 as a reinsurance company. Montpelier re was very profitable from 2001 onwards until Hurricanes Katrina, Wilma & Rita struck in 2005 and caused Montpelier over $1.1 billion in losses. As a result Montpelier re was forced into a large dilutive capital raising. All told, Montpelier re lost 56% of its book value in 2005.
Reading through the annual reports of Montpelier re prior to these events would have given an investor no hint as to Montpelier Re’s potential exposure. On the eve of the disaster, in Montpelier Re’s 2004 annual report Anthony Taylor, CEO, said
“Rest assured that our principal aim is to be prudent stewards of your capital throughout the underwriting cycle. As that cycle now softens, we are particularly aware of the importance of exercising strictest discipline in the underwriting and risk management of our business.”
Montpelier Re were confident enough of their risk exposure that they took the unusual step of making a large capital return to shareholders amounting to $390 million plus a large dividend in 2004.
Where an insurer such as Montpelier Re has a short operating history, an investor may be tempted to rely on annual reports and reported financials to assess the conservatism of management. Montpelier’s shareholder returns had been excellent since 2001, growing nearly 50% from 2002 to 2004, so everything looked positive on the surface.
What was lacking with Montpelier Re was a long history of operating successfully as a reinsurer over time? This was the decisive risk variable for any investor looking at the company and why I believe investors should look at new insurance start ups in Bermuda, amongst other places, with a skeptical eye.
Loss reserves will be conservative if management are disciplined underwriters and setting their reserves prudently. So what can we look for to tell if management are being conservative?
1. Track record of management – if an insurer has a track record of disciplined underwriting and conservative reserving over a 15-20 year period then it is a fair bet that management are setting loss reserves at appropriate levels through multiple cycles of soft and hard markets.
2. Actuarial estimates - the management of Markel Corporation (MKL, Financial) maintain that they set their loss reserves with the expectation they will more likely prove redundant than deficient. Examining Markel’s actuarial estimates, it is clear Markel’s loss reserves sit well above the mid point of actuary estimates of loss reserves.
3. Distinguish the cause of large loss reserve increases – contrast two situations
1st situation
Insurer A with an excellent history of loss reserving acquires another insurance company B with legacy loss exposures that turn out to be far worse than expected. Insurer A sustains large loss reserve increases as a result Insurer B’s problem loss exposures, which in turn depresses Insurer A’s share price. Insurer A will ultimately take steps to resolve Insurer B’s problems and this will often present an excellent opportunity for investors to opportunistically buy Insurer A’s shares at discounted prices. Examples of this include Markel Corporation’s (MKL) acquisition of Terra Nova, Berkshire Hathaway’s (BRKA/B) derivative losses on acquiring General Re, Fairfax Financial’s (FFH, Financial) legacy loss problems sustained after acquiring TIG & Crum & Foster.
2nd situation
Insurer C with a history of poor underwriting and loss reserving sustains large loss write offs on new product lines written. Insurer C announces large write downs and its share price falls. This is generally a situation which arguably does not present an attractive investing opportunity. Poorly run insurers, absent some transforming event or significant management changes, are destined to repeat their same mistakes.
Disclosure: I own shares of MKL,BRKB & FFH
_________________
Source: Insurance Stock Investor
