This piece is the sixth out of seven in a series that I have been writing at Aleph Blog.? Here are links to the first five pieces:

• On Insurance Investing, Part 1 (reducing share count)
• On Insurance Investing, Part 2 (growing fully convertible book value per share)
• On Insurance Investing, Part 3 (price momentum and mean reversion)
• On Insurance Investing, Part 4 (Management & reserving conservatism)
• On Insurance Investing, Part 5 (Management quality & product quality)

Recently I decided to spend some time analyzing the insurance industry.? It?s a different place today than when I became a buy-side analyst ten years ago.? Why?

First, for practical purposes, all of the insurers of credit are gone.? Yes, we have Assured Guaranty, and MBIA is limping along. Old Republic still exists. Radian and MGIC exist in reduced states.? The rest have disappeared.? In one sense, this should not have been a surprise, because the mortgage and credit guaranty businesses never had a scientific model for reserving.? I?m not even sure it is possible to have that.

Second, the title insurers are diminished.? Some, like LandAmerica are gone. Fidelity National seems to be diversifying itself out of insurance, buying up a restaurant chain last year.

Third, health insurers face an uncertain future.? Obamacare may disappear, or Obamacare could slowly eliminate insurers.? It?s a mess.? Insurers debate to what degree they should compete in insurance exchanges.

But beyond all of that, valuations are fair-to-cheap across the insurance industry.? Part of that may stem from ETFs.? Insurers as a whole are smaller than the banks, but not as much smaller as they used to be.? Now, if you are a hedge fund, and you want to short banks, you probably have the best liquidity shorting a basket of financials, which shorts insurers as well.

That may be part of the issue.? There are other aspects, which I will try to address as I go through subindustries.

Offshore

By ?Offshore? I mean P&C reinsurers and secondarily insurers that do business significantly in the US, and who list primarily on US exchanges, but are not based in the US.? Most of them are located in Bermuda.

In 2011-2012, many of them were challenged by the high levels of catastrophes globally.? But the prices of the reinsurers did not fall because pricing power returned, and investors expect higher future earnings as a result.

Before I go on, I need to explain that what I will use to give a rough analysis of value is a Price-to-Book vs Return on Equity analysis [PB-ROE].? For more details, you can read my article here.? The short explanation is that companies in the insurance business (and other financials) are constrained by the amount of equity (net worth) that they have.? The ability to earn a return as a percentage of the equity [ROE] drives the market valuation as a fraction of the equity [P/B].

Here is a scatterplot for PB-ROE for the Offshore group:

 

Companies above the line may be overvalued, and companies below the line may be undervalued.? ROE is what is expected by analysts for the next fiscal year, not what has been obtained in the past.

The fit is fairly tight, and indicates mostly logical valuations for this group.? The companies that are possibly overvalued are: Arch Capital [ACGL] and Renaissance Re [RNR]. Possibly undervalued: Tower Group [TWGP] and Endurance Specialty [ENH].

Now, this simple model can fail if you have an intelligent management team that has a better model.? Arch Capital and Renaissance Re may be that.? But with an expected ROE of less than 20%, it is hard to justify their valuation, when the average stock in this group needs an expected 11% ROE to be valued at book.

Why such a high ROE to get book?? Earnings quality.? Reinsurers have noisy earnings due to catastrophes.? You don?t give high valuations to companies that run hot or cold.? But the trick here is to see who is accumulating book value the fastest ? they tend to be the stars over time.? Endurance and Arch have been good at that.

Life

The life insurance business would be simple, if it indeed were only life insurance.? Much of the industry is handed over to annuities, and all manner of asset gathering.? Even life insurance can be made more complex through variable and variable universal life, where assets are invested in stocks, and do not receive a rate from the company.

Part of the trouble is that variable products are not simple, but the insurers offer guarantees for a fee.? When I see those products, my reaction is usually, ?How do they hedge that?!?

Thus I am concerned for insurers that are ?equity-sensitive? as I reckon them.? Here is the PB-ROE scatterplot:

 

A tight fit.? The insurers that are seemingly undervalued are equity-sensitive ones: Phoenix Companies [PNX], Aegon [AEG], and ING [ING].? Those that are overvalued are Citizens [CIA], Eastern Insurance Holdings [EIHI], and Atlantic American [AAME].? For the undervalued companies, I am unlikely to buy because I am skeptical of the accounting.? I would look further down the list and consider buying some companies that are more reliable, like Assurant [AIZ], National Western [NWLI], and Fortegra Financial Corp [FRF].

One more note: to get book value in Life Insurance, you need a 9.8% ROE on average.? That?s high, but I expect that is so because investors are skeptical about the accounting.

Property & Casualty

This graph gives PB-ROE for the entire onshore P&C insurance industry:

 

It?s a good fit.? Again, the casualties of the last year weigh on the property-centric insurers, but for the most part, this is logical.

Potential underperformers include First Acceptance [FAC], Employers Holdings [EIG], and Erie Indemnity [ERIE].? Below the line: Hartford Financial Services [HIG], Hilltop Holdings [HTH] Hartford Financial [HIG], and United Insurance Holdings [USIH].

Again, these are only screening tools.? Before buying or selling, understanding management and reserving quality, and riskiness of the lines of business makes a considerable difference.? Erie Indemnity has an ?asset light? model where it manages insurers, but does not bear underwriting risk.? Hartford has a significant life insurance and annuity exposure.? Models are models, and we have to understand their limitations.

Health

With Obamacare, I don?t know which end is up.? It could end up being a giant sop to the health insurers, or it could destroy the health insurers in order to create a government single-payer model, rather than the optimal model for cost reduction, where first parties pay directly, or pay insurers.? You want reductions in medical costs, get the government out of healthcare, and that includes the corporate deduction for employee health insurance.

My rationale is this: it could mess up the private market enough that the solution reached for is a single payer solution. I?ve talked with a decent number of health actuaries on this. The ability to price risk is distinctly limited. Young people pay too much, older folks too little. That?s a formula for antiselection. I think Obamacare was badly designed. I will not achieve its ends, and when the expenses start coming in, they will be far higher than anticipated. That has been the experience of the government in health care in the US. Utilization is underestimated, the further removed people from feeling its costs.

There are many models for profitability here, which makes things complex, but here is the present PB-ROE graph:

It?s an okay fit, with the idea that the following companies might be undervalued: Wellpoint [WLP] and Humana [HUM].? And the following overvalued: ?Molina Healthcare [MOH].

I don?t regard myself as an expert on the health insurance sub-industry, so treat this with skepticism.? I include it for completeness, because I think the PB-ROE concept has value in insurance.? One more note, the PB-ROE model thinks of this as a safe investment subindustry, because to have a book value valuation, you have to have an ROE of 1.8%.

Financial Insurers

This group comprises the surviving mortgage, title and financial insurers, and two companies in the ghoulish business of buying life insurance policies from sick people.? Here?s the PB-ROE graph:

This graph is weird, because it slopes down, and does not have a good fit.? That?s because we?ve been through a rough period financially, and in many cases GAAP accounting does not do a good job with these companies that take a lot of credit risk.

We can still look for companies that have high price-to-book, and low ROEs ? note Life Partners [LPHI] and Radian [RDN] as possible sell candidates. We can also look for companies that have low price-to-book, and high ROEs ? note Assured Guaranty [AGO] and MBIA [MBI] as possible buy candidates.

This subsector is more difficult than most, because credit is not an underwritable risk.? It is feast and famine.? We are in a period of feast now, so in some ways what is bad is good.? The more risk, the more return.? But winter may come soon ? who knows what the Fed may do?? In general, I avoid this subsector for longs.

Insurance-Related Companies

This is a group that is a non-group.? It?comprises brokers and insurance service providers.? Here?s the PB-ROE graph:

It doesn?t look like much of a group.

As it is the potential outperformers include?Brown & Brown [BRO], and Aon [AON], two leading insurance brokers.? A potential underperformer Willis Group [WSH], another leading insurance broker.

Summary

Insurance is complex, and the accounting is doubly complex, which is a major reason why many stay away from it.? But insurers as a group have had reliable and outsized returns over the rememberable past, which should encourage us to do a little kicking of the tires when a decent amount of the industry trades below its net worth and is still earning money with little debt.

In my opinion, this is a recipe for earnings in the future, and why I own a lot of insurers for myself, and for clients.

In the final part of this series, I will go over some nuances of insurance accounting ? I leave it to the end because it is kind of dull, but can make a lot of difference, because some companies look cheap and aren?t really cheap.

Full disclosure: long AIZ, ENH, NWLI for clients and myself

 

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

This will be a short but important part in this series on insurance investing.? It deals with the accounting, and applies to all areas of insurance.? Insurance accounting is complex. When an insurance policy is written, the insurer does not know the true cost of the liability that it has incurred; that will only be known over time.

Now the actuaries inside the firm most of the time have a better idea than outsiders as to where reserve should be set to pay future claims from existing business, but even they don’t know for sure.? Some lines of insurance do not have a strong method of calculating reserves.? This was/is true of most financial insurance, title insurance, etc., and as such, many such insurers got wiped out in the collapse of the housing bubble, because they did not realize that they were taking one big nondiversifiable risk.? The law of large numbers did not apply, because the results were highly correlated with housing prices, financial asset prices, etc.

Even with a long-tailed P&C insurance coverage, setting the reserves can be more of an art than science.? That is why I try to underwrite insurance management teams to understand whether they are conservative or not.? I would rather get a string of positive surprises than negative surprises, and you tend to one or the other.

There are a couple ways to analyze this:

1) This had more punch when interest rates were higher, because insurance managements were more tempted to compromise underwriting, because they had compelling investment opportunities, but asking the anti-question, “How are you planning on growing the top line next year?” is a good one.

An inexperienced or liberal management team will try to talk about business opportunities.? An experienced, or conservative management team will say, “We don’t target top line growth.? We aim for growth in fully converted book value per share.? We only grow the top line when the market favors that, and ability to write risks at favorable prices is easy.”

Conservative investors should be wary of any financial company that is growing aggressively; finance is a mature industry, and sustainable competitive advantages are few.

2) What is the company’s attitude on reserving?? How often do they report significant additional claims incurred from business written more than a year ago?? Good companies establish strong reserves on current year business, which depress current year profits, but gain reserve releases from prior year strongly set reserves.

So get out the 10K, and look for “Increase (decrease) in net losses and loss expenses incurred in respect of losses occurring in: prior years.”? That value should be consistently negative.? That is a sign that he management team does not care about maximizing current period profits but is conservative in its reserving practices.

One final note: point 2 does not work with life insurers.? They don’t have to give that disclosure.? My concern with life insurers is different at present because I don’t trust the reserving of secondary guarantees, which are promises made where the liability cannot easily be calculated, and where the regulators are behind the curve.

As such, I am leery of life insurers that write a lot of variable business, among other hard-to-value practices.? Simplicity of product design is a plus to investors.

In all things as investors, aim for a margin of safety.? That is the hallmark of value investing.