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White Mountains Insurance Group
Write-up of 10-K (long)

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By RWRocksOn
April 5, 2005

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WHITE MOUNTAIN INSURANCE 10-K AND WRITE UP

http://www.whitemountains.com/

A good deal of this document/post is narrative � merely a picking through of the latest 10-K � the purpose of which is mostly to familiarize myself with this company that I have owned for the past year. The 10K runs over 250 pages long but much of the information is repetitive. I would ask those who follow the company on a regular basis to pay particular attention to the END of the post, where I outline what I perceive the major holes in what I have written, the result of my ignorance and lack of time.

HOW DID I GET THE IDEA?

I first heard of the White Mountain from a Bill Mann write-up. At the beginning of 2004, I was looking to finally suck it up and get out of the trash I owned from my Rule Maker/Rule breaker/internet tech days. I had bought BRK during 2002 and 2003 and wanted a little diversification. I had also finally heard of Jack Byrne, ironically, by reading something about Overstock.com and his son. I then found out about Byrne Sr.'s record at GEICO. I also thought that I understood two fundamental issues about insurance very well: you need to have a team that writes disciplined insurance and that uses the float wisely. I felt that although I didn't know much if anything about insurance risks or ratios, that these two fundamental qualities could be gleaned from management's past records and the reputation of those involved.

I also had the idea of looking for the next BRK. WEB's comment that he could easily make higher returns if only BRK were smaller sparked a search for a company modeled on the BRK example. I wanted to get in on the BRK growth curve about ten years ago. WTM fit the bill.

So I sold off some big losers, couple of stagnant stocks and one or two companies on which I had made a little money and bought a position in White Mountain (unfortunately, AFTER the OneBeacon acquisition).

Some Bill Mann posts on White Mountain

http://www.fool.com/news/mft/2005/mft05020231.htm

http://www.fool.com/News/mft/2004/mft04070126.htm

http://www.fool.com/portfolios/rulemaker/2002/rulemaker021106.htm

HOW WAS THE COMPANY FORMED?

White Mountain was originally founded in 1980 as a Delaware based corporation. In 10/1999, the company completed reorganization and relocated to Bermuda, probably to take gain tax benefits (they still pay US taxes on US operations but not on other operations). In 11/2004, White Mountains completed another reorganization that brought the legal and operating subsidiaries into line and allows White Mountains to manage independently the financial structures of its main operating segments.

WHAT DOES THE COMPANY DO?

WTM is in the business of property and casualty insurance and reinsurance and investing the float from these lines of business.

WHAT ARE THE REVENUE STREAMS?

White Mountains reportable segments are OneBeacon, White Mountains Re, Esurance and Other Operations.

OneBeacon is a US based property and casualty insurance underwriters that was acquired by WTM from Aviva on June 1, 2001.

White Mountain Re has the following subsidiaries: Folksamerica, SwissRe, Sirius International (acquired in 4/2004) with both international and US segments (Scandinavian RE � is in run-off since 2002) and provides reinsurance advisory services through WTM underwriting Limited.

Esurance has been a unit of WTM since 10/2002 and markets personal auto insurance directly to customers and through select online agents

Other Operations include the holding companies and two insurance companies that are in run-off.

OneBeacon Section

HOW DO THE REVENUE STREAMS HAVE DIVERSIFICATION?

WHAT ARE THE MOATS?

The 10-K has a succinct discussion of the combined ratio, which is the loss ratio (payouts/payment of insurance policies) added to the expense ratio (the ratio of commissions, taxes and other underwriting expenses to the earned premiums). As noted, one wants their company's combined ratio to be under 100% (BUT NOT AT THE EXPENSE OF UNDERWRITING DISCIPLINE.)

REVENUE STREAM: The premiums are split about evenly between specialty, commercial and personal.

MOAT: The 10-K states that OneBeacon has built specialty (niche) business that "are not subject to extreme competitive market conditions and are distinct in their product design." (marine, rural, medical, tuition reimbursement).

OneBeacon's specialty business includes a Limited Assigned Distribution (LAD) provider, AutoOne that uses a multi-tiered private passenger auto product in NY that provides flexibility to adjust to changing market and competitor conditions.

One Beacon also used a multi-tiered product called OneChoice that uses sophisticated pricing models that have a greater statistical correlation between historical loss experience and price than traditional pricing models have shown. This allows management to renew a policy at more favorable rates instead of having to choose between letting the policy expire and renewing the policy at an unfavorable rate.

Management believes "that segmentation is a key driver of OneBeacon's success in specialty lines."

HOW ARE REVENUE STREAMS BEING GROWN?

Growth has been both internal and external.

The purchase of OneBeacon was transforming for White Mountains.

In just the past year, OneBeacon has acquired Atlantic Specialty. They have also entered into new lines like excess and surplus property insurance, forming advisory relationships with reciprocal insurance exchanges.

Revenues streams are also grown by cost containment. OneBeacon has developed systems for tracking insurance fraud and used in-house counsel and audit teams to reduce outside billings. They have targeted litigation management, expense management and staff productivity as additional areas for improvement in 2005.

They are also diversifying product lines and expanding geographically. http://biz.yahoo.com/prnews/050404/nem030.html?.v=5

RISKS:

Asbestos: One Beacon has re-in coverage from highly rated companies (NICO and GenRe � both subsidiaries of BRK). Here is a link to a discussion of reserving for risk off the BRK board: http://boards.fool.com/Message.asp?mid=18275701

Terrorism: the 10K discussed the Terrorism Risk Insurance Act on page 15. OneB will retain $160m for commercial policies subject to the Terrorism Act. The Act is up for renewal in 2005. OneB has resisted the head n the sand approach to terrorism losses and worked to reduce its risk in major metropolitan areas by using probable maximum loss (PML) modeling.

One Beacon purchases re-insurance for its catastrophe business (de facto hedging).

The point is made that risk is not passed on to re-in but rather OneB retains an obligation to its ceding companies and must collect from the re-in company.

Loss and loss adjustment expense reserves are outline on page 10K-15-16 and in more detail from page 65 on. These are case reserves for claims reported and reserves for losses that have occurred but for which claims have not yet been reported (IBNR). There is a somewhat (for me) mind-numbing explanation of losses, accounting and prediction models for the subsequent 10 pages or so.

Pension plan: OneBeacon had a retirement pension plan at acquisition that WMT curtailed in 2002. Expensing for the plan is described on page 77.

WHAT IS THE POTENTIAL FOR GROWTH?

One Beacon's policies are concentrated in NY and Massachusetts.

White Mountain Re Section:

HOW DO THE REVENUE STREAMS HAVE DIVERSIFICATION?

Lead capacity for reinsurance in three main classes �liability, property and health. WMRe receives no more than 10% of gross premium from an individual ceding company but about 50% of premiums are written through three major third party brokers (Benfield, AON and Guy Carpenter). Geographically, 67% is written for US, the majority of the remainder for Europe and then some in Asia and the rest of the New World.

Direct program insurance (through Sirius America)

Reinsurance advisory services

WHAT ARE THE MOATS?

HOW ARE REVENUE STREAMS BEING GROWN?

External growth: Since 1995 White Mountain Re has completed ten acquisitions of fundamentally sound businesses that were owned by organizations that no longer considered them core businesses.

11/2004 � acquired Tryg-Baltica Forsikring, which was placed into run-off although Sirius International will renew select business.

3/2004 � Sierra Insurance group was purchased and placed into run-off with the claims administration being managed by a TPA (third party administrator).

Internal growth:

The premiums written by White Mountain Re have grown from $688m to $1.2B over the past three years.

WHAT IS THE POTENTIAL FOR GROWTH?

External: there is always the potential for acquiring new companies, but none are mentioned specifically in the 10-K

RISKS:

There is a nice explanation of using the rein business and treaty and facultative basis on 10k-18. Basically, treaty is on the basis of time and facultative is on the basis of risk category. Rein can also be written on a quota basis. The 10-K again makes the point that there can be a significant period of time elapsing between receipt of premium and payment of claims.

Loss reserves are outlined on 10K p 23.

Esurance Section:

Was acquired by WM in 2000, located in San Francisco and is mostly an on-line company.

HOW DO THE REVENUE STREAMS HAVE DIVERSIFICATION?

Esurance writes policy in 17 states with CA, FL and TX dominating the business.

WHAT ARE THE MOATS?

Uses tiered, highly segmented risk categories keeps prices competitive without compromising loss ration targets. There is heavy competition for market share.

HOW ARE REVENUE STREAMS BEING GROWN?

Esurance advertises both on line and off line.

Costs are reduced by the use of the Internet and phone where no commissions are paid.

Rapid claims processing reduces secondary claims (like rental cars) and they have active investigations to counteract fraud.

WHAT IS THE POTENTIAL FOR GROWTH?

Esurance can grow geographically into other states

RISKS:

LAE is presented on page 27.

Other Operations:

This intermediary companies provide financing for White Mountain. Fund America and Fund America Enterprises Holding Inc. There are several other companies that are in run-off

HOW DO THE REVENUE STREAMS HAVE DIVERSIFICATION?

Through FA BRK purchased both warrants and preferred stock. The preferred stock pays a mandatory dividend of 2.35% per quarter and the warrants were exercised in 2004 for $294m in cash.

Zenith also owns preferred stock with dividends ranging from 2.5% per quarter to no less than 3.5% per quarter.

WHAT ARE THE MOATS?

N/A

HOW ARE REVENUE STREAMS BEING GROWN?

Other operations have invested in Montpelier Re, Symetra.

WHAT IS THE POTENTIAL FOR GROWTH?

Sky's the limit. Investing may shift out of relatively low paying fixed maturity instruments and into common equities if the market produces value picks.

RISKS:

Investments:

The majority of WTM total of $10b investments consist of fixed maturity investments (75%), but there is also some investing in equities and short-term investments. The return on invested assets was 7% in 2004 and 20% from the equity portfolio.

Montpelier Re (I own shares of MRH): WTM, the Benfield group and several other private investors establish MRH with $1b in capital to take advantage of the favorable underwriting and pricing environment. WTM currently carries 7.2m warrants of Montpelier exercisable until 12/2011 at $16.67 per share (recent stock price is $34) and owns about 6m shares from the initial offering.

White Mountain also invests in Symetra and Main Street America.

HOW DOES MANGEMENT SHOW QUALITY?

Jack Byrne has an amazing record from GEICO, although he is now only on the Board. I have heard good things about John Gillespie and Ray Barette on the Internet and would be interested if anyone has a Morningstar write-up of either of these two chaps. I would also consider the holding by BRK to be an endorsement by WEB

WTM has four operating principles espoused in their 10-K and on their website that brings tears to my eyes. Underwriting comes first, maintaining a disciplined balance sheet, invest for total return, think like owners.

One Beacon enjoys an A credit rating from AM Best (3/15 ranking). From the 10-K: "OneBeacon's objective is to underwrite only profitable business without regard to market share or premium growth". Sirius International, Sirius America and Folksamerica all are rated A by Best (3/15 possible)

Tiered pricing, PML modeling

SOME NUMBERS:

Current market cap is $5.4b and there are 10.8m shares outstanding. Shares jumped in 2001 with raising capital for the OneBeacon purchase from 5.8 million to 8.2m and then additional warrants have been exercised, mostly by BRK (which owns 16% of WTM).

VALUATION: Current fully converted diluted book value per share is about $340 giving a P/B (diluted and converted) of 1.76. The converted book value has risen 82% since the end of 2000 while the stock price has risen a similar amount (88%). P/B (converted) for the 2000�2003 has been 1.68, 1.54, 1.25, 1.57. The stock price approached 700 earlier in 2005 for a ratio that temporarily exceeded 2.

Up to date ratios can be found here for the major segments of White Mountain: http://www.whitemountains.com/financials/article.cfm?articleid=299

OneBeacon: net premiums written have varied from $2.5b, $1.97b and $2.5b over the past three years. The company cost WTM $1.2b in debt and warrants

White Mountain Reinsurance has $8.2b and $3.7b in total assets and $1.7b and $1.0b in shareholder equity in 2004 and 2003 respectively.

Esurance made a profit for the first time in 2004.

                   2002            2003                2004

Equity        2,407,900,000    2,979,200,000      3,883,900,000

Net income    88,000,000      281,000,000        419,000,000

Assets      17,267,000,000   15,882,000,000     19,015,000,000

Liabilities                   12,902,800,000     15,131,200,000

EV                             1,151,000,000      4,344,000,000

ROE            3%               9%                 10%

ROA          0.5%             1.7%                2.2%

Debt/equity       33          .25                 .20

Increase in equity            23%                 30%

EV is market cap + liabilities � assets

I backed out a $660 million from net income in 2002 that was a result of accounting reclassification only.

ROE and ROA used end of year assets and equity.

WTM recently increased its dividend to $8 per share.

MY TAKE:

The basic premise of White Mountain is to produce a float at low cost with disciplined underwriting and then use the float to make acquisitions and investment that add to per share equity. I have found that once you start looking deeper than this statement, it is extremely difficult to get your arms around the company, due to the diverse nature of its subsidiaries and the time interval between premium collection and loss payout in the insurance business.

In perhaps no other industry does the focus on long term over short-term results reflect the quality of management as in the insurance and especially the reinsurance business. I would imagine that over a ten year period I would like to see the net premiums for One Beacon going up, but I think that for a three year period, the net premium number, or the change theretofore, should almost be ignored � it's the risk the premiums bring to the loss ratio that are important, not the raw number.

In a similar manner, the annual variations in ROE and ROA are almost to be ignored. Management also remarked that their float has largely been acquired � and that cash flow from operations can be negative as investments acquired are used to pay off claims as run-off proceeds. The figures that I like to look at are the percent increase in equity relative to the debt ratio. I think that rise in the former contrasted to the fall in the latter shows that WTM is becoming more and more able to fund its own acquisitions � and so hopefully will not have to rely on external financing or issuing any more shares.

The capital structure is outlined on 10K-59. They use a total debt and preferred stock to total tangible capital ratio of 21% for 2004 and 24% for 2003. They have benefited from the perceived strength of the company by being able to issue Senior Notes and retire a $740m amortizing bank facility. The senior notes issued by Fund America are only rated 10/24 and 9/24 by Fitch/s, Moody's and S&P.

But the real value of White Mountain is in the mission statement:

http://www.whitemountains.com/about/article.cfm?articleid=161

My words are so much noise set against this background.

Management claims to be in alignment with shareholders. Are they? In 2000, the Company issued a one-time award of 81K options, with the exercise price based on the market value on the grant date (2/6/2000) plus a 6% per annum increase over the 10-year life of the options. Options reduced earnings per share by about 6%. There are 46K options outstanding with 10K exercisable at the end of 2004.

General and administrative costs were up over 50% last year, mostly due to the increase in incentive compensation accruals that were driven by a 41% increase in WTM stock price during the year, but WTM fully expenses the cost of such programs every year (10-K �61). The amount of long-term compensation will drop off dramatically in the next 3-5 years.

The long-term incentive plan is described starting page F-47. These are performance based and the principal performance share goal is after tax corporate return on equity measured by growth in its intrinsic value per share. This is a weighted ratio (and would be interesting to apply over a period of years and to other companies) with a 50% weighting to growth in economic value per share and 25% each in tangible GAAP book value per share and growth in market value per share. The company paid out $40m in 2004.

OneBeacon and Folksamerica have performance plans as well.

The Byrne family owns about 20% of WTM and although Jack Byrne recently sold off some stock, it represented about 3% of his family's holding in WTM. He personally retains about a million shares. http://biz.yahoo.com/prnews/050308/netu049_1.html

While investment income has bee stagnant over the past three year (366m, 290m, 360m), common equity security income has risen 6.6m to 9.5m to 15m over the same time frame and realized gains from for 2004, including Montpelier Re shares were $100 m. It will be interesting to see if WTM is able to continue increasing total return from common equities.

To buy or not to buy?

Hard to say that WTM would be undervalued with its current P/B and P/E ratios. White Mountains share price has risen steadily over the past ten years: http://investor.whitemountains.com/phoenix.zhtml?c=103286&p=irol-edgarchart with an abrupt take off after being able to pull off the OneBeacon acquisition (albeit with taking on debt and diluting shares). This ability combined with the sterling background of the management and the operating principles are likely the reason that the market puts a premium on the P/B value (which at times has been greater than 2) and why I would consider looking to load up during this time of general pessimism about the insurance industry if the price continues to drop as it has over the past three months.

It would take a lot to recommend selling WTM, giving its proven ability to make large acquisitions with a sudden boost in shareholder equity. In addition, one assumes that about 35% of the shares aren't going to trade much (Byrne + BRK holdings)

Issues I'd like to see addressed:

What is the general purpose of buying an insurance company and then placing it into run-off?

An acquisition-by-acquisition analysis of White Mountain's growth over the past year?

An explanation of how the Liberty Acquisition works.

Pension plan issues (10 K pages F-42 - 46)

I have to get this somewhat incomplete write-up out the door or my fingers will fall off from typing, but I look forward to constructive criticism and additions to my thoughts.


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