Warren Buffett has expressed doubts about acquiring additional insurance companies for Berkshire Hathaway (NYSE:BRK.B), but he might considering buying HCC Insurance (NYSE: HCC) and W.R. Berkley (NYSE:WRB). Both are excellent underwriters focused on specialty lines and have large investment portfolios that would generate higher returns as part of Berkshire, and neither company is very expensive.
On buying insurance companies
At the last annual meeting, Buffett was asked about buying more insurance companies. Without totally ruling out the possibly, he said that he'd prefer to build up Berkshire's insurance operations organically.
Question: If the commercial insurance business is attractive, why not make an acquisition? Are prices too high?
Warren: If you look at the big insurers, some of them we wouldn't want. Some of them we would, but the prices are higher than we'd pay (it's cheaper for us to build our own business, which basically costs book value). It's better to build than buy, if you can find the right people. We have a terrific manager in Ajit, and other people have sought him out. There are certain commercial operations we would've bought, but we never got the right price. I predict we'll have a good commercial insurance operation in short-time.
Why Buffett might make an exception
In certain cases, it would make sense for Berkshire to pay more than book value to acquire an existing business. Some of the most profitable, best-run insurance companies offer specialty products in niche markets. Over decades, they have developed deep underwriting expertise and customer relationships, and it would be very difficult for Berkshire to replicate their lines of businesses. It would be easier and faster to pay a little more than book value to acquire such a business.
In addition to providing access to new markets and a staff of skilled underwriters, it would immediately give access to the float that these companies generate. That float could be more effectively invested as part of Berkshire. Not only does Berkshire's financial strength allow insurance float to be invested more aggressively (including more equities), it will be in the hands of extremely talent capital allocators, namely Buffett but also Charlie Munger, Ted Weschler, and Todd Combs.
Two potentially attractive acquisitions: HCC Insurance and W.R. Berkley
Do such companies exist? To find out, I screened nearly 40 property and casualty insurance companies using the following criteria:
- Expertise in specialty markets
- Excellent underwriting track record
- Predominantly fixed-income investment portfolio
- Less than $20 billion in market cap
- Trading at less than 1.4 times book
I found two companies that fit quite well: HCC, based in Houston, Texas, and W.R. Berkley, based in Greenwich, Conn. Both companies focus on specialty markets where deep expertise has allowed them to generate excellent underwriting results.
Enviable underwriting track records
The easiest way to assess a company's underwriting track record is to review its combined ratio. Both HCC and W.R. Berkley have performed admirably by those measures -- generating similar or better underwriting results than Berkshire, which is also an excellent underwriter.
Berkshire could generate higher investments returns
Both HCC and W.R. Berkley have large investment portfolios, but they are very conservatively invested -- primarily in fixed-income securities. As stand-alone entities, this is a prudent choice. It's safe, but it limits the potential returns of the portfolio, particularly in today's low-interest rate environment.
|Investments ($MM)||% Fixed Income||Realized Income||Realized Return|
Berkshire, given its size, stability, and financial strength, can safely invest more aggressively -- only 17% of Berkshire's investment portfolio is in fixed income. A much larger chunk is invested in equities. This, along with Warren's skill as an investor, has led to much higher returns over time. If Berkshire bought one of these companies, the investment portfolio could be safely adjusted to generate significantly better returns.
The price is right
Even a great business could be a bad investment if the price is too high.
Fortunately, these two companies trade a very reasonable valuations. On the basis of price-to-book, the primary valuation metric for insurance companies, both are actually cheaper than Berkshire, which trades at 1.4 times book value. And, based on their market caps and assuming a reasonable buyout premium, Buffett could afford to purchase both in cash. And he'd still have far more than $20 billion in cash reserves.
|Market Cap ($MM)||Price/Book||Price/Earnings|
Of course, I don't know if either company wants to sell. This is a crucial question because Buffett doesn't do unfriendly deals. But if either company was interested in a sale, Buffett would be smart to make an offer. At the right price, both businesses would fit in very well at Berkshire.