There is a reason why Warren Buffett (Trades, Portfolio) decided to build his business empire on insurance businesses. Insurance is a highly inefficient industry where excess profits can be made by those firms willing to take on extra risk, albeit for a higher price. Even though some of the industry is now seeing profits come under pressure thanks to the use of data, sectors such as motor insurance, where Telematics are giving an accurate driver profile, allowing the insurer to more correctly price the risk, other sectors still rely on human input to judge the risk-reward of writing a certain risk -- risks that cannot be accurately priced by computers due to the lack of data. A great example is Buffett's decision to sell the California Earthquake Authority's $1.5 billion of reinsurance for four years in return for a premium of $590 million in 1996. Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) is also planning to break into the Japanese earthquake insurance market.
Only about 10% of Japanese companies are currently insured against tremors because of the high cost of reinsurance, which puts other insurers off. Buffett would be able to use his insurance empire to make these policies profitable and relatively low cost for buyers. Another reason why insurance companies have been a lucrative investment for Buffett over the years is their investment float.
Buying the float
Similar to an option trader that has a margin requirement, an insurance company needs to have skin in the game to underwrite insurance contracts. Insurers invest their capital reserves to generate extra profits. These reserves grow during good years but shrink during bad years, with the net effect hopefully being steady growth. If premiums are stable and expanding, float is permanent capital for an insurance company to invest in multiple growth opportunities.
Because insurance companies have to hold a large float to reserve against any unforeseen events, such as an abnormal year where claims dramatically exceed premiums received, it is usually better to value these businesses on book value rather than earnings alone. Earnings fail to reflect the investment skill of float managers who may be achieving a portfolio return of 10% per annum, giving the business more capital to invest in the generation of new business.
Book value and book value growth are more appropriate metrics to evaluate an insurance company.
Two undervalued opportunities
Two insurance businesses that currently stick out as being undervalued on a price-book (P/B) basis are Kansas City Life Insurance Co. (KCLI, Financial) and National Western Life Inc. (NWLI, Financial). Kansas is currently trading at a trailing 12-month price-earnings (P/E) ratio of 20.2 and a price to tangible book ratio of 0.7. Over the past six years, the company has compounded book value at a rate of 2.4% per annum, which is hardly outstanding. The shares, however, have not traded above $49 per share during this period despite the fact the book value has risen from $62.8 to $72.4. Normalized earnings per share have ranged between $2.40 and $2.92. The shares offer a dividend yield of 2.2%. If the company can continue to compound book value at 2.4%, as well as distributing 2.2% per dividend yield, investors could be set to achieve a 4.6% per annum return, excluding any P/B multiple expansion.
National Western has been able to produce slightly better returns than Kansas. Over the past six years, the company's book value has grown at a compound annual rate of 6.2%, from $351 per share to $490 per share. Over the same period, normalized earnings per share have risen at a compound annual rate of 12.6%, growing from $15.3 to $29.2. The shares currently trade at a price to tangible book ratio of 0.7 and EV/EBITDA multiple of 6.6. A token dividend amounting to a yield of 0.11% is on offer. Assuming no multiple expansion, as book value grows, shareholders are set to receive a return of 6.2% per annum. If the shares do trade up to book value, returns could be even more.
Disclosure: The author owns no stock mentioned.
