Friday, April 3, 2015

P&C Insurers and Net Investment Per Share: The 1 Column Approach to Valuation

A recent post by The Brooklyn Investor on Markel (MKL) got me thinking about the two column approach to valuing hybrid insurance / capital allocation companies like Berkshire Hathaway or Markel.

The two column approach says that an insurance company with a history of profitable underwriting (i.e. a combined ratio consistently below 100%) has two sources of valuation (actually three, but the third is an intangible aspect difficult to estimate):
  • The value of net investments per share (since investments are funded with “float,” which at a well underwrote insurer is a perpetual negative cost source of funding and therefore not a true liability).
  • Earnings (at an appropriate multiple) from non-insurance operations.
As you would expect, Warren Buffett does an immensely better job of explaining this valuation method. See the 2010 Berkshire Annual Report, page 6.

For almost all insurers, #2 above can be ignored since very few have non-insurance operations. Even Markel, which is considered a “mini-Berkshire” by many investors, earns such a small amount (at least currently) from its “Markel Ventures” subsidiary that non-insurance operations can be thought of as a rounding error (The Brooklyn Investor addressed this in a subsequent post).

So, for most insurers out there, this leaves us with 1 column: net investment per share. Many analysts feel comfortable using this metric for Markel, but it is hardly ever used when looking at the run of the mill P&C insurer. I've often wondered why that is, so I decided to run the “1 column” valuation for a group of large P&C insurers.  Net investments per share = ((cash + total investments - short-term debt - long-term debt) / shares outstanding). (Please Note: Net Investments in the table below do not adjust for deferred acquisition charges, reinsurance agreements, and other line items that may distort comparisons among companies).

The results show that Markel is not cheaper than peer P&C companies. In fact, it is above average (higher priced) when we look at the price/investments column (i.e. you’re paying $0.68 for every dollar of net investments at MKL, and only $0.575 at the average peer).

Is it justified to pay more for MKL? Many would argue yes. It has a history of solid investment portfolio performance, book value growth, and underwriting. Yet, at least over the past decade, its peers also have a history of solid underwriting (average combined ratio of 92.1% although, admittedly, many insurers have higher volatility in their combined ratio than MKL and the last decade has been somewhat benign in terms of catastrophic losses).

Will Markel's management be able to continue growing book value at double digit rates and finding attractive investment opportunities? That is the $64,000 question isn't it? While valuation relative to net investments per share can give us a feel for how richly priced shares are, like almost all Financial companies with no competitive advantage outside of people/culture, it all comes down to our faith in management.

And that brings me to the main point of thinking about this. Why don’t more large P&C insurers follow the hybrid / capital allocation model? The benefits of negative cost “float,” the inherent leverage in using unearned insurance premiums, and the virtuous cycle of reinvesting cash flows from high quality investments are all well documented. Wouldn't the entire insurance industry benefit from skewing in this direction?

Of course, this is a little bit like asking why don’t more people buy stocks when they’re cheap (or as Will Rogers once wrote: “Buy stocks that go up; if they don’t go up, don’t buy them”). Finding a really good capital allocator (like Warren Buffett or Tom Gaynor) is beyond needle in a haystack difficult. On top of this, finding an insurance organization with the discipline to consistently underwrite profitable policies (and more importantly walk away from unprofitable policies) is just as difficult.

But still, there is room for improvement. Couldn't an activists target Allstate to capture some of the value of its investment portfolio? I see hedge funds going to the trouble of starting their own reinsurance companies to get “permanent funding” . . . isn't W.R. Berkley a ready made target for permanent capital (I do realize there would be plenty of conflicts of interest in being an activist in a P&C insurer and then inserting yourself into the management of said insurers investment portfolio). Conversely, why hasn't a large insurer scooped up MKL in an effort to capture its hybrid business model on a larger asset base? (obvious answer: why would you buy a smaller company just to replace yourself and your entire executive team?).

Maybe I’m just way off base and don’t understand insurance accounting well enough. Maybe the hybrid model only works when its built from the ground up (Warren Buffett does spend a lot of time discussing culture and partnership in his writings). Or, Maybe I've been brainwashed by the value investing communities infatuation with all things Buffett. 

Whatever the answer, the “1 column” valuation approach seems to show that MKL already has some premium built in (compared to peers) for its capital allocation and underwriting skills. Is the premium high or low? Time will tell.

Disclosure: Long MKL

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