If you're interested in investing in property & casualty (P&C) insurance companies, you might find it helpful to look at a basic framework for evaluating them. I present to you a checklist covering five key areas: management, underwriting, reserves, investments and valuation. At the Motley Fool, we're big fans of using investment checklists -- it's a great way to improve your investment process. Below you'll find a description of each item on my checklist along with illustrative examples.
When investing in an insurance company, management is by far the most important consideration. Insurance is a leveraged business, and the financial statements are comprised of a lot of discretionary estimates. If a company's management isn't capable and honest, then it's not worth investing in.
The first two things to check are track record and incentives. Look at growth in book value per share, returns on equity, capital allocation decisions, etc. Does management have a history of generating value for shareholders? Pull up the company's proxy statement and determine if management's incentives are aligned with shareholders. The best compensation policies are based on long-term metrics that drive shareholder returns, such as returns on capital, underwriting profitability, and growth in book value per share.
Example: Markel (NYSE: MKL), a Richmond, Va.-based specialty insurer, has a first-class management team with a great track record. Over the past 20 years, the company has delivered book value per share growth of 16% annually. I also think Markel has the best incentive system in the corporate world (if you know of a better one, tell me so I can research the company). Pay for top executives is based on growth in book value per share over a rolling five-year period. It's simple, but highly effective at ensuring alignment with shareholder interests.
Make sure the company is a disciplined underwriter. Check the company's combined ratio over the past five or 10 years. Anything less than 100 indicates that underwriting is profitable -- the more consistently a company is able to underwrite profitably, the better.
Example: HCC Insurance (NYSE: HCC), a specialty insurer based in Texas, is one of the country's most consistently profitably underwriters. The company empowers its underwriters to make almost all policy decisions, but the underwriters compensation is based on the profitability of the policies they approve. As you might imagine, this structure has created a very disciplined underwriting culture. Over the past five years, the company has underwritten at a combined ratio between 84 and 91.
The amount of reserves is based on management estimates. So, it's important to make sure management has a conservative history of reserving. If management has under-reserved, then current profits are likely overstated, and future profits will eventually suffer. If you look at the company's 10-K, there is historical data on the company's reserved and payouts. You want to make sure the company doesn't have a history of deficiencies.
Example: RLI Corp (NYSE: RLI) is probably the best insurer that you've never heard of. It's a small, well-run insurer in Illinois. Historically, the company has been conservative in its reserves -- present estimates indicate reserve redundancies every year going back to 2003. In total, I've estimated that company was nearly 30% over-reserved at the end of 2012.
Most insurers hold pretty conservative fixed income portfolios, but that's not always the case, so it's important to review the investments. Look at the split between bonds and equity. Look at the credit ratings and duration of the fixed income portfolio. Generally, make sure you're comfortable with the assets. If the company has a strong investor managing its float, like Tom Gayner at Markel, that's a definite plus.
Example: HCI Group (NYSE: HCI), a Florida-based homeowner's insurer, has an interesting investment strategy. Its portfolio consists mostly of the cash with a small allocation to bonds and a minuscule allocation to equities. That alone is unusual, but the company also has investments in a restaurant, two marinas, and an Indian IT firm. Obviously, cash doesn't generate investment returns. Owning waterfront businesses in Florida is a risky move for a hurricane insurer, and investing in an Indian IT business is definitely an out-of-the-box move.
CEO Paresh Patel says HCI is holding cash in order to profit from increasing interest rates. He also explains that the company is following the path laid out by Warren Buffet and Berkshire Hathaway by purchasing non-insurance related businesses. But, the company lacks a successful investment track record or a proven investor on the management team. In the end, there's too much uncertainty in the company's investment strategy, which reinforces my view that HCI could be a very risky investment.
Personally, I don't obsess over valuation -- I wouldn't ever buy an insurer solely because a valuation model says it's cheap. But I don't ignore valuation, either. The price you pay will determine your returns. So, you should always estimate valuation and potential returns, but keep it very simple.
First, estimate normalized underwriting profits (combined ratio times premium volume) and normalized investment profits (investments times annual returns). Sum those two estimates, take out taxes, and you'll have rough estimate of total normalized profits. Divide that by the company's market capitalization, and the result should be rough indicator of future returns. That's my back-of-the-envelope approach, which I always use as a first pass. If the company is really interesting, I'll go into more detail or make modifications. Of course, it's not the only approach -- feel free to use another valuation methodology.
Example: Safety Insurance Group (NASDAQ: SAFT) is a small Massachusetts-based auto insurer. Using the basic approach described above, I estimated potential returns based on today's price. The result is roughly 10% annually over the next five to 10 years.
Here's how I came up with that estimate: The company earned $674 million in premiums over the past year. A combined ratio of 95, which is the company's average over the past 10 years, implies $34 million in pre-tax underwriting profit. And, the company has $1.2 billion in investments, almost all fixed income. Over the long term, that portfolio should be able to earn around 4% annually, or $49 million per year.
The company also generates about $18 million per year in fees, which should be factored into total pre-tax profits of $102 million annually. After paying 29% of that in taxes, the company's net profits are $72 million. By dividing that profit estimate by the company's current market cap of $857 million, I get an estimated return of 8%.
Note, my assumption didn't account for any potential growth. Safety Insurance won't grow much, but its profits should increase by about 2% per year just based on population growth, inflation, etc. That would increase total returns to 10% annually -- for most investors, that equates to roughly fair value. But, as I've said, it's a very rough, imprecise estimate based on average returns over a long time period. Actual returns could vary widely. Because the future is unknown, valuation is more art than science.
Foolish bottom line
The property & casualty insurance industry can be challenging place to invest. It's important understand the basics of a company -- management, underwriting, reserves, investments, and valuation -- before investing. It doesn't guarantee success, but it will definitely increase your chances of it.