Two Insurance Questions

First question:

Good afternoon.  I’m an avid reader of your blog and want to thank you for the work that you’ve done. I’m reading through the 10-Ks of insurers to try and educate myself and wanted to see if you can provide some advice.  I’m trying to find a guide/book that can help me understand the mechanics of the loss reserve developments show as an adjustment to each “vintage” year.  For example, I’m trying to understand if these are rolling reserves or if they are standalone on an annual basis.  I’m also trying to understand how changes in reserves flow through the income statement.  If you have a book that you can point me to, I’d really appreciate it.  Thanks for your help and have a nice weekend.

First, to any casualty actuaries reading me, if I get this wrong please correct me.  I am a life actuary by training, though I’ve tried to learn your discipline in broad from outside.

There are two main exhibits for P&C reserving in 10Ks — there are the loss triangles that go by accident year (i.e. the year in which the claim is incurred, rather than paid).  But the triangles show what has been paid, and how the incurred estimate changes over time.  With this, you can see how estimates of losses have proven liberal or conservative over time.

The second main exhibit breaks down reserve setting  for the current year.  It breaks into two main parts:

  • What reserves have you set for the business written in the current year?
  • How have you changed your estimate of losses incurred for prior years?

My article last night dealt with the latter of those questions.  What this implies is that good companies are very conservative in setting reserves for the current year, and lets the excess of those reserves release over time.  This may not juice stock performance in the short run, but in the long-run, it will lead to good results, because there will be few negative surprises from reserving.

Here’s the second question:

I’ve been intrigued by the recent reader questions, specifically the last couple questions on insurance stocks (RGA, AIZ and others). It sparked a mini research project this weekend for me and I read through a bunch of your old posts, along with some of the company reports and conference call transcripts. I don’t have in depth knowledge of the insurance industry…. I like the business model and understand the basic business, but am not yet well versed with reading and deciphering balance sheet items and insurance industry specific metrics-although I’m getting there

My question is very general in nature. As a value investor, each month I go through 6 or 7 different screens (basic value metrics like P/E, P/B, P/FCF, etc…). I know you’ve said that insurance stocks tend to follow their book value over time, but can trade in ranges from 0.5 to 2.0 times book… and I’ve read through your thoughts on adjusting book value for intangible items and AOCI. But my question is basically: “Why is the market pricing so many insurance stocks so far below book value?” I know that the near term outlook for interest rates is that they’ll stay low, and I know the near term outlook for the industry isn’t great, but it seems like the market is pricing these stocks for poor results for years.

I know you can’t answer this question specifically, but I just wanted to hear your expertise on why you think these stocks are so far below their book value. I subscribe to Value Line and was reading the latest section on Life Insurers (section 8 from last month)… Value Line covers 10 or 12 of these stocks- RGA, LNC, MET, AFL, PRU, AIZ among others… and all of them seem to be priced at very low prices to earnings and/or book value. In the stock you like, National Western Life Insurance (NWLI), as I’m sure you know-it’s priced at .44 x book, and 6x forward earnings. Almost all of the stocks I looked at in Value line are single digit current P/E ratios as well.

The other thing I’ve noticed as I looked at the 10 year financial histories of these stocks is this: most of them are successfully growing their businesses (premium income seems to be steadily rising each year with most of them), and most of them are growing their book values. Some had the bad year in 2008, but many of them seem to be growing their book values at 10-15% per year consistently for the past decade.

So you have stocks that are selling at very low P/E ratios, very low P/B ratios (and low relative to their own historical valuations in both those categories), AND they are growing their book values (most of them at least).

I guess I’m just looking for some help as to what I could be missing? What does the market see that warrants these valuations?

Insurance is a mature industry.  It’s not a sexy industry.  Further, the accounting in insurance is complex, and few outside the industry understand it.  I have a huge book explaining the nuances of GAAP accounting for life insurers… it is complex.

Now there are some reserving issues with life insurers.  With secondary guarantees, there is little way to tell that reserving is adequate with Variable Products, or Universal Life with no lapse guarantees.

As such, I avoid the companies that are heavy with these products.  Part of the discount there is the distrust of the accounting, but the taint spreads to the industry as a whole,  and as such, the whole life insurance industry trades at a discount.  Some more so, some less.

That said, well-run insurance companies pay great dividends and compound book value at high rates.  Aside from NWLI, I don’t own any pure play life insurers,  Yes, I own SFG, but it is mostly a disability insurer.  AIZ offers funeral insurance, but it is #1 there, with weak competition.  I own RGA. a life reinsurer, but the issues are very different.

There are concerns in life insurance about crediting rate guarantees that can’t be met.  I don’t own any companies with that problem; that is a real problem.

I’m happy to own the insurers without accounting problems, which have low P/B & P/E ratios.  In the long run, their ability to compound returns will benefit any portfolio — it is only a question as to when serious and large investors realize this.  I am willing to wait for this.

Full disclosure: long NWLI SFG AIZ RGA AFL