The economics and operations of a reinsurer are not entirely unlike those of a private equity or hedge fund: Both involve small groups of people wielding billion-dollar arsenals to bet on the outcome of future events. Thus, it's no surprise that many new reinsurers are financed by their hedge and private equity brethren.
I think Flagstone Reinsurance Holdings (NYSE: FSR ) is one of a new crop of recent reinsurer IPOs that fits this hybrid model and could be a solid long-term performer.
However, reinsurance can be a risky business. White Mountain (NYSE: WTM ) Chairman Jack Byrne, a man Warren Buffett has described as the "Babe Ruth of insurance," lost virtually all of his investment in reinsurance sidecar Olympus Re after the shocking hurricane losses of 2005. Other investors who took a hit on Olympus include Franklin Resources (NYSE: BEN ) , Third Avenue, Fairholme Capital, and Och-Ziff.
Who's the boss?
A bet on a reinsurer is basically a bet that the guys running it will make you money without taking on too much risk. Although reinsurance is less of a commodity than primary insurance, the primary competitive advantage any reinsurer ultimately has is the skill and discipline of its management team. It's not much of a surprise that Berkshire Hathaway stands atop the reinsurance industry, thanks to Ajit Jain and Warren Buffett.
On that count, Flagstone scores very high in the management department. The company was founded by Chairman Mark Byrne (you guessed it -- Jack's son) and CEO David Brown, who own a combined 12% of the company. The two had previously teamed up together to run a fixed-income arbitrage hedge fund that managed more than $1 billion in assets. The chief underwriting officers (CUOs) are Guy Swayne, who cut his teeth as CUO of ACE's (NYSE: ACE ) Tempest Re unit, and Gary Prestia, who was previously CEO of Alea's North American Reinsurance division.
Conservative is as conservative does
Flagstone's modus operandi is similar to the value investing philosophy that it's OK to underperform in the short term if that means avoiding foolish risks and having enough ammo for when the fattest pitches are thrown.
In an article with Bermuda Reinsurance Magazine, CEO David Brown stated: "When we raised capital, we promised lower returns than our competitors. ... What I mean is that if the wind doesn't blow and the earth doesn't shake, that we'll make lower returns than our competition, who are more highly levered. The offset to that is that when those natural perils do occur, we expect to report a smaller loss than others."
Thus, Flagstone is willing to accept lower returns in exchange for lower risk. If a substantial loss event occurs, Flagstone will have a lot of dry powder to make a lot of really favorable bets. This strategy worked very well for disciplined reinsurers following Hurricane Katrina-induced 2005 losses. Reinsurers who weren't too exposed had the capacity to reap the profits of much harder pricing in 2006, which was one of the best years in recent memory for the property-and-casualty space.
Flagstone, which was capitalized in the wake of Hurricane Katrina, was founded on this very premise of waiting for the most opportune times to place a bet.
Management stated in the latest earnings call that Flagstone targets 17% annual growth in book value per share. Given that reinsurance is an extremely unpredictable business, the ride is sure to be bumpy, so the company reasonably evaluates the measure over three-year increments.
At the end of the last quarter, book value per share stood at $12.31. The stock price is almost identical to the IPO price of $13.50, meaning Flagstone is trading at a modest 10% premium to book value. In contrast, fellow reinsurers Montpelier Re (NYSE: MRH ) , RenaissanceRe (NYSE: RNR ) , and Arch Capital Group (Nasdaq: ACGL ) trade at 30%, 67%, and 45% premiums, respectively.
Thus, it's reasonable to assume that Flagstone's 10% premium to book has upside potential as the company establishes itself, so investors buying in near this current premium could get a bit more bang for their buck on top of the underlying growth in book value per share.
Please keep in mind, though, that reinsurance is a highly volatile industry. Still, given Flagstone's pedigreed management and conservative attitude, I think buying its shares could be a favorable risk-return proposition.
Berkshire Hathaway is a Motley Fool Inside Value recommendation, while Montpelier Re is a recommendation of Motley Fool Hidden Gems. Both are recommendations in Motley Fool Stock Advisor as well. Try any of our investing services free for 30 days.
Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.