Investing in Property and Casualty insurance business (P&C)

This post is written to remind me of what to look out for when investing in P&C companies. Charlie Muger cautioned that for most of us, we will often miss out things if we don’t use a check list. Thus I’ve created a ‘checklist’ in the second part of the post for companies to pass before I would purchase them.
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What is P&C?


Property/casualty insurance is insurance on homes, cars, and businesses. Technically, property insurance protects a person or business with an interest in physical property against its loss or the loss of its income-producing abilities. Casualty insurance mainly protects a person or business against legal liability for losses caused by injury to other people or damage to the property of others.

Commercial Lines
-automobile
-businessowners (property and liability combined for smaller commercial customers)
-capital assets (output policy)
-crime and fidelity
-electronic commerce
-employment-related practices liability
-equipment breakdown (formerly boiler and machinery)
-farm
-financial institutions
-general liability
-inland marine (diverse commercial goods and properties)
-management protection
-market segments
-medical-professional liability
-package policies (property and liability combined)
-property
-umbrella
-workers compensation

Personal Lines
-automobile
-dwelling property
-homeowners (property and liability combined)
-inland marine (diverse personal goods)
-personal liability (including personal umbrella)

(source: http://www.iso.com/index.php?option=com_content&task=view&id=12&Itemid=399)


The Checklist


1. Combined Ratio should be low.


2. Expense Ratio should be low if they are a low cost competitor (who issnt?)


3. Loss Ratio should be low, but not artificially manufactured by under-reserving. Warren Buffett talks about the buried suit problem. If a family buried their deceased in a rented tux, the bills will arrive long after the person dies.

4. Cost of Float if positive (ie UNprofitable underwriting) should be low compared to risk free government yield. If it is negative, then people are providing capital to the firm to invest at cheaper than free rate.


5. Book value (adjusted for distributed earnings) gives a good indication of historical growth rate of intrinsic value.


6. Investment performance determines the long term prosperity of many firms


7. P&C firms NEED to have extraordinary financial strength (indicators: net debt to total capital & liquid asset to potential claims)

8. Insiders should be significant shareholders due to the buried suit problem. In the insurance industry, due to the long tail liabilities , companies with heavy insider ownership have a greater incentive to think long term and engage only in profitable underwriting.

This and That
Managerial talent matters a lot in this industry as most firms have inherently no moat / competitive advantage. Superb underwriter combined with superb investor and low overhead promises a potential bonanza for investors.

Be ready to accept the underwriting cycle. A few years of profitability will attract new entrants ready to do business at any price, thus pushing premium to unacceptably low level. When catastrophe happens, weaker firms gets wiped out and industry goes back to profitability. The industry has generated high underwriting profit and prices have soften considerably over the past 2 years, have lower expectation in the near term.

See the following quote on an example of strict underwriting discipline.

From OdysseyRe’s 2007 Annual Report
“As the market becomes more challenging, we will respond by heightening OdysseyRe’s commitment to disciplined underwriting. Shareholders can expect us to purposefully contract our business in response to the deteriorating climate.”
Andrew A. Barnard,
President and Chief Executive Officer
OdysseyRe

Due to the fat tail, (imagine Katrina, 911 and Sichuan Earthquake happening in a same place at the same time), invest in insurer who have a good knowledge of what they are insuring (think Buffett or Ajit Jain). If not, stick with insurers that underwrites events that falls in a normal curve, auto accidents, fire accidents, property, etc (GEICO, Progressive, Chubbs).

On the previous point of importance of insider share ownership, see the recent ouster of AIG’s CEO Martin Sullivan which has lost discipline in investing and capital structure vs. previous CEO Hank Greenberg (one of AIG’s largest shareholder) who has kept debt low, kept expenses low, and generated good underwriting profit and growth for decades.

Other examples include Markel (80+% of shareholders are employees), Berkshire Hathaway (Buffett + Munger…duh), and Fairfax Financial Holdings (Canadian investor Prem Wasta).

Appendix
-Cost of float is calculated by dividing Underwriting profit / (loss) by float.
-Definition of Float (from Buffett’s 2001 letter)
To begin with, float is money we hold but don’t own. In an insurance operation, float arises because premiums are received before losses are paid, an interval that sometimes extends over many years. During that time, the insurer invests the money. This pleasant activity typically carries with it a downside: The premiums that an insurer takes in usually do not cover the losses and expenses it eventually must pay. That leaves it running an "underwriting loss," which is the cost of float. An insurance business has value if its cost of float over time is less than the cost the company would otherwise incur to obtain funds. But the business is a lemon if its cost of float is
higher than market rates for money.

…we have calculated our float..by adding net loss reserves, loss adjustment reserves, funds held under reinsurance assumed and unearned premium reserves, and then subtracting insurance related receivables, prepaid acquisition costs, prepaid taxes and deferred charges applicable to assumed reinsurance.