Commercial purchasers of insurance often hire insurance brokers to search for the best coverage from a price and quality standpoint. In return for their services, insurance brokers receive a commission that is a percentage of the premium. Insurance brokers bear no underwriting risk; the primary risk of an insurance broker is that margins get squeezed when P&C rates go soft. This has the countervailing advantage for investors, that after a major catastrophe, the brokers will always do well, because rates rise, and the brokers have no risk of getting tagged for claims.

Part of the story for the insurance brokerages has been the continuing acquisition of small “Mom-and-Pop” insurance brokerages. Twenty years ago, the insurance brokerage space was fragmented. There is still a decent amount of fragmentation today, but now there are major firms that define the sub-industry.

Among the biggest firms, there are sometimes other business lines that form a significant part of the total enterprise. Human resources consulting, benefits consulting, risk management consulting are common ancillary enterprises. Less common are asset management services, and owning insurance companies, but some of the bigger firms do those.

Expense control and discipline in acquisitions are critical aspects of a successful insurance brokerage, as the lack of either one will impair long term earnings power. Our biggest concern with acquisitions is that the prices paid to “roll up” smaller insurance brokerages will eventually rise to levels that make their purchase uneconomic, but the purchases will continue in a foolish attempt to gain market share.

The insurance brokers had a great run of growth through the nineties. Since 2000, their performance has been flat for a number of reasons: underperformance of non-insurance brokerage operations, and slowing organic growth. With P&C premium rates moving from slow positive growth to flat at present, flat performance from the sub-industry for the near term is what we would expect.

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Bringing it to the Present

Some things I got right here, and others wrong.? On net, the group didn’t do much since I wrote the above in 2004.? But almost all of the little companies got acquired, often by private equity, even a few that I thought were garbage.? The big players suffered through the scandal of contingent compensation, while the little players ignored the threat successfully, because the threat from Spitzer and other AGs would not stand up in court.? The big players buckled under the load of bad PR.

So, among the publicly traded companies five remain — Marsh & McLennan, Aon, Willis Group, Brown & Brown, and AJ Gallagher.? I own none of them, and looking at the valuations and soft P&C insurance markets, I have no interest at all.? Short them if you like, though I won’t.

One closing note, contingent commissions have returned.? In any sort of business transaction where there are multiple parties at the table, be aware of who is allied with whom.? Do not assume that there are neutral parties.? Who is paying whom?? If buying from someone, be skeptical about trusting the opinions of “neutral parties” that are paid by them.

Reinsurance takes on the risk profile of the insurers that they reinsure. Put simply, reinsurers pay a portion of the claims reinsured in excess of a threshold, in exchange for a premium paid to assume the risk.

Ten years ago, the major European reinsurers, together with Lloyd’s of London dominated reinsurance. Many major US companies had significant reinsurance operations. These statements are less true today. The European reinsurers have been downgraded because of past poor underwriting, reducing their current reinsurance capacity. US firms have tended to specialize over the last decade. Many companies closed, sold, or spun off their reinsurance operations.

There has been a tendency for reinsurers to migrate to Bermuda over the past ten years. There is a combination of professionalism, favorable regulation, and low taxation that encourages reinsurers to set up shop in Bermuda. A great deal of opportunistic capital shows up and forms new companies after major disasters, in order to take advantage of the higher premium rates available. This has had the effect of making it hard for older reinsurers to heal after a major catastrophe, such as Hurricane Andrew or 9/11. They bear the claims, but get less of the benefit of higher premiums because of all of the new competition.

This makes the character of a reinsurer’s management team all the more important. It is very difficult to bounce back from big underwriting losses, so conservatism in reserving and rate-setting is required for long term financial success. One key to assessing conservatism is whether a reinsurer will slow down in a soft market, and return capital to shareholders. It takes humility and discipline to sit back when market conditions aren’t favorable, and your competitors are growing their premium volumes rapidly.

In one sense, because of opportunistic capital, the reinsurance industry resembles a series of Lloyd’s syndicates. After a major catastrophe, new companies form that have no legacy liabilities, and write fresh business at high premium rates. They are similar to Lloyd’s syndicates at their start. Old reinsurers tagged with claims from the catastrophe resemble Lloyd’s syndicates with open years that they can’t close, because the claims have not settled, or the claims impair their capital. The older reinsurers, once hobbled, will have a tendency to slow down, and perhaps merge their way out of existence.

One more new issue is reinsurance receivables. With all of the credit downgrades, many insurers find themselves with reinsurance receivables from claims that they submitted, but have not settled yet. There are quite a few insurers and reinsurers that have reinsurance receivables greater than their capital and surplus. In a crisis, where prompt payment from reinsurers is needed, a high degree of reinsurance receivables from low rated insurers could result in ratings downgrades, and possibly insolvency. This has led many insurers to request collateralization of reinsurance when dealing with lower rated reinsurers. To the extent that reinsurers agree to collateralization, it makes their assets less flexible, and reduces the degree of leverage that they can operate at. Most reinsurers are resisting posting collateral, but so long as reinsurance receivables don’t get paid rapidly, and credit quality is low, the demand for collateral can only grow.

Investment policy for reinsurers is similar to that of the companies that they reinsure. Most reinsurers run conservative portfolios, because they take enough risk underwriting reinsurance. Some newer reinsurers are using hedge funds as part of their investment strategy, thinking that they can earn more investment income, but with lower risk. The jury is still out on this approach. We fear that some of the reinsurers are taking on what we call “too smart for your own good” risk, and that hedge fund investments will prove to be less diversified than they expected in a crisis, perhaps even a crisis with insurance claim applications, like 9/11.

Reinsurers mirror the hard and soft P&C markets globally, but with greater volatility. The hard market 1994-1997, gives way to a soft market 1998-2000, followed by the 2000-present hard market. Property reinsurance rates are slowly falling at present, but rates are adequate for profitability. Casualty and Life reinsurance rates are rising but at slowing rate; the amount of rise varies considerably by line of business. In general our outlook for reinsurance stocks is positive, but highly selective. Stick with conservative management teams and you will do well over the full underwriting cycle.

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Bringing it to the Present

This was written before the hurricanes of 2004 and 2005.? Think about it.? After 2005, there was a belief, supported by the concept of global warming, that hurricanes would be far more than in the past.? I did not buy that.? Two years of bad hurricanes is not a trend; four might be.

Cut to today.? Five wimpy hurricane seasons.? No earthquakes. Few huge European Windstorms. Few hurricanes hitting Japan.

That doesn’t mean the future will be good.? In fact for reinsurers, because surplus is so adequate, premiums may be too low.? But valuations of reinsurers are low, reflecting that risk.? I ind the sector reasonable but not cheap.

Full disclosure: long PRE, RGA

I am rarely a fan of commercial lines insurers. Over the past ten years, it has been the lowest returning sub-industry in insurance. There are several reasons for this: first, asbestos has been an open-ended drag on the industry’s surplus. Second, many commercial lines companies underwrote coverages where those insured understood the risk better than the companies. Examples of this include directors and officers, errors and omissions, surety, environmental, and political risk. Third, the devolving legal landscape has often left commercial lines insurers at a disadvantage in the courtroom. Policies get interpreted as providing coverage in ways not contemplated at the contract’s inception. Fourth, wars over market share depress premium levels.

Commercial coverages are typically larger in size, and do not share in the law of large numbers to the same degree that life and personal lines do. Underwriting results have a greater degree of variability because of this. The greater degree of profit and loss potential attracts less cautious insurance executives, underwriters, and investors. This can lead to tremendous results in the stock market if you buy the commercial lines stocks just as the underwriting cycle shifts from phase 2 to phase 3, such as in 2000. It can be equally bad if you buy them as the underwriting cycle shifts from phase 4 to phase 1, such as in 1998-1999.

Reserving for commercial lines insurers is similar to that for personal lines insurers, but the main difference comes from the uncertainty of claims reporting in long-tailed coverages. With auto and home coverages, most claims are filed and settled within a few months. Almost no claims extend over two years. Now considerable environmental damage coverage: claims could be filed decades after occurrence, settlement could take years, and the size of the claim could be significantly larger than anticipated. This makes reserve setting for commercial lines insurers more of an art than a science.

Secular shifts in society can utterly change the probability and severity of claims. As an example, consider directors and officers [D&O] coverage before and after 2000. Many of the events in the corporate scandals investigated in the last few years came from events in the 1990s. Insurers writing D&O coverage in the 1990s had to raise their reserves for accident years the 1990s but the financial result was felt between 2001 and 2003.

Many industry analysts, including the rating agencies, still believe that reserves are insufficient by roughly $50 billion, and that this black hole is spread among the commercial lines insurers and reinsurers of the world. The soft market accident years of 1997-2001 are blamed for this insufficiency. The question that wins the big money for this space goes to the clever analyst that can figure out to whom the black hole belongs.

The $50 billion insufficiency is probably why the stocks of the commercial lines insurers have gone nowhere over the past six years, even in the face of a very hard insurance market over the past three to four years. Commercial lines insurers are in phase 4 of the underwriting cycle, with modest valuations at present. Until the insufficiency is dealt with, or proven false, it is our belief that commercial lines stock will remain rangebound.

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Bringing it to the Present

Well, in 2004, I was wrong here.? Leaving aside AIG, and its losses, and understated reserves, the commercial lines sector did quite well.? Yes, it is very difficult to value commercial lines insurers, because the reserving is less than scientific.? But the difficulties alleged by the rating agencies failed to appear, unless they were somehow sloshed into the hurricane disasters of 2004-5, or like eating an elephant — one bite at a time.

Earnings quality of commercial insurers is always lower than that of personal lines insurers, so the group should trade at a discount to personal lines, as it does now.? And all that said, personal lines insurers did outperform the commercial insurers, even excluding AIG.

Full disclosure: long CB (they are not cheap for insurance prices, but they don’t argue over paying claims)

If someone wants to drive a car or take out a secured loan, personal lines insurance typically needs to be bought to protect the interests of other drivers, and lenders, respectively.

Personal lines coverages are simpler in their form, in that they typically renew annually. Commissions are smaller than for life products. Reserves divide into two classes, those for the premium paid but not yet earned, and those for claims incurred. Incurred claims fall into two categories: those reported to the company, and an estimate of those incurred but not yet reported to the company [IBNR].

Personal lines insurers have two sources of profit, underwriting and investment income. The track record of the industry has been less than stellar. Most companies over the past fifteen years have lost money on underwriting and made money on investments. In general, the best managed, and most profitable personal lines writers give up sales growth in order to have an underwriting profit.

This has been less true of homeowners? insurance, where personal lines writers have consistently lost money on underwriting. Part of the reason for that is homeowners is often treated as a poor stepchild to auto insurance, and only used to generate additional automobile premium.

Performance of the personal lines insurers over the past ten years reflects the relatively hard market through 1997, with strong investment performance through 1999 not getting reflected in stock prices. Money was flowing away to technology stocks. In March of 2000, the next hard market began, and the stocks personal lines insurers rebounded, despite relatively poor performance in the investment markets.

At present, the personal lines insurers are entering phase 1 of the underwriting cycle. Premium rates are trending flat in automobile, and rising in the low single-digit percents for homeowners, but the increases are slowing. Valuations are not excessive, so there should not be a major selloff, unless premium rates soften dramatically. We expect premiums to remain flat for a while, so personal lines stocks should perform at roughly the rate of the return on equity for now.

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Bringing it to the Present

We are back to Phase 1 of the underwriting cycle.? There have been no big disasters, God-given or man-made to deplete surplus, for a long time.

My view is that the personal insurers should always trade at a premium to the commercial insurers because they are safer.? It is always easier to run a short-tail company than a long-tail company.? At present, that relationship is normal.

Personal lines companies have a tailwind in that the zeitgeist has policymakers taking actions to prevent accidents — graduated licensing, anti-drunk driving, making cars safer for drivers even it creates more cars that get totaled, while passengers survive better.

Valuations are reasonable-to-cheap in aggregate here, and the same is true of the life sector.? I am overweight insurers by a factor of six, relative to their weight in the indexes.? They comprise all of my exposure to financials.

Full disclosure: long ALL, SAFT