Foolish readers have written in to ask for tips on valuing insurance companies. I'm still grappling with that question, but I've learned a few things along the way.
Integrity is key
When valuing an insurer, Fools need to understand the intangible factors. In a nutshell, insurers sell risk protection, and their job is to put a price on uncertainty. Thus, when dealing with an insurer's financial statements, we're only seeing management's best calculated guess.
Whenever you're dealing with estimates, you have to be able to trust the person doing the calculations. Thus, your first step in valuing an insurance company should be to gauge management's quality and integrity. Dishonest managers might one day leave you with a worthless stock.
Judging management's worth can be a tricky issue. A legion of intelligent people have placed bets on both the long and short sides of Fairfax Financial Holdings
First, figure out whose side management is on. If executives own a ton of stock purchased with their own money, or they founded the company and treat it like their "baby," then they likely have a sizable monetary and emotional incentive to increase the value of its shares. That's a good thing.
On the other hand, if management doesn't have its eye on shareholder value, then it's probably sitting across the table from you. Considering they're running your company, that's bad news.
Investors should pay very close attention to compensation practices. Does management forgo its bonuses when targets aren't met? Does the company issue a ton of stock options, diluting the rest of shareholders? Also, check out the firm's acquisition track records. Does management meet its merger targets, or does it seem like the company's just building a bigger empire with shareholder money, simply to give themselves a larger paycheck?
Most importantly, investors need to figure out whether employees get compensated based on volume or profitability. Volume-based incentives rapidly deteriorate underwriting quality, as we've seen in banking, mortgage lending, and insurance. In fact, WR Berkley's
An honest management team isn't afraid of transparency, and it'll often be the one shining the flashlight. Stock Advisor recommendation Berkshire Hathaway
What they say
You can also get a feel for management by listening to earnings calls. During one conference call, I heard WR Berkley's CEO say that because his sons were involved in the business, he needed to make sure reserves were strong -- that definitely sounded like somebody I could trust.
What they do
It's almost important that management walks the walk. Check out the company's historical track record. Every year, insurers update their past estimates as they receive more information and pay claims. The changes in those estimates are booked as "reserve development."
You can find an insurer's track record of reserve development in the cumulative redundancy table. If losses turn out to be more than expected, then there's a deficiency -- the original loss estimate wasn't enough to meet actual future claims. (If losses are less than expected, there's a redundancy.)
A good example of an insurer with a conservative track record of reserve estimates is RenaissanceRe
Foolish final thoughts
Those are some of the qualitative characteristics you'll want to look for in an insurer: integrity, aligned interests, and a track record of strong performance. In the second part of this article, we'll talk about quantitative criteria.
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's disclosure policy is your best defense.