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Understanding Insurers: Berkshire Hathaway, Markel & FBD Uncovered
Well-managed insurance companies that can maintain underwriting discipline can make for attractive investments over the long-haul. Warren Buffett's Berkshire Hathaway has delivered above average returns for decades, and Markel, a US-based Berkshire look-a-like, has already developed an enviable long-term track record. And in Ireland, FBD Holdings has considerable attractions for medium- to long-term investors despite the difficulties it encountered in 2013.
This Featured Article is aimed at providing you with an understanding of what makes good insurers tick and the attractions they hold for investors. For subscribers to GillenMarkets, all three stocks are on our key 'Recommended' list, and we maintain ongoing coverage of them via our weekly bulletin.
The three companies are each different, following different underwriting and investment policies. However, while they differ in strategy, they are similar in one crucial aspect: they are all excellent underwriters with a robust understanding of risk and a willingness to walk away from unprofitable or under-priced business.
In the intensely competitive marketplace, they each follow different strategies to ensure profitability: Markel is a niche global operator, FBD controls a dominant position in the farmers' market in Ireland, and Berkshire's operations follow either a low-cost strategy in the US or a global niche strategy. Over the long-term, this has allowed all three operators to generate strong underwriting results, and this differentiates them from the insurance pack. - where underwriting losses across the cycle are the norm.
In addition to generating underwriting profits, insurers get to invest their policy holders monies (the float) on behalf of shareholders. In effect, this provides insurers with the ability to leverage returns for shareholders by using (investing) policy holders monies (held to cover claims). As most insurers grow their premiums over time, this 'float' of policy holders monies grows even while the insurer pays off the claims due. In effect, a profitable underwriter can use a growing 'float' of policy holder cash to invest and generate additional returns on behalf of shareholders.
The investment policies that each insurer has for investing their excess cash ('float') are different, ranging from mostly bank deposits and government bonds (FBD) to mostly equities (Berkshire). Overall, the combination of underwriting results and investment returns has allowed each insurer to grow its book value - a proxy for intrinsic value and thus shareholder returns - at rates well in excess of what global equity markets have produced over the past twenty years.
How insurers operate
Insurers agree to shoulder some, or all, of their policyholders' risks, in return for which they receive a compensatory premium. While this may sound simple, the insurance marketplace can be a tricky place to navigate.
Firstly, the insurance market is highly competitive, particularly when it comes to individual consumers looking for personal insurance. Higher competition reduces the control that any individual insurer has over price, which impacts profitability. Secondly, the market is difficult to operate in because the probability of whether a future event (such as a car crash) will occur is, by definition, unknowable and the pricing of policies is thus inherently subjective and possibly inaccurate.
Comparing different insurance businesses
Insurers derive returns from two distinct areas: their underwriting operations, and returns from their investment portfolio. At the industry level, the typical insurer will run at a modest underwriting loss (i.e. claims and underwriting expenses are consistently greater than premiums), and make up this loss through returns on their investment portfolio. Given the intensely competitive nature of the insurance market, this is a somewhat understandable, if precarious, position for insurers.
However, some of the best insurers - and we consider Berkshire, Markel and FBD to be among those insurers - are capable of running at a consistent underwriting profit and benefitting from investment returns which allows them to grow their book value at a strong pace.
Describing the three insurers
Markel Corp is the easiest to classify: it covers 'unusual' risks (such as catastrophe, reinsurance, equine) which gives it an element of pricing power as very few insurance operators can do what they do.
FBD, for the purpose of our analysis, has two business lines: (a) it operates in farming and small business insurance in rural Ireland, where its market dominance and strong bond with local communities gives it an element of pricing power; and (b) it operates in motor/home insurance where policyholders are highly price sensitive. This subjects FBD to intense competitive pressures, although this line only accounts for c. 25% of premiums.
Berkshire Hathaway operates in some respects like Markel Corp, and in others like FBD. In the case of its operations that are similar to Markel - unusual risk policies - it is a world-class player as no player can rival its size or strength, which gives it a high degree of pricing power and low competition. In the cases where it provides personal line insurance - like FBD - it opts to pursue a low-cost approach, unlike FBD, which allows it to compete well in its markets.
The Underwriting Record
Despite running different operations, each of the three insurers that we cover has achieved a consistently strong underwriting performance.
The chart opposite displays the combined ratio for each of the insurers. In years where the combined ratio is above 100, the insurer has generated a loss.
Since 1993, Berkshire has run at an underwriting loss only once in every five years. Markel, also since 1993, has run at an underwriting loss once in every three to four years. FBD, since 1998, has run at an underwriting loss once in every three to four years, also.
The operating records of the three insurers are superior than the industry averages, and have allowed the insurers to both grow their earnings and generate a 'float' which they can use to invest in markets and earn a further return. The concept of float is covered in the next section.
Earning Investment Returns: What is float?
When an insurance company takes in money from a policy, there is typically a lag between the time when that money comes in and the time when that money is paid back out in the form of a claim (if at all). The insurance company is free to invest this money - called 'float' - in the interim in order to earn a return on the money.
Of course, the 'float' can grow over time, as economic activity grows and increases the level of overall insurance business being done. Better operators can also grow their own share of the overall 'growing' insurance market. Hence, while claims always reduce the float available, a decent insurance company should see its 'float' grow over time. The table highlights the 'float' in each three insurance companies in 2000 and in 2014.
Float may not sound particularly impressive, but it is important to remember that, if an insurance business runs at a consistent profit over its lifetime, then the cost of this float for the insurer is less than zero - that is, it has essentially borrowed money and has been paid to do so. Thus, float is a form of costless leverage and, when in the hands of a capable investor, it has the ability to magnify an insurer's profitability without as much of the attendant risk associated with leverage.
In addition, if the insurer is capable of generating consistent underwriting profits, then the float will gradually increase over time, providing a growing pool of liquidity which the insurer is free to invest for its own benefit. As the above table on the right shows, growth in float since 2000 has been substantial for Markel (13.1% compound per annum), decent for Berkshire (8.2% c.p.a.) and slow for FBD (3.1% c.p.a.).
How do the 3 companies invest float?
The three companies differ markedly in their approach to investing the float generated by their insurance operations.
The panel on the right displays the breakdown of each insurers' float investment style by displaying each asset class as a percentage of the total float. Berkshire clearly has the greatest allocation to equities, which is unsurprising, given Buffett's predilection for, and skill in, equity investing.
FBD, on the other hand, has a large position in bank deposits and fixed income, which is a result of three factors: (i) the short-term nature of their policies, which requires readily available cash; (ii) losses from their equity/property portfolios which may have made them relatively more risk-averse; and (c) the EU's introduction of the Solvency II Directive, which restricts how much equity and property European insurers can hold on their balance sheet. (Note: The green box for FBD is property holdings).
Markel is similar in profile to FBD, as it holds a large portion in fixed income and bank deposits. However, Markel is actively taking steps to increase its equity holdings. FBD and Markel, given their relatively conservative investment styles, will be most dependent on their insurance operations to drive the majority of their earnings and returns - Berkshire, on the other hand, will be capable of deriving a large portion of its returns from equities. However, the corollary to this is that Berkshire is exposed to the greater risk of a permanent loss as equities are naturally the riskiest of the asset classes.
How have each of the 3 companies fared?
The easiest and most logical way to capture an insurer's success is to look at the growth in their book value as this captures the returns from both underwriting operations and investing the float.
The chart on the right displays the growth in each of the insurers' book value. Berkshire's value is for its insurance operations only (i.e. the book value of its other businesses has been stripped out). FBD's book value only starts in 1998, and includes the cumulative value of dividends paid out.
Over their respective timelines, each of the insurers has achieved a highly respectable growth in their book value. Markel leads the way, growing its book value by 17% compound per annum since 1994. Berkshire has grown by 14% c.p.a. over the same time, and FBD has grown by 13% c.p.a. since 1998.
Buffett argues that book value is a proxy for intrinsic value so, over time, growth in book value should provide a rough guide for the returns a shareholder has received from a company. Clearly, all three of the companies above - despite differing investment styles and insurance operations - have each grown their book value at a rate that is significantly above returns from general equities over the past twenty years.
The final question to answer is one of valuation: what premium (or discount) is the market applying to each of the insurers? Too high a price can truncate future returns to a greater or lesser extent.
Today, FBD's shares trade at a price-to-book value ratio of 1.36 times (using our own internal estimates of book value). It is difficult to say what the 'correct' book value is for any given company, but we can say that, historically, investors have been willing to pay an average price-to-book value ratio of 1.45. Today, then, the price-to-book value ratio awarded by investors to FBD is 6% below the historical average.
Indeed, in a low interest rate environment one could argue for a higher than average multiple to book value. If all of FBD's book value was invested in risk-free government bonds the company (and shareholders) could earn less than 3% today. But FBD has shown an ability to earn, on average, between 12-16% on its assets (book value or net assets) over time. Hence, it is obvious that investors can justify paying a higher multiple of book value than historically given the alternative returns available from risk-free bonds.
Hence, the current 6% discount valuation compared to historical long-term averages looks good value to us, and is probably explained by FBD's three recent profit warnings, which have depressed market expectations about FBD's ability to earn an acceptable return and grow its business. These concerns look a little myopic to us.
Looking at the two US insurers in the same light (and stripping out acquisition goodwill from book value) sees investors paying circa 1.5 times book value (or net asset value) for Markel and 1.7 times book value for Berkshire. Both Markel and Berkshire are better businesses than FBD, in our view, and deserve a higher valuation than FBD. But, in truth, none of the three looks overvalued to us in a world of extremely low long-term interest rates.
Rory Gillen is founder of GillenMarkets.com, the online investment website, and author of 3 Steps to Investment Success published in October 2012.